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Technically Speaking: The 4-Phases Of A Full-Market Cycle

In a recent post, I discussed the “3-stages of a bear market.”  To wit:

“Yes, the market will rally, and likely substantially so.  But, let me remind you of Bob Farrell’s Rule #8 from our recent newsletter:

Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend

  1. Bear markets often START with a sharp and swift decline.
  2. After this decline, there is an oversold bounce that retraces a portion of that decline.
  3. The longer-term decline then continues, at a slower and more grinding pace, as the fundamentals deteriorate.

Dow Theory also suggests that bear markets consist of three down legs with reflexive rebounds in between.

However, the “bear market” is only one-half of a vastly more important concept – the “Full Market Cycle.”

The Full Market Cycle

Over the last decade, the media has focused on the bull market, making an assumption that the current trend would last indefinitely. However, throughout history, bull market cycles make up on one-half of the “full market” cycle. During every “bull market” cycle, the market and economy build up excesses, which must ultimately be reversed through a market reversion and economic recession. In the other words, as Sir Issac Newton discovered:

“What goes up, must come down.” 

The chart below shows the full market cycles over time. Since the current “full market” cycle is yet to be completed, I have drawn a long-term trend line with the most logical completion point of the current cycle.

[Note: I am not stating the markets are about to crash to the 1600 level on the S&P 500. I am simply showing where the current uptrend line intersects with the price. The longer that it takes for the markets to mean revert, the higher the intersection point will be. Furthermore, the 1600 level is not out of the question either. Famed investor Jack Bogle stated that over the next decade we are likely to see two more 50% declines.  A 50% decline from the all-time highs would put the market at 1600.]

As I have often stated, I am not bullish or bearish. My job as a portfolio manager is simple; invest money in a manner that creates returns on a short-term basis, but reduces the possibility of catastrophic losses, which wipe out years of growth.

Nobody tends to believe that philosophy until the markets wipe about 30% of portfolio values in a month.

The 4-Phases

AlphaTrends previously put together an excellent diagram laying out the 4-phases of the full-market cycle. To wit:

“Is it possible to time the market cycle to capture big gains? Like many controversial topics in investing, there is no real professional consensus on market timing. Academics claim that it’s not possible, while traders and chartists swear by the idea.

The following infographic explains the four important phases of market trends, based on the methodology of the famous stock market authority Richard Wyckoff. The theory is that the better an investor can identify these phases of the market cycle, the more profits can be made on the ride upwards of a buying opportunity.”

So, the question to answer, obviously, is:

“Where are we now?”

Let’s take a look at the past two full-market cycles, using Wyckoff’s methodology, as compared to the current post-financial-crisis half-cycle. While actual market cycles will not exactly replicate the chart above, you can clearly see Wyckoff’s theory in action.

1992-2003

The accumulation phase, following the 1991 recessionary environment, was evident as it preceded the “internet trading boom” and the rise of the “dot.com” bubble from 1995-1999. As I noted previously:

“Following the recession of 1991, the Federal Reserve drastically lowered interest rates to spur economic growth. However, the two events which laid the foundation for the ‘dot.com’ crisis was the rule-change which allowed the nation’s pension funds to own equities and the repeal of Glass-Steagall, which unleashed Wall Street upon a nation of unsuspecting investors.

The major banks could now use their massive balance sheet to engage in investment-banking, market-making, and proprietary trading. The markets exploded as money flooded the financial markets. Of course, since there were not enough ‘legitimate’ deals to fill demand and Wall Street bankers are paid to produce deals, Wall Street floated any offering it could despite the risk to investors.”

The distribution phase became evident in early-2000 as stocks began to struggle.

Names like Enron, WorldCom, Global Crossing, Lucent Technologies, Nortel, Sun Micro, and a host of others, are “ghosts of the past.” Importantly, they are the relics of an era the majority of investors in the market today are unaware of, but were the poster children for the “greed and excess” of the preceding bull market frenzy.

As the distribution phase gained traction, it is worth remembering the media and Wall Street were touting the continuation of the bull market indefinitely into the future. 

Then, came the decline.

2003-2009

Following the “dot.com” crash, investors had all learned their lessons about the value of managing risk in portfolios, not chasing returns, and focusing on capital preservation as the core for long-term investing.

Okay. Not really.

It took about 27-minutes for investors to completely forget about the previous pain of the bear market and jump headlong back into the creation of the next bubble leading to the “financial crisis.” 

During the mark-up phase, investors once again piled into leverage. This time not just into stocks, but real estate, as well as Wall Street, found a new way to extract capital from Main Street through the creation of exotic loan structures. Of course, everything was fine as long as interest rates remained low, but as with all things, the “party eventually ends.”

Once again, during the distribution phase of the market, the analysts, media, Wall Street, and rise of bloggers, all touted “this time was different.” There were “green shoots,” it was a “Goldilocks economy,” and there was “no recession in sight.” 

They were disastrously wrong.

Sound familiar?

2009-Present

So, here we are, a decade into the current economic recovery and a market that has risen steadily on the back of excessively accommodative monetary policy and massive liquidity injections by Central Banks globally.

Once again, due to the length of the “mark up” phase, most investors today have once again forgotten the “ghosts of bear markets past.”

Despite a year-long distribution in the market, the same messages seen at previous market peaks were steadily hitting the headlines: “there is no recession in sight,” “the bull market is cheap” and “this time is different because of Central Banking.”

Well, as we warned more than once, all that was required was an “exogenous” event, which would spark a credit-event in an overly leveraged, overly extended, and overly bullish market. The “virus” was that exogenous event.

Lost And Found

There is a sizable contingent of investors, and advisors, today who have never been through a real bear market. After a decade long bull-market cycle, fueled by Central Bank liquidity, it is understandable why mainstream analysis believed the markets could only go higher. What was always a concern to us was the rather cavalier attitude they took about the risk.

“Sure, a correction will eventually come, but that is just part of the deal.”

As we repeatedly warned, what gets lost during bull cycles, and is always found in the most brutal of fashions, is the devastation caused to financial wealth during the inevitable decline. It isn’t just the loss of financial wealth, but also the loss of employment, defaults, and bankruptcies caused by the coincident recession.

This is the story told by the S&P 500 inflation-adjusted total return index. The chart shows all of the measurement lines for all the previous bull and bear markets, along with the number of years required to get back to even.

What you should notice is that in many cases bear markets wiped out essentially all or a very substantial portion of the previous bull market advance.

There are many signs suggesting the current Wyckoff cycle has entered into its fourth, and final stage. Whether, or not, the current decline phase is complete, is the question we are all working on answering now.

Bear market cycles are rarely ended in a month. While there is a lot of “hope” the Fed’s flood of liquidity can arrest the market decline, there is still a tremendous amount of economic damage to contend with over the months to come.

In the end, it does not matter IF you are “bullish” or “bearish.” What matters, in terms of achieving long-term investment success, is not necessarily being “right” during the first half of the cycle, but by not being “wrong” during the second half.

Previous Employment Concerns Becoming An Ugly Reality

Last week, we saw the first glimpse of the employment fallout caused by the shutdown of the economy due to the virus. To wit:

“On Thursday, initial jobless claims jumped by 3.3 million. This was the single largest jump in claims ever on record. The chart below shows the 4-week average to give a better scale.”

This number will be MUCH worse when claims are reported later this morning, as many individuals were slow to file claims, didn’t know how, and states were slow to report them.

The importance is that unemployment rates in the U.S. are about to spike to levels not seen since the “Great Depression.” Based on the number of claims being filed, we can estimate that unemployment will jump to 15-20% over the next quarter as economic growth slides 8%, or more. (I am probably overly optimistic.)

The erosion in employment will lead to a sharp deceleration in economic and consumer confidence, as was seen Tuesday in the release of the Conference Board’s consumer confidence index, which plunged from 132.6 to 120 in March.

This is a critical point. Consumer confidence is the primary factor of consumptive behaviors, which is why the Federal Reserve acted so quickly to inject liquidity into the financial markets. While the Fed’s actions may prop up financial markets in the short-term, it does little to affect the most significant factor weighing on consumers – their jobs.

The chart below is our “composite” confidence index, which combines several confidence surveys into one measure. Notice that during each of the previous two bear market cycles, confidence dropped by an average of 58 points.

With consumer confidence just starting its reversion from high levels, it suggests that as job losses rise, confidence will slide further, putting further pressure on asset prices. Another way to analyze confidence data is to look at the composite consumer expectations index minus the current situation index in the reports.

Similarly, given we have only started the reversion process, bear markets end when deviations reverse. The differential between expectations and the current situation, as you can see below, is worse than the last cycle, and only slightly higher than before the “dot.com” crash.

If you are betting on a fast economic recovery, I wouldn’t.

There is a fairly predictable cycle, starting with CEO’s moving to protect profitability, which gets worked through until exhaustion is reached.

As unemployment rises, we are going to begin to see the faults in the previous employment numbers that I have repeatedly warned about over the last 18-months. To wit:

“There is little argument the streak of employment growth is quite phenomenal and comes amid hopes the economy is beginning to shift into high gear. But while most economists focus at employment data from one month to the next for clues as to the strength of the economy, it is the ‘trend’ of the data, which is far more important to understand.”

That “trend” of employment data has been turning negative since President Trump was elected, which warned the economy was actually substantially weaker than headlines suggested. More than once, we warned that an “unexpected exogenous event” would exposure the soft-underbelly of the economy.

The virus was just such an event.

While many economists and media personalities are expecting a “V”-shaped recovery as soon as the virus passes, the employment data suggests an entirely different outcome.

The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current cycle peaked at 2.2% in 2015, and has been on a steady decline ever since. At 1.3%, which predated the virus, it was the lowest level ever preceding a recessionary event. All that was needed was an “event” to start the dominoes falling. When we see the first round of unemployment data, we are likely to test the lows seen during the financial crisis confirming a recession has started. 

No Recession In 2020?

It is worth noting that NO mainstream economists, or mainstream media, were predicting a recession in 2020. However, as we noted in 2019, the inversion of the “yield curve,” predicted exactly that outcome.

“To CNBC’s point, based on this lagging, and currently unrevised, economic data, there is ‘NO recession in sight,’ so you should be long equities, right?

Which indicator should you follow? The yield curve is an easy answer.

While everybody is ‘freaking out’ over the ‘inversion,’it is when the yield-curve ‘un-inverts’ that is the most important.

The chart below shows that when the Fed is aggressively cutting rates, the yield curve un-inverts as the short-end of the curve falls faster than the long-end. (This is because money is leaving ‘risk’ to seek the absolute ‘safety’ of money markets, i.e. ‘market crash.’)”

I have dated a few of the key points of the “inversion of the curve.” As of today, the yield-curve is now fully un-inverted, denoting a recession has started.

While recent employment reports were slightly above expectations, the annual rate of growth has been slowing. The 3-month average of the seasonally-adjusted employment report, also confirms that employment was already in a precarious position and too weak to absorb a significant shock. (The 3-month average smooths out some of the volatility.)

What we will see in the next several employment reports are vastly negative numbers as the economy unwinds.

Lastly, while the BLS continually adjusts and fiddles with the data to mathematically adjust for seasonal variations, the purpose of the entire process is to smooth volatile monthly data into a more normalized trend. The problem, of course, with manipulating data through mathematical adjustments, revisions, and tweaks, is the risk of contamination of bias.

We previously proposed a much simpler method to use for smoothing volatile monthly data using a 12-month moving average of the raw data as shown below.

Notice that near peaks of employment cycles the BLS employment data deviates from the 12-month average, or rather “overstates” the reality. However, as we will now see to be the case, the BLS data will rapidly reconnect with 12-month average as reality emerges.

Sometimes, “simpler” gives us a better understanding of the data.

Importantly, there is one aspect to all the charts above which remains constant. No matter how you choose to look at the data, peaks in employment growth occur prior to economic contractions, rather than an acceleration of growth. 

“Okay Boomer”

Just as “baby boomers” were finally getting back to the position of being able to retire following the 2008 crash, the “bear market” has once again put those dreams on hold. Of course, there were already more individuals over the age of 55, as a percentage of that age group, in the workforce than at anytime in the last 50-years. However, we are likely going to see a very sharp drop in those numbers as “forced retirement” will surge.

The group that will to be hit the hardest are those between 25-54 years of age. With more than 15-million restaurant workers being terminated, along with retail, clerical, leisure, and hospitality workers, the damage to this demographic will be the heaviest.

There is a decent correlation between surges in the unemployment rate and the decline in the labor-force participation rate of the 25-54 age group. Given the expectation of a 15%, or greater, unemployment rate, the damage to this particular age group is going to be significant.

Unfortunately, the prime working-age group of labor force participants had only just returned to pre-2008 levels, and the same levels seen previously in 1988. Unfortunately, it may be another decade before we see those employment levels again.

Why This Matters

The employment impact is going to felt for far longer, and will be far deeper, than the majority of the mainstream media and economists expect. This is because they are still viewing this as a “singular” problem of a transitory virus.

It isn’t.

The virus was simply the catalyst which started the unwind of a decade-long period of debt accumulation and speculative excesses. Businesses, both small and large, will now go through a period of “culling the herd,” to lower operating costs and maintain profitability.

There are many businesses that will close, and never reopen. Most others will cut employment down to the bone and will be very slow to rehire as the economy begins to recover. Most importantly, wage growth was already on the decline, and will be cut deeply in the months to come.

Lower wage growth, unemployment, and a collapse in consumer confidence is going to increase the depth and duration of the recession over the months to come. The contraction in consumption will further reduce revenues and earnings for businesses which will require a deeper revaluation of asset prices. 

I just want to leave you with a statement I made previously:

“Every financial crisis, market upheaval, major correction, recession, etc. all came from one thing – an exogenous event that was not forecast or expected.

This is why bear markets are always vicious, brutal, devastating, and fast. It is the exogenous event, usually credit-related, which sucks the liquidity out of the market, causing prices to plunge. As prices fall, investors begin to panic-sell driving prices lower which forces more selling in the market until, ultimately, sellers are exhausted.

It is the same every time.”

Over the last several years, investors have insisted the markets were NOT in a bubble. We reminded them that everyone thought the same in 1999 and 2007.

Throughout history, financial bubbles have only been recognized in hindsight when their existence becomes “apparently obvious” to everyone. Of course, by that point is was far too late to be of any use to investors and the subsequent destruction of invested capital.

It turned out, “this time indeed was not different.” Only the catalyst, magnitude, and duration was.

Pay attention to employment and wages. The data suggests the current “bear market” cycle has only just begun.

Technically Speaking: 5-Questions Bulls Need To Answer Now.

In last Tuesday’s Technically Speaking post, I stated:

From a purely technical basis, the extreme downside extension, and potential selling exhaustion, has set the markets up for a fairly strong reflexive bounce. This is where fun with math comes in.

As shown in the chart below, after a 35% decline in the markets from the previous highs, a rally to the 38.2% Fibonacci retracement would encompass a 20% advance.

Such an advance will ‘lure’ investors back into the market, thinking the ‘bear market’ is over.”

Chart Updated Through Monday

Not surprisingly, as we noted in this weekend’s newsletter, the headlines from the mainstream media aligned with our expectations:

So, is the bear market over? 

Are the bulls now back in charge?

Honestly, no one knows for certain. However, there are 5-questions that “Market Bulls” need to answer if the current rally is to be sustained.

These questions are not entirely technical, but since “technical analysis” is simply the visualization of market psychology, how you answer the questions will ultimately be reflected by the price dynamics of the market.

Let’s get to work.

Employment

Employment is the lifeblood of the economy.  Individuals cannot consume goods and services if they do not have a job from which they can derive income. From that consumption comes corporate profits and earnings.

Therefore, for individuals to consume at a rate to provide for sustainable, organic (non-Fed supported), economic growth they must work at a level that provides a sustainable living wage above the poverty level. This means full-time employment that provides benefits, and a livable wage. The chart below shows the number of full-time employees relative to the population. I have also overlaid jobless claims (inverted scale), which shows that when claims fall to current levels, it has generally marked the end of the employment cycle and preceded the onset of a recession.

This erosion in jobless claims has only just begun. As jobless claims and continuing claims rise, it will lead to a sharp deceleration in economic confidence. Confidence is the primary factor of consumptive behaviors, which is why the Federal Reserve acted so quickly to inject liquidity into the financial markets. While the Fed’s actions may prop up financial markets in the short-term, it does little to affect the most significant factor weighing on consumers – their job. 


Question:  Given that employment is just starting to decline, does such support the assumption of a continued bull market?


Personal Consumption Expenditures (PCE)

Following through from employment, once individuals receive their paycheck, they then consume goods and services in order to live.

This is a crucial economic concept to understand, which is the order in which the economy functions. Consumers must “produce” first, so they receive a paycheck, before they can “consume.”  This is also the primary problem of Stephanie Kelton’s “Modern Monetary Theory,” which disincentivizes the productive capacity of the population.

Given that Personal Consumption Expenditures (PCE) is a measure of that consumption, and comprises roughly 70% of the GDP calculation, its relative strength has great bearing on the outcome of economic growth.

More importantly, PCE is the direct contributor to the sales of corporations, which generates their gross revenue. So goes personal consumption – so goes revenue. The lower the revenue that flows into company coffers, the more inclined businesses are to cut costs, including employment and stock buybacks, to maintain profit margins.

The chart below is a comparison of the annualized change in PCE to corporate fixed investment and employment. I have made some estimates for the first quarter based on recent data points.


Question: Does the current weakness in PCE and Fixed Investment support the expectations for a continued bull market from current price levels? 


Junk Bonds & Margin Debt

While global Central Banks have lulled investors into an expanded sense of complacency through years of monetary support, it has led to willful blindness of underlying risk. As we discussed in “Investor’s Dilemma:”

Classical conditioning (also known as Pavlovian or respondent conditioning) refers to a learning procedure in which a potent stimulus (e.g. food) is paired with a previously neutral stimulus (e.g. a bell). What Pavlov discovered is that when the neutral stimulus was introduced, the dogs would begin to salivate in anticipation of the potent stimulus, even though it was not currently present. This learning process results from the psychological “pairing” of the stimuli.”

That “stimuli” over the last decade has been Central Bank interventions. During that period, the complete lack of “fear” in markets, combined with a “chase for yield,” drove “risk” assets to record levels along with leverage. The chart below shows the relationship between margin debt (leverage), stocks, and junk bond yields (which have been inverted for better relevance.)

While asset prices declined sharply in March, it has done little to significantly revert either junk bond yields or margin debt to levels normally consistent with the beginning of a new “bull market.”

With oil prices falling below $20/bbl, a tremendous amount of debt tied to the energy space, and the impact the energy sector has on the broader economy, it is likely too soon to suggest the markets have fully “priced in” the damage being done.


Question:  What happens to asset prices if more bankruptcies and forced deleveraging occurs?


Corporate Profits/Earnings

As noted above, if the “bull market” is back, then stocks should be pricing in stronger earnings going forward. However, given the potential shakeout in employment, which will lower consumption, stronger earnings, and corporate profits, are not likely in the near term.

The risk to earnings is even higher than many suspect, given that over the last several years, companies have manufactured profitability through a variety of accounting gimmicks, but primarily through share buybacks from increased leverage. That cycle has now come to an end, but before it did it created a massive deviation of the stock market from corporate profitability.

“If the economy is slowing down, revenue and corporate profit growth will decline also. However, it is this point which the ‘bulls’ should be paying attention to. Many are dismissing currently high valuations under the guise of ‘low interest rates,’ however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the market and corporate profits after tax. The only other time in history the difference was this great was in 1999.”

It isn’t just the deviation of asset prices from corporate profitability, which is skewed, but also reported earnings per share.

The impending recession, and consumption freeze, is going to start the mean-reversion process in both corporate profits, and earnings. I have projected the potential reversion in the chart below. The reversion in GAAP earnings is pretty calculable as swings from peaks to troughs have run on a fairly consistent trend.

Using that historical context, we can project a recession will reduce earnings to roughly $100/share. (Goldman Sachs currently estimates $110.) The resulting decline asset prices to revert valuations to a level of 18x (still high) trailing earnings would suggest a level of 1800 for the S&P 500 index. (Yesterday’s close of 2626 is still way to elevated.)

The decline in economic growth epitomizes the problem that corporations face today in trying to maintain profitability. The chart below shows corporate profits as a percentage of GDP relative to the annual change in GDP. The last time that corporate profits diverged from GDP, it was unable to sustain that divergence for long. As the economy declines, so will corporate profits and earnings.


Question: How long can asset prices remain divorced from falling corporate profits and weaker economic growth?


Technical Pressure

Given all of the issues discussed above, which must ultimately be reflected in market prices, the technical picture of the market also suggests the recent “bear market” rally will likely fade sooner than later. As noted above”

Such an advance will ‘lure’ investors back into the market, thinking the ‘bear market’ is over.”

Importantly, despite the sizable rally, participation has remained extraordinarily weak. If the market was seeing strong buying, as suggested by the media, then we should see sizable upticks in the percent measures of advancing issues, issues at new highs, and a rising number of stocks above their 200-dma.

However, on a longer-term basis, since this is the end of the month, and quarter, we can look at our quarterly buy/sell indication which has triggered a “sell” signal for the first time since 2015. While such a signal does not demand a major reversion, it does suggest there is likely more risk to the markets currently than many expect.


Question:  Does the technical backdrop currently support the resumption of a bull market?


There are reasons to be optimistic on the markets in the very short-term. However, we are continuing to extend the amount of time the economy will be “shut down,” which will exacerbate the decline in the unemployment and personal consumption data. The feedback loop from that data into corporate profits and earnings is going to make valuations more problematic even with low interest rates currently. 

While Central Banks have rushed into a “burning building with a fire hose” of liquidity, there is the risk that after a decade of excess debt, leverage, and misallocation of assets, the “fire” may be too hot for them to put out.

Assuming that the “bear market” is over already may be a bit premature, and chasing what seems like a “raging bull market” is likely going to disappoint you.

Bear markets have a way of “suckering” investors back into the market to inflict the most pain possible. This is why “bear markets” never end with optimism, but in despair.

Where “I Bought It For The Dividend” Went Wrong

In early 2017, I warned investors about the “I bought it for the dividend” investment thesis. To wit:

“Company ABC is priced at $20/share and pays $1/share in a dividend each year. The dividend yield is 5%, which is calculated by dividing the $1 cash dividend into the price of the underlying stock.

Here is the important point. You do NOT receive a ‘yield.’

What you DO receive is the $1/share in cash paid out each year.

Yield is simply a mathematical calculation.

At that time, the article was scoffed at because we were 8-years into an unrelenting bull market where even the most stupid of investments made money.

Unfortunately, the “mean reversion” process has taken hold, which is the point where the investment thesis falls apart.

The Dangers Of “I Bought It For The Dividend”

“I don’t care about the price, I bought it for the yield.”

First of all, let’s clear up something.

In January of 2018, Exxon Mobil, for example, was slated to pay an out an annual dividend of $3.23, and was priced at roughly $80/share setting the yield at 4.03%. With the 10-year Treasury trading at 2.89%, the higher yield was certainly attractive.

Assuming an individual bought 100 shares at $80 in 2018, “income” of $323 annually would be generated.

Not too shabby.

Fast forward to today with Exxon Mobil trading at roughly $40/share with a current dividend of $3.48/share.

Investment Return (-$4000.00 ) + Dividends of $323 (Yr 1) and $343 (Yr 2)  = Net Loss of $3334

That’s not a good investment.

In just a moment, we will come and revisit this example with a better process.

There is another risk, which occurs during “mean reverting” events, that can leave investors stranded, and financially ruined.

Dividend Loss

When things “go wrong,” as they inevitably do, the “dividend” can, and often does, go away.

  • Boeing (BA)
  • Marriott (MAR)
  • Ford (F)
  • Delta (DAL)
  • Freeport-McMoRan (FCX)
  • Darden (DRI)

These companies, and many others, have all recently cut their dividends after a sharp fall in their stock prices.

I previously posted an article discussing the “Fatal Flaws In Your Financial Plan” which, as you can imagine, generated much debate. One of the more interesting rebuttals was the following:

If a retired person has a portfolio of high-quality dividend growth stocks, the dividends will most likely increase every single year. Even during the stock market crashes of 2002 and 2008, my dividends continued to grow. The total value of the portfolio will indeed fluctuate every year, but that is irrelevant since the retired person is living off his dividends and never selling any shares of stock.

Dividends usually go up even when the stock market goes down.

This comment is the basis of the “buy and hold” mentality, and many of the most common investing misconceptions.

Let’s start with the notion that “dividends always increase.”

When a recession/market reversion occurs, the “cash dividends” don’t increase, but the “yield” does as prices collapse. However, your INCOME does NOT increase. There is a risk it will decline as companies cut the dividend or eliminate it.

During the 2008 financial crisis, more than 140 companies decreased or eliminated their dividends to shareholders. Yes, many of those companies were major banks; however, leading up to the financial crisis, there were many individuals holding large allocations to banks for the income stream their dividends generated. In hindsight, that was not such a good idea.

But it wasn’t just 2008. It also occurred dot.com bust in 2000. In both periods, while investors lost roughly 50% of their capital, dividends were also cut on average of 12%.

While the current market correction fell almost 30% from its recent peak, what we haven’t seen just yet is the majority of dividend cuts still to come.

Naturally, not EVERY company will cut their dividends. But many did, many will, and in quite a few cases, I would expect dividends to be eliminated entirely to protect cash flows and creditors.

As we warned previously:

“Due to the Federal Reserve’s suppression of interest rates since 2009, investors have piled into dividend yielding equities, regardless of fundamentals, due to the belief ‘there is no alternative.’ The resulting ‘dividend chase’ has pushed valuations of dividend-yielding companies to excessive levels disregarding underlying fundamental weakness. 

As with the ‘Nifty Fifty’ heading into the 1970s, the resulting outcome for investors was less than favorable. These periods are not isolated events. There is a high correlation between declines in asset prices, and the dividends paid out.”

Love Dividends, Love Capital More

I agree investors should own companies that pay dividends (as it is a significant portion of long-term total returns)it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress.

It is a good indicator of the strength of the underlying economy. As noted by Political Calculations recently:

Dividend cuts are one of the better near-real-time indicators of the relative health of the U.S. economy. While they slightly lag behind the actual state of the economy, dividend cuts represent one of the simplest indicators to track.

In just one week, beginning 16 March 2020, the number of dividend cuts being announced by U.S. firms spiked sharply upward, transforming 2020-Q1 from a quarter where U.S. firms were apparently performing more strongly than they had in the year-ago quarter of 2019-Q1 into one that all-but-confirms that the U.S. has swung into economic contraction.

Not surprisingly, the economic collapse, which will occur over the next couple of quarters, will lead to a massive round of dividend cuts. While investors lost 30%, or more in many cases, of their capital, they will lose the reason they were clinging on to these companies in the first place.

You Can’t Handle It

EVERY investor has a point, when prices fall far enough, regardless of the dividend being paid, they WILL capitulate, and sell the position. This point generally comes when dividends have been cut, and capital destruction has been maximized.

While individuals suggest they will remain steadfast to their discipline over the long-term, repeated studies show that few individuals actually do. As noted just recently is “Missing The 10-Best Days:”

“As Dalbar regularly points out, individuals always underperform the benchmark index over time by allowing “behaviors” to interfere with their investment discipline. In other words, investors regularly suffer from the ‘buy high/sell low’ syndrome.”

Behavioral biases, specifically the “herding effect” and “loss aversion,” repeatedly leads to poor investment decision-making. In fact, Dalbar is set to release their Investor Report for 2020, and they were kind enough to send me the following graphic for investor performance through 2019. (Pre-Order The Full Report Here)

These differentials in performance can all be directly traced back to two primary factors:

  • Psychology
  • Lack of capital

Understanding this, it should come as no surprise during market declines, as losses mount, so does the pressure to “avert further losses” by selling. While it is generally believed dividend-yielding stocks offer protection during bear market declines, we warned previously this time could be different:

“The yield chase has manifested itself also in a massive outperformance of ‘dividend-yielding stocks’ over the broad market index. Investors are taking on excessive credit risk which is driving down yields in bonds, and pushing up valuations in traditionally mature companies to stratospheric levels. During historic market corrections, money has traditionally hidden in these ‘mature dividend yielding’ companies. This time, such rotation may be the equivalent of jumping from the ‘frying pan into the fire.’” 

The chart below is the S&P 500 High Dividend Low Volatility ETF versus the S&P 500 Index. During the recent decline, dividend stocks were neither “safe,” nor “low volatility.” 

But what about previous “bear markets?” Since most ETF’s didn’t exist before 2000, we can look at the “strategy” with a mutual fund like Fidelity’s Dividend Growth Fund (FDGFX)

As you can see, there is little relative “safety” during a market reversion. The pain of a 38%, 56%, or 30%, loss, can be devastating particularly when the prevailing market sentiment is one of a “can’t lose” environment. Furthermore, when it comes to dividend-yielding stocks, the psychology is no different; a 3-5% yield, and a 30-50% loss of capital, are two VERY different issues.

A Better Way To “Invest For The Dividend”

“Buy and hold” investing, even with dividends and dollar-cost-averaging, will not get you to your financial goals. (Click here for a discussion of chart)

So, what’s the better way to invest for dividends? Let’s go back to our example of Exxon Mobil for a moment. (This is for illustrative purposes only and not a recommendation.)

In 2018, Exxon Mobil broke below its 12-month moving average as the overall market begins to deteriorate.

If you had elected to sell on the break of the moving average, your exit price would have been roughly $70/share. (For argument sake, you stayed out of the position even though XOM traded above and below the average over the next few months.)  

Let’s rerun our math from above.

  • In 2018, an individual bought 100 shares at $80.
  • In 2019, the individual sold 100 shares at $70.

Investment Return (-$1000.00 ) + Dividends of $323 (Yr 1) and $343 (Yr 2)  = Net Loss of $334

Not to bad.

Given the original $8,000 investment has only declined to $7,666, the individual could now buy 200 shares of Exxon Mobil with a dividend of $3.48 and a 9.3% annual yield.

Let’s compare the two strategies.

  • Buy And Hold: 100 shares bought at $80 with a current yield of 4.35% 
  • Risk Managed: 200 shares bought at $40 with a current yield of 9.3%

Which yield would you rather have in your portfolio?

In the end, we are just human. Despite the best of our intentions, emotional biases inevitably lead to poor investment decision-making. This is why all great investors have strict investment disciplines they follow to reduce the impact of emotions.

I am all for “dividend investment strategies,” in fact, dividends are a primary factor in our equity selection process. However, we also run a risk-managed strategy to ensure we have capital available to buy strong companies when the opportunity presents itself.

The majority of the time, when you hear someone say “I bought it for the dividend,” they are trying to rationalize an investment mistake. However, it is in the rationalization that the “mistake” is compounded over time. One of the most important rules of successful investors is to “cut losers short and let winners run.” 

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and strategy has horrid consequences.

Margin Call: You Were Warned Of The Risk

I have been slammed with emails over the last couple of days asking the following questions:

“What just happened to my bonds?”

“What happened to my gold position, shouldn’t it be going up?”

“Why are all my stocks being flushed at the same time?”

As noted by Zerohedge:

“Stocks down, Bonds down, credit down, gold down, oil down, copper down, crypto down, global systemically important banks down, and liquidity down

Today was the worst day for a combined equity/bond portfolio… ever…”

This Is What A “Margin Call,” Looks Like.

In December 2018, we warned of the risk. At that time, the market was dropping sharply, and Mark Hulbert wrote an article dismissing the risk of margin debt. To wit:

“Plunging margin debt may not doom the bull market after all, reports to the contrary notwithstanding.

According to research conducted in the 1970s by Norman Fosback, then the president of the Institute for Econometric Research, there is an 85% probability that a bull market is in progress when margin debt is above its 12-month moving average, in contrast to just a 41% probability when it’s below.

Why, then, do I suggest not becoming overly pessimistic? For several reasons:

1) The margin debt indicator issues many false signals

2) There is insufficient data

3) Margin debt is a strong coincident indicator.”

I disagreed with Mark on several points at the time. But fortunately the Federal Reserve’s reversal on monetary policy kept the stock market from sinking to levels that would trigger “margin calls.”

As I noted then, margin debt is not a technical indicator that can be used to trade markets. Margin debt is the “gasoline,” which drives markets higher as the leverage provides for the additional purchasing power of assets. However, that “leverage” also works in reverse as it provides the accelerant for larger declines as lenders “force” the sale of assets to cover credit lines without regard to the borrower’s position.

That last sentence is the most important and is what is currently happening in the market.

The issue with margin debt, in terms of the biggest risk, is the unwinding of leverage is NOT at the investor’s discretion.

It is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) 

When lenders fear they may not be able to recoup their credit-lines, they force the borrower to either put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen all at once as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

When an “event” occurs that causes lenders to “panic” and call in margin loans, things progress very quickly as the “math” becomes a problem. Here is a simple example.

“If you buy $100,000 of stock on margin, you only need to pay $50,000. Seems like a great deal, especially if the stock price goes up. But what if your stock drops to $60,000? Suddenly, you’ve lost $40,000, leaving you with only $10,000 in your margin account. The rules state that you need to have at least 25 percent of the $60,000 stock value in your account, which is $15,000. So not only do you lose $40,000, but you have to deposit an additional $5,000 in your margin account to stay in business.

However, when margin calls occur, and equity is sold to meet the call, the equity in the portfolio is reduced further. Any subsequent price decline requires additional coverage leading to a “death spiral” until the margin line is covered.

Example:

  • $100,000 portfolio declines to $60,000. Requiring a margin call of $5000.
  • You have to deposit $5000, or sell to cover. 
  • However, if you don’t have the cash, then a problem arises. The sell of equity reduces the collateral requirement requiring a larger transaction: $5000/.25% requirement = $20,000
  • With the margin requirement met, a balance of $40,000 remains in the account with a $10,000 margin requirement. 
  • The next morning, the market declines again, triggering another margin call. 
  • Wash, rinse, repeat until broke.

This is why you should NEVER invest on margin unless you always have the cash to cover.

Just 20% 

As I discussed previously, the level we suspected would trigger a margin event was roughly a 20% decline from the peak.

“If such a decline triggers a 20% fall from the peak, which is around 2340 currently, broker-dealers are likely going to start tightening up margin requirements and requiring coverage of outstanding margin lines.

This is just a guess…it could be at any point at which “credit-risk” becomes a concern. The important point is that ‘when’ it occurs, it will start a ‘liquidation cycle’ as ‘margin calls’ trigger more selling which leads to more margin calls. This cycle will continue until the liquidation process is complete.

The Dow Jones provided the clearest picture of the acceleration in selling as “margin calls” kicked in.

The last time we saw such an event was in 2008.

How Much More Is There To Go?

Unfortunately, FINRA only updates margin debt with about a 2-month lag.

Mark’s second point was a lack of data. This isn’t actually the case as margin debt has been tracked back to 1959. However, for clarity, let’s just start with data back to 1980. The chart below tracks two things:

  1. The actual level of margin debt, and;
  2. The level of “free cash” balances which is the difference between cash and borrowed funds (net cash).

As I stated above, since the data has not been updated since January, the current level of margin, and negative cash balances, has obviously been reduced, and likely sharply so.

However, previous “market bottoms,” have occurred when those negative cash balances are reverted. Given the extreme magnitude of the leverage that was outstanding, I highly suspect the “reversion” is yet complete. 

The relationship between cash balances and the market is better illustrated in the next chart. I have inverted free cash balances, to show the relationship between reversals in margin debt and the market. Given the market has only declined by roughly 30% to date, there is likely more to go. This doesn’t mean a fairly sharp reflexive bounce can’t occur before a further liquidation ensues.

If we invert margin debt to the S&P 500, you can see the magnitude of both previous market declines and margin liquidation cycles. As stated, this data is as of January, and margin balances will be substantially lower following the recent rout. I am just not sure we have “squeezed” the last bit of blood out of investors just yet. 

You Were Warned

I warned previously, the idea that margin debt levels are simply a function of market activity, and have no bearing on the outcome of the market, was heavily flawed.

“By itself, margin debt is inert.

Investors can leverage their existing portfolios and increase buying power to participate in rising markets. While ‘this time could certainly be different,’ the reality is that leverage of this magnitude is ‘gasoline waiting on a match.’

When an event eventually occurs, it creates a rush to liquidate holdings. The subsequent decline in prices eventually reaches a point that triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying ‘collateral,’ the forced sale of assets will reduce the value of the collateral, triggering further margin calls. Those margin calls will trigger more selling, forcing more margin calls, so forth and so on.

That event was the double-whammy of collapsing oil prices and the economic shutdown in response to the coronavirus.

While it is certainly hoped by many that we are closer to the end of the liquidation cycle, than the beginning, the dollar funding crisis, a blowout in debt yields, and forced selling of assets, suggests there is likely more pain to come before we are done.

It’s not too late to take actions to preserve capital now, so you have capital to invest later.

As I wrote in Tuesday’s missive “When Too Little Is Too Much:”

“With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

The good news is that a great ‘buying’ opportunity is coming. Just don’t be in a ‘rush’ to try and buy the bottom. 

I can assure you, when we ultimately see a clear ‘risk/reward’ set up to start taking on equity risk again, we will do so ‘with both hands.’ 

And we are sitting on a lot of cash just for that reason.”

You can’t “buy low,” if you don’t have anything to “buy with.”

Technically Speaking: Risk Limits Hit, When Too Little Is Too Much

For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Importantly, we did not “sell everything” and go to cash.

Since then, we took profits and rebalanced risk again in late January and early February as well.

Our clients, their families, their financial and emotional “well being,” rest in our hands. We take that responsibility very seriously, and work closely with our clients to ensure that not only are they financially successful, but they are emotionally stable in the process.

This is, and has been, our biggest argument against “buy and hold,” and “passive investing.” While there are plenty of case studies showing why individuals will eventually get back to even, the vast majority of individuals have a “pain point,” where they will sell.

So, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threashold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened, which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern the Fed’s actions wouldn’t be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our Special Report for our RIAPro Subscribers (Risk-Free 30-Day Trial) last week:

“As you can see in the chart below, this is a massive surge of liquidity, hitting the market at a time the market is testing important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.” This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, with that important trendline broken, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private-sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008, which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is the annual change in nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%; however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20 / share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

In other words, Wall Street estimates are still in “fantasy land.” 

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples, we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again, there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be an unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market.

Probably.

But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you, when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

RIA PRO: Risk Limits Hit

For the last several months we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Since then, as you know, we have taken profits, and rebalanced risk several times within the portfolios.

Importantly, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threshold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern we didn’t know if the Fed’s actions would be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions, but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our last week, in the Special Report Red Line In The Sand:

“As you can see in the chart below, this is a massive surge of liquidity hitting the market at a time the market is hitting important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure. However, given the extreme oversold condition, noted above, it is likely we are going to see a bounce, which we will use to reduce risk into.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.”

This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

This also explains why the market “failed to rally” when the Fed announced $500 billion today. There is another $500 billion coming tomorrow. We will see what happens.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008 which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is annual nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%, however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20/share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market?

Probably.

But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you that when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

Technically Speaking: On The Cusp Of A Bear Market

“Tops are a process, and bottoms are an event”

Over the last couple of years, we have discussed the ongoing litany of issues that plagued the underbelly of the financial markets.

  1. The “corporate credit” markets are at risk of a wave of defaults.
  2. Earnings estimates for 2019 fell sharply, and 2020 estimates are now on the decline.
  3. Stock market targets for 2020 are still too high, along with 2021.
  4. Rising geopolitical tensions between Russia, Saudi Arabia, China, Iran, etc. 
  5. The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  6. Economic growth is slowing.
  7. Chinese economic data has weakened further.
  8. The impact of the “coronavirus,” and the shutdown of the global supply chain, will impact exports (which make up 40-50% of corporate profits) and economic growth.
  9. The collapse in oil prices is deflationary and can spark a wave of credit defaults in the energy complex.
  10. European growth, already weak, continues to weaken, and most of the EU will likely be in recession in the next 2-quarters.
  11. Valuations remain at expensive levels.
  12. Long-term technical signals have become negative. 
  13. The collapse in equity prices, and coronavirus fears, will weigh on consumer confidence.
  14. Rising loan delinquency rates.
  15. Auto sales are signaling economic stress.
  16. The yield curve is sending a clear message that something is wrong with the economy.
  17. Rising stress on the consumption side of the equation from retail sales and personal consumption.

I could go on, but you get the idea.

In that time, these issues have gone unaddressed, and worse dismissed, because of the ongoing interventions of Central Banks.

However, as we have stated many times in the past, there would eventually be an unexpected, exogenous event, or rather a “Black Swan,” which would “light the fuse” of a bear market reversion.

Over the last few weeks, the market was hit with not one, but two, “black swans” as the “coronavirus” shutdown the global supply chain, and Saudi Arabia pulled the plug on oil price support. Amazingly, we went from “no recession in sight”, to full-blown “recession fears,” in less than month.

“Given that U.S. exporters have already been under pressure from the impact of the “trade war,” the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number. 

With our Economic Output Composite Indicator (EOCI) already at levels which has previously denoted recessions, the “timing” of the virus could have more serious consequences than currently expected by overzealous market investors.”

On The Cusp Of A Bear Market

Let me start by making a point.

“Bull and bear markets are NOT defined by a 20% move. They are defined by a change of direction in the trend of prices.” 

There was a point in history where a 20% move was significant enough to achieve that change in overall price trends. However, today that is no longer the case.

Bull and bear markets today are better defined as:

“During a bull market, prices trade above the long-term moving average. However, when the trend changes to a bear market prices trade below that moving average.”

This is shown in the chart below, which compares the market to the 75-week moving average. During “bullish trends,” the market tends to trade above the long-term moving average and below it during “bearish trends.”

In the last decade, there have been three previous occasions where the long-term moving average was violated but did not lead to a longer-term change in the trend.

  • The first was in 2011, as the U.S. was dealing with a potential debt-ceiling and threat of a downgrade of the U.S. debt rating. Then Fed Chairman Ben Bernanke came to the rescue with the second round of quantitative easing (QE), which flooded the financial markets with liquidity.
  • The second came in late-2015 and early-2016 as the market dealt with a Federal Reserve, which had started lifting interest rates combined with the threat of the economic fallout from Britain leaving the European Union (Brexit). Given the U.S. Federal Reserve had already committed to hiking interest rates, and a process to begin unwinding their $4-Trillion balance sheet, the ECB stepped in with their own version of QE to pick up the slack.
  • The latest event was in December 2018 as the markets fell due to the Fed’s hiking of interest rates and reduction of their balance sheet. Of course, the decline was cut short by the Fed reversal of policy and subsequently, a reduction in interest rates and a re-expansion of their balance sheet.

Had it not been for these artificial influences, it is highly likely the markets would have experienced deeper corrections than what occurred.

On Monday, we have once again violated that long-term moving average. However, Central Banks globally have been mostly quiet. Yes, there have been promises of support, but as of yet, there have not been any substantive actions.

However, the good news is that the bullish trend support of the 3-Year moving average (orange line) remains intact for now. That line is the “last line of defense” of the bull market. The only two periods where that moving average was breached was during the “Dot.com Crash” and the “Financial Crisis.”

(One important note is that the “monthly sell trigger,” (lower panel) was initiated at the end of February which suggested there was more downside risk at the time.)

None of this should have been surprising, as I have written previously, prices can only move so far in one direction before the laws of physics take over. To wit”

Like a rubber band that has been stretched too far – it must be relaxed before it can be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

With the markets previously more than 20% of their long-term mean, the correction was inevitable, it just lacked the right catalyst.

The difference between a “bull market” and a “bear market” is when the deviations begin to occur BELOW the long-term moving average on a consistent basis. With the market already trading below the 75-week moving average, a failure to recover in a fairly short period, will most likely facilitate a break below the 3-year average.

If that occurs, the “bear market” will be official and will require substantially lower levels of equity risk exposure in portfolios until a reversal occurs.

Currently, it is still too early to know for sure whether this is just a “correction” or a “change in the trend” of the market. As I noted previously, there are substantial differences, which suggest a more cautious outlook. To wit:

  • Downside Risk Dwarfs Upside Reward. 
  • Global Growth Is Less Synchronized
  • Market Structure Is One-Sided and Worrisome. 
  • COVID-19 Impacts To The Global Supply Chain Are Intensifying
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
  • Peak Buybacks
  • China, Europe, and the Emerging Market Economic Data All Signal a Slowdown
  • The Democrats Control The House Which Effectively Nullifies Fiscal Policy Agenda.
  • The Leadership Of The Market (FAANG) Has Faltered.

Most importantly, the collapse in interest rates, as well as the annual rate of change in rates, is screaming that something “has broken,” economically speaking.

Here is the important point.

Understanding that a change is occurring, and reacting to it, is what is important. The reason so many investors “get trapped” in bear markets is that by the time they realize what is happening, it has been far too late to do anything about it.

Let me leave you with some important points from the legendary Marty Zweig: (h/t Doug Kass.)

  • Patience is one of the most valuable attributes in investing.
  • Big money is made in the stock market by being on the right side of the major moves. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.
  • Success means making profits and avoiding losses.
  • Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major decision.
  • The trend is your friend.
  • The problem with most people who play the market is that they are not flexible.
  • Near the top of the market, investors are extraordinarily optimistic because they’ve seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. At the top, optimism is king; speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated. 
  • I measure what’s going on, and I adapt to it. I try to get my ego out of the way. The market is smarter than I am, so I bend.
  • To me, the “tape” is the final arbiter of any investment decision. I have a cardinal rule: Never fight the tape!
  • The idea is to buy when the probability is greatest that the market is going to advance.

Most importantly, and something that is most applicable to the current market:

“It’s okay to be wrong; it’s just unforgivable to stay wrong.” – Marty Zweig

There action this year is very reminiscent of previous market topping processes. Tops are hard to identify during the process as “change happens slowly.” The mainstream media, economists, and Wall Street will dismiss pickup in volatility as simply a corrective process. But when the topping process completes, it will seem as if the change occurred “all at once.”

The same media which told you “not to worry,” will now tell you, “no one could have seen it coming.”

The market may be telling you something important, if you will only listen.

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Technically Speaking: Sellable Rally, Or The Return Of The Bull?

Normally, “Technically Speaking,” is analysis based on Monday’s market action. However, this week, we are UPDATING the analysis posted in this past weekend’s newsletter, “Market Crash & Navigating What Happens Next.”

Specifically, we broke down the market into three specific time frames looking at the short, intermediate, and long-term technical backdrop of the markets. In that analysis, we laid out the premise for a “reflexive bounce” in the markets, and what to do during the process of that move. To wit:

“On a daily basis, the market is back to a level of oversold (top panel) rarely seen from a historical perspective. Furthermore, the rapid decline this week took the markets 5-standard deviations below the 50-dma.”

Chart updated through Monday

“To put this into some perspective, prices tend to exist within a 2-standard deviation range above and below the 50-dma. The top or bottom of that range constitutes 95.45% of ALL POSSIBLE price movements within a given period.

A 5-standard deviation event equates to 99.9999% of all potential price movement in a given direction. 

This is the equivalent of taking a rubber band and stretching it to its absolute maximum.”

Importantly, like a rubber band, this suggests the market “snap back” could be fairly substantial, and should be used to reduce equity risk, raise cash, and add hedges.”

Importantly, read that last sentence again.

The current belief is that the “virus” is limited in scope and once the spread is contained, the markets will immediately bounce back in a “V-shaped” recovery.  Much of this analysis is based on assumptions that “COVID-19” is like “SARS” in 2003 which had a very limited impact on the markets.

However, this is likely a mistake as there is one very important difference between COVID-19 and SARS, as I noted previously:

“Currently, the more prominent comparison is how the market performed following the ‘SARS’ outbreak in 2003, as it also was a member of the ‘corona virus’ family. Clearly, if you just remained invested, there was a quick recovery from the market impact, and the bull market resumed. At least it seems that way.”

“While the chart is not intentionally deceiving, it hides a very important fact about the market decline and the potential impact of the SARS virus. Let’s expand the time frame of the chart to get a better understanding.”

“Following a nearly 50% decline in asset prices, a mean-reversion in valuations, and an economic recession ending, the impact of the SARS virus was negligible given the bulk of the ‘risk’ was already removed from asset prices and economic growth. Today’s economic environment could not be more opposed.”

This was also a point noted by the WSJ on Monday:

Unlike today, the S&P 500 ETF (SPY) spent about a year below its 200-day moving average (dot-com crash) prior to the SARS 2003 outbreak. Price action is much different now. SPY was well above its 200-day moving average before the coronavirus outbreak, leaving plenty of room for profit-taking.”

Importantly, the concern we have in the intermediate-term is not “people getting sick.” We currently have the “flu” in the U.S. which, according to the CDC, has affected 32-45 MILLION people which has already resulted in 18-46,000 deaths.

Clearly, the “flu” is a much bigger problem than COVID-19 in terms of the number of people getting sick. The difference, however, is that during “flu season,” we don’t shut down airports, shipping, manufacturing, schools, etc. The negative impact to exports and imports, business investment, and potentially consumer spending, which are all direct inputs into the GDP calculation, is going to be reflected in corporate earnings and profits. 

The recent slide, not withstanding the “reflexive bounce” on Monday, was beginning the process of pricing in negative earnings growth through the end of 2020.

More importantly, the earnings estimates have not be ratcheted down yet to account for the impact of the “shutdown” to the global supply chain. Once we adjust (dotted blue line) for the a negative earnings environment in 2020, with a recovery in 2021, you can see just how far estimates will slide over the coming months. This will put downward pressure on stocks over the course of this year.

Given this backdrop of weaker earnings, which will be derived from weaker economic growth, in the months to come is why we suspect we could well see this year play out much like 2015-2016. In 2015, the Fed was beginning to discuss tapering their balance sheet which initially led to a decline. Given there was still plenty of liquidity, the market rallied back before “Brexit” risk entered the picture. The market plunged on expectations for a negative economic impact, but sprung back after Janet Yellen coordinated with the BOE, and ECB, to launch QE in the Eurozone.

Using that model for a reflexive rally, we will likely see a failed rally, and a retest of last weeks lows, or potentially even set new lows, as economic and earnings risks are factored in. 

Rally To Sell

As expected, the market rallied hard on Monday on hopes the Federal Reserve, and Central Banks globally, will intervene with a “shot of liquidity” to cure the market’s “COVID-19” infection.

The good news is the rally yesterday did clear initial resistance at the 200-dma which keeps that important break of support from being confirmed. This clears the way for the market to rally back into the initial “sell zone” we laid out this past weekend.

Importantly, while the volume of the rally on Monday was not as large as Friday’s sell-off, it was a very strong day nonetheless and confirmed the conviction of buyers. With the markets clearing the 200-dma, and still oversold on multiple levels, there is a high probability the market will rally into our “sell zone” before failing.

For now look for rallies to be “sold.”

The End Of The Bull

I want to reprint the last part of this weekend’s newsletter as the any rally that occurs over the next couple of weeks will NOT reverse the current market dynamics.

“The most important WARNING is the negative divergence in relative strength (top panel).  This negative divergence was seen at every important market correction event over the last 25-years.”

“As shown in the bottom two panels, both of the monthly ‘buy’ signals are very close to reversing. It will take a breakout to ‘all-time highs’ at this point to keep those signals from triggering.

For longer-term investors, people close to, or in, retirement, or for individuals who don’t pay close attention to the markets or their investments, this is NOT a buying opportunity.

Let me be clear.

There is currently EVERY indication given the speed and magnitude of the decline, that any short-term reflexive bounce will likely fail. Such a failure will lead to a retest of the recent lows, or worse, the beginning of a bear market brought on by a recession.

Please read that last sentence again. 

Bulls Still In Charge

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the weeks, and months, ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.) Currently, the good news for the bulls, is the bullish trend line from the 2015 lows held. However, weekly “sell signals” are close to triggering, which does increase short-term risks.

With the seasonally strong period of the market coming to its inevitable conclusion, economic and earnings data under pressure, and the virus yet to be contained, it is likely a good idea to use the current rally to rebalance portfolio risk and adjust allocations accordingly.

As I stated in mid-January, and again in early February, we reduced exposure in portfolios by raising cash and rebalancing portfolios back to target weightings. We had also added interest rate sensitive hedges to portfolios, and removed all of our international and emerging market exposures.

We will be using this rally to remove basic materials and industrials, which are susceptible to supply shocks, and financials which will be impacted by an economic slowdown/recession which will likely trigger rising defaults in the credit market.

Here are the guidelines we recommend for adjusting your portfolio risk:

Step 1) Clean Up Your Portfolio

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Take profits in positions that have been big winners
  3. Sell laggards and losers
  4. Raise cash and rebalance portfolios to target weightings.

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

  1. Determine areas requiring new or increased exposure.
  2. Determine how many shares need to be purchased to fill allocation requirements.
  3. Determine cash requirements to make purchases.
  4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
  5. Determine entry price levels for each new position.
  6. Determine “stop loss” levels for each position.
  7. Determine “sell/profit taking” levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are adjusting exposure to areas we like now, and using the rally to reduce/remove the sectors we do not want exposure too.

Stay alert, things are finally getting interesting.

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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.

#MacroView: Japan, The Fed, & The Limits Of QE

This past week saw a couple of interesting developments.

On Wednesday, the Fed released the minutes from their January meeting with comments which largely bypassed overly bullish investors.

“… several participants observed that equity, corporate debt, and CRE valuations were elevated and drew attention to  high levels of corporate indebtedness and weak underwriting standards in leveraged loan markets. Some participants expressed the concern that financial imbalances-including overvaluation and excessive indebtedness-could amplify an adverse shock to the economy …”

“… many participants remarked that the Committee should not rule out the possibility of adjusting the stance of monetary policy to mitigate financial stability risks, particularly when those risks have important implications for the economic outlook and when macroprudential tools had been or were likely to be ineffective at mitigating those risks…”

The Fed recognizes their ongoing monetary interventions have created financial risks in terms of asset bubbles across multiple asset classes. They are also aware that the majority of the policy tools are likely ineffective at mitigating financial risks in the future. This leaves them being dependent on expanding their balance sheet as their primary weapon.

Interestingly, the weapon they are dependent on may not be as effective as they hope. 

This past week, Japan reported a very sharp drop in economic growth in their latest reported quarter as a further increase in the sales-tax hit consumption. While the decline was quickly dismissed by the markets, this was a pre-coronovirus impact, which suggests that Japan will enter into an “official” recession in the next quarter.

There is more to this story.

Since the financial crisis, Japan has been running a massive “quantitative easing” program which, on a relative basis, is more than 3-times the size of that in the U.S. However, while stock markets have performed well with Central Bank interventions, economic prosperity is only slightly higher than it was prior to the turn of century.

Furthermore, despite the BOJ’s balance sheet consuming 80% of the ETF markets, not to mention a sizable chunk of the corporate and government debt market, Japan has been plagued by rolling recessions, low inflation, and low-interest rates. (Japan’s 10-year Treasury rate fell into negative territory for the second time in recent years.)

Why is this important? Because Japan is a microcosm of what is happening in the U.S. As I noted previously:

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

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

As my colleague Doug Kass recently noted, Japan is a template of the fragility of global economic growth. 

“Global growth continues to slow and the negative impact on demand and the broad supply interruptions will likely expose the weakness of the foundation and trajectory of worldwide economic growth. This is particularly dangerous as the monetary ammunition has basically been used up.

As we have observed, monetary growth (and QE) can mechanically elevate and inflate the equity markets. For example, now in the U.S. market, basic theory is that in practice a side effect is that via the ‘repo’ market it is turned into leveraged trades into the equity markets. But, again, authorities are running out of bullets and have begun to question the efficacy of monetary largess.

Bigger picture takeaway is beyond the fact that financial engineering does not help an economy, it probably hurts it. If it helped, after mega-doses of the stuff in every imaginable form, the Japanese economy would be humming. But the Japanese economy is doing the opposite. Japan tried to substitute monetary policy for sound fiscal and economic policy. And the result is terrible.

While financial engineering clearly props up asset prices, I think Japan is a very good example that financial engineering not only does nothing for an economy over the medium to longer-term, it actually has negative consequences.” 

This is a key point.

The “Stock Market” Is NOT The “Economy.”

Roughly 90% of the population gets little, or no, direct benefit from the rise in stock market prices.

Another way to view this issue is by looking at household net worth growth between the top 10% to everyone else.

Since 2007, the ONLY group that has seen an increase in net worth is the top 10% of the population.


“This is not economic prosperity.

This is a distortion of economics.”


From 2009-2016, the Federal Reserve held rates at 0%, and flooded the financial system with 3-consecutive rounds of “Quantitative Easing” or “Q.E.” During that period, average real rates of economic growth rates never rose much above 2%.

Yes, asset prices surged as liquidity flooded the markets, but as noted above “Q.E.” programs did not translate into economic activity. The two 4-panel charts below shows the entirety of the Fed’s balance sheet expansion program (as a percentage) and its relative impact on various parts of the real economy. (The orange bar shows now many dollars of increase in the Fed’s balance sheet that it took to create an increase in each data point.)

As you can see, it took trillions in “QE” programs, not to mention trillions in a variety of other bailout programs, to create a relatively minimal increase in economic data. Of course, this explains the growing wealth gap, which currently exists as monetary policy lifted asset prices.

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. Not surprisingly, the latest round of QE, which rang “Pavlov’s bell,” has moved back to a near perfect 1:1 ratio.

Clearly, QE worked well in lifting asset prices, but as shown above, not so much for the economy. 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 QE will be implemented at the first hint of a more protracted downturn in the market. However, as suggested by the Fed, QE will likely only be employed when rate reductions aren’t enough. This was a point made 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 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.

So, 2-years ago David lays out the plan, and on Wednesday, the Fed reiterates that plan.

Does the Fed see a recession on the horizon? Is this why there are concerns about valuations?

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.

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

If the market fell into a recession tomorrow, the Fed would be starting with a $4.2 Trillion balance sheet with interest rates 3% 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.

Importantly, QE, and rate reductions, have the MOST effect when the economy, markets, and investors are extremely negative.

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

Such was the case in 2009. Not today.

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.

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.

Furthermore, we have much more akin with Japan than many would like to believe.

  • A decline in savings rates
  • An aging demographic
  • A heavily indebted economy
  • A decline in exports
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases

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

While another $2-4 Trillion in QE might indeed be successful in keeping the bubble inflated for a while longer, there is a limit to the ability to continue pulling 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 the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be larger than currently imagined. The Fed’s biggest fear is finding themselves powerless to offset the negative impacts of the next recession. 

If more “QE” works, great.

But as investors, with our retirement savings at risk, what if it doesn’t.

Gone Fishing Newsletter: The Inflation Edition

We are thrilled to present a recent article from Samantha LaDuc, the Founder of LaDucTrading.com and the CIO at LaDuc Capital LLC. 

Samantha LaDuc is known for timing major inflection points in equities, commodities, bonds/rates, currencies and volatility. As a Macro-to-Micro strategic technical analyst, educator and trader, she makes her insights available to active traders and investors who want to minimize risk while seizing year-making opportunities.  


Spoiler Alert: We have no inflation in commodities.

Healthcare, Education, Concert Tickets … absolutely.

Image

But what about the stuff we consume and use every day?

CRB Commodities is made up of the following weighting:

  • Softs (Coffee, Sugar, Orange Juice) 23.5%
  • Energy 17.6%
  • Grains 17.6%
  • Precious Metals 17.6%
  • Industrials (Copper & Cotton) 11.8%
  • Meats 11.8%

Commodities – Big Picture on a Monthly Time-frame – show that we are still in a multi-decade low.

“Yields have been falling, reflecting concerns about global growth, and also the dramatic change of direction by central banks, which was itself largely driven by fears for growth. The 10-year Treasury yield is now almost a full percentage point lower than it was two years ago, and its trend is clearly downward. Indeed, if we take inflation expectations into account, the real 10-year Treasury yield has just gone negative.

According to the Bloomberg commodity indexes, industrial metals have now under-performed precious metals over the period since Donald Trump was elected U.S. president; and the price of oil is collapsing anew relative to gold. These moves only make sense if people are worried about growth.” – John Authers, Bloomberg

Sounds dreary, and John’s commentary was before the CoronaVirus outbreak really grabbed American businesses’ attention.

Despite my bearish leanings as detailed here: Perfect Storm: CoronaVirus and Market Risks, from my vantage point, we ‘should’ bounce soon (yellow circle). If not, we have more serious deflation to deal with – not just disinflation in the commodity patch.

Now let’s drop the USD softly behind the same chart and add some annotations. We have potential for a bounce, but also a lot of resistance and indecision. No clean signal yet. Still chop. And a DXY that has been range-bound for 4 years! Clearly, the US Dollar makes the weather for commodities and Foreign Exchange volatility as at an All Time Low. You know my saying: Outliers Revert With Velocity. Watch the USD for The Tell.

I should also add to this Intermarket analysis with the Macro read: it’s bearish inflation.

 @ISABELNET_SA Chart is suggesting that M2 velocity YoY leads US core inflation by 21 months. It has been quite accurate for more than 20 years. And it portends lower.

Image

Commodities are Dead, Long Live Commodities?

So why fight the trend? Humor me for ‘the other side” of the argument. Let’s assume inflation catches a bounce, pulling up commodities and yields with it, what segments are most likely to rise?

Food – Softs, Grains, Meats: China is experiencing strong Food price inflation from drought conditions (Rice), culling of all that Pork (and soon Chicken?). But in the US, these input prices are declerating (Coffee, Corn, Hogs, etc). With the new Coronavirus shutting off the flow of goods into and out of China for the time-being – and I suspect until April/May – we could start to see a tick up in Food Prices. Worst case, as the pandemic spreads, people with be unwilling/unable to go to work which could also trigger supply chain constraints. Prices could accelerate quickly on supply contraction.

Energy: What’s the bull case for Energy? Oversold, “value” play with high trailing dividend yields? They are high for a reason and still major laggard of all SPY sectors for several years now. Oil investment is waning not expanding (given Trump’s energy policies). So aside from a geopolitical ‘flare’ to temporarily disrupt supply, like with Iran, the case for sustainable higher oil is weak. And if/when Venezuela comes back online, it would be a big hit to the bull case (more supply). In the meantime, we have demand destruction out of China as a result of the CoronaVirus and general trends in decreasing demand due to:

1) Deglobalization
2) Decarbonization
3) Debt saturation
4) Donald Trump

Industrials: Copper is the big one, and it is at 2016 levels, so not expressing an economic growth look. Translation: The Trump Bump (2017) has been Dumped.

Precious Metals: Here are two charts that sum up my frustration on the perception versus reality of bidding up precious metals.

(Separate from the whole Palladium and Platinum play, which I have written about since early November as a bullish thesis.)

Treasury yields are negative after adjusting for inflation so that is supposed to be a plus for gold….

But, Gold/Silver Mining stocks are looking weary and potentially rolling over.

OK, I may have talked you out of a Commodity bump, but stick with me.

Commodities, The New Bonds?

Just over a year ago, the Fed finished systematically hiking rates (after 8 of them) as ECB quit QE. Today, Fed has lowered rates 3 times in 2019 and market is pricing in 2 more cuts for 2020! Fed clearly seems to unwind their 2017 tightening to avoid what happened in Fall of 2018 where U.S. stocks collapsed nearly 20% from Oct 3 to Dec 31st. Basically, the Fed realized it had spent three years tightening into a low inflation, low growth U.S. economy, and the global economy was too fragile to handle the liquidity and tightening drain.

But rate cuts at this point have reached the law of diminishing returns and Repo operations to inject capital in the money markets seems inadequate to jump-start growth. Fiscal policies in combination may be the fuel that flame inflation, in which case, commodities could recover and rally, but there are some heady headwinds:

Headwinds:

  1. Demand destruction from slowing global growth from Coronavirus in particular, economic cycle and ‘protectionist’ trends in general.
  2. Lower yields pull commodities with it, (and vice versa), but right now Fed has their proverbial thumb on any increases.
  3. Global central banks have suppressed volatility by anchoring expectations with “lower for longer”, thereby enhancing the effect of rate cuts which suppresses commodities.
  4. A more dovish Fed also reduces the US-Foreign bond yield spread which strengthens the dollar, thereby suppressing local currency valuation while burdening thier USD funding obligations.
  5. A stronger dollar is tailwind to commodity run (inversely related since commodities are priced in USD).

Tailwinds:

  1. Local and Coordinated Global Fiscal Policies trigger global economic optimism; Debt and Deficit hawks be damned.
  2. Containment of CoronaVirus psychologically and financially allow for economic expansion. Both will drive yields higher.

Until these factors reveal themselves, yields are falling and at risk of breaking critical support.

Top 10 Reasons for Bond Reversal:

From Buy Bonds, Wear Zirconia:

  1. Yields are approaching my buy point just above All Time Lows.
  2. Bonds/Yields are on their respective Bollinger Bands/Keltner Channel bands (yellow circle on weekly chart) which often acts as resistance causing a rubberband.snap-back effect.
  3. Seasonal tendency to Sell Bonds starts Jan 31st.
  4. Nomura’s Charlie McElligott  “1m Price Reversal” trade has run its course (1.94 drop to 1.64 in 10 yr yield since Dec 18th)
  5. Duration infatuation” (the safety-trade) often kicks in at the first sign of trouble, but then unwinds.
  6. The “normal” viral drag on US10Yr has the following tendency – yields fall then bounce back sharply.
  7. Fed won’t want the yield curve inversion which already erased half of the Q4 steepening.
  8. UPDATED PRE FOMC: Fed may need to guide inflation above target … which in turn supports a steeper curve, SO there is strong potential for final 2020 rate cut to CAUSE inflation expectations to rise.
  9. And the best reason potentially of all: Stocks are now Yielding More Than Bonds Again

“In the early summer of last year, the 10-Year Treasury Note was bid up considerably, resulting in it yielding less than the S&P 500’s dividend yield. In fact, at the point of the largest divergence between the two in late August, the dividend yield of the S&P 500 was 56.9 bps higher than the yield on the 10-Year Treasury. Although the disparity between the two has shrunk from that August peak, that trend has generally continued in the months since then, though equities’ surge into the end of the year saw bonds briefly yielding more in December. Since the start of the new year, stocks once again hold a higher yield, especially today as worries about the coronavirus have resulted in the selling of risk assets (raising the S&P 500’s yield) and subsequent buying of safe-havens (lowering the 10-Year Treasury yield). Now, the spread between the S&P 500’s dividend yield and that of the 10-Year is at its widest level in favor of the S&P 500 since October 10th.” –  DATATREK

I am nothing if not persistent.

Here is my client post from January 24th on this related subject: All Alone With My Higher Yield Thesis:

High Yield corporate debt is in trouble with Oil dropping 20% since Jan 7th and Shale companies facing their biggest loan refinancing wall in 20 years. When HY credit passes 358 bp then Momentum will very likely sell off – like happened in early September 2019 – and Value will finally catch a sustainable bid! And when Hedge Funds cover their Value shorts,  they sell Bonds! And when bonds get sold, with momentum selling off too, rates rip and we have a perfect storm set up for a massive VIX spike and gamma flipping.”

That is still my baseline projection. Market just doesn’t see it yet.


LaDuc Trading/LaDuc Capital LLC Is Not a Financial Advisor, RIA or Broker/Dealer.  Trading Stocks, Options, Futures and Forex includes significant financial risk. We teach and inform. You enter trades at your own risk. Learn more.

Gone Fishing Newsletter: The Inflation Edition

We are thrilled to present a recent article from Samantha LaDuc, the Founder of LaDucTrading.com and the CIO at LaDuc Capital LLC. 

Samantha LaDuc is known for timing major inflection points in equities, commodities, bonds/rates, currencies and volatility. As a Macro-to-Micro strategic technical analyst, educator and trader, she makes her insights available to active traders and investors who want to minimize risk while seizing year-making opportunities.  


Spoiler Alert: We have no inflation in commodities.

Healthcare, Education, Concert Tickets … absolutely.

Image

But what about the stuff we consume and use every day?

CRB Commodities is made up of the following weighting:

  • Softs (Coffee, Sugar, Orange Juice) 23.5%
  • Energy 17.6%
  • Grains 17.6%
  • Precious Metals 17.6%
  • Industrials (Copper & Cotton) 11.8%
  • Meats 11.8%

Commodities – Big Picture on a Monthly Time-frame – show that we are still in a multi-decade low.

“Yields have been falling, reflecting concerns about global growth, and also the dramatic change of direction by central banks, which was itself largely driven by fears for growth. The 10-year Treasury yield is now almost a full percentage point lower than it was two years ago, and its trend is clearly downward. Indeed, if we take inflation expectations into account, the real 10-year Treasury yield has just gone negative.

According to the Bloomberg commodity indexes, industrial metals have now under-performed precious metals over the period since Donald Trump was elected U.S. president; and the price of oil is collapsing anew relative to gold. These moves only make sense if people are worried about growth.” – John Authers, Bloomberg

Sounds dreary, and John’s commentary was before the CoronaVirus outbreak really grabbed American businesses’ attention.

Despite my bearish leanings as detailed here: Perfect Storm: CoronaVirus and Market Risks, from my vantage point, we ‘should’ bounce soon (yellow circle). If not, we have more serious deflation to deal with – not just disinflation in the commodity patch.

Now let’s drop the USD softly behind the same chart and add some annotations. We have potential for a bounce, but also a lot of resistance and indecision. No clean signal yet. Still chop. And a DXY that has been range-bound for 4 years! Clearly, the US Dollar makes the weather for commodities and Foreign Exchange volatility as at an All Time Low. You know my saying: Outliers Revert With Velocity. Watch the USD for The Tell.

I should also add to this Intermarket analysis with the Macro read: it’s bearish inflation.

 @ISABELNET_SA Chart is suggesting that M2 velocity YoY leads US core inflation by 21 months. It has been quite accurate for more than 20 years. And it portends lower.

Image

Commodities are Dead, Long Live Commodities?

So why fight the trend? Humor me for ‘the other side” of the argument. Let’s assume inflation catches a bounce, pulling up commodities and yields with it, what segments are most likely to rise?

Food – Softs, Grains, Meats: China is experiencing strong Food price inflation from drought conditions (Rice), culling of all that Pork (and soon Chicken?). But in the US, these input prices are declerating (Coffee, Corn, Hogs, etc). With the new Coronavirus shutting off the flow of goods into and out of China for the time-being – and I suspect until April/May – we could start to see a tick up in Food Prices. Worst case, as the pandemic spreads, people with be unwilling/unable to go to work which could also trigger supply chain constraints. Prices could accelerate quickly on supply contraction.

Energy: What’s the bull case for Energy? Oversold, “value” play with high trailing dividend yields? They are high for a reason and still major laggard of all SPY sectors for several years now. Oil investment is waning not expanding (given Trump’s energy policies). So aside from a geopolitical ‘flare’ to temporarily disrupt supply, like with Iran, the case for sustainable higher oil is weak. And if/when Venezuela comes back online, it would be a big hit to the bull case (more supply). In the meantime, we have demand destruction out of China as a result of the CoronaVirus and general trends in decreasing demand due to:

1) Deglobalization
2) Decarbonization
3) Debt saturation
4) Donald Trump

Industrials: Copper is the big one, and it is at 2016 levels, so not expressing an economic growth look. Translation: The Trump Bump (2017) has been Dumped.

Precious Metals: Here are two charts that sum up my frustration on the perception versus reality of bidding up precious metals.

(Separate from the whole Palladium and Platinum play, which I have written about since early November as a bullish thesis.)

Treasury yields are negative after adjusting for inflation so that is supposed to be a plus for gold….

But, Gold/Silver Mining stocks are looking weary and potentially rolling over.

OK, I may have talked you out of a Commodity bump, but stick with me.

Commodities, The New Bonds?

Just over a year ago, the Fed finished systematically hiking rates (after 8 of them) as ECB quit QE. Today, Fed has lowered rates 3 times in 2019 and market is pricing in 2 more cuts for 2020! Fed clearly seems to unwind their 2017 tightening to avoid what happened in Fall of 2018 where U.S. stocks collapsed nearly 20% from Oct 3 to Dec 31st. Basically, the Fed realized it had spent three years tightening into a low inflation, low growth U.S. economy, and the global economy was too fragile to handle the liquidity and tightening drain.

But rate cuts at this point have reached the law of diminishing returns and Repo operations to inject capital in the money markets seems inadequate to jump-start growth. Fiscal policies in combination may be the fuel that flame inflation, in which case, commodities could recover and rally, but there are some heady headwinds:

Headwinds:

  1. Demand destruction from slowing global growth from Coronavirus in particular, economic cycle and ‘protectionist’ trends in general.
  2. Lower yields pull commodities with it, (and vice versa), but right now Fed has their proverbial thumb on any increases.
  3. Global central banks have suppressed volatility by anchoring expectations with “lower for longer”, thereby enhancing the effect of rate cuts which suppresses commodities.
  4. A more dovish Fed also reduces the US-Foreign bond yield spread which strengthens the dollar, thereby suppressing local currency valuation while burdening thier USD funding obligations.
  5. A stronger dollar is tailwind to commodity run (inversely related since commodities are priced in USD).

Tailwinds:

  1. Local and Coordinated Global Fiscal Policies trigger global economic optimism; Debt and Deficit hawks be damned.
  2. Containment of CoronaVirus psychologically and financially allow for economic expansion. Both will drive yields higher.

Until these factors reveal themselves, yields are falling and at risk of breaking critical support.

Top 10 Reasons for Bond Reversal:

From Buy Bonds, Wear Zirconia:

  1. Yields are approaching my buy point just above All Time Lows.
  2. Bonds/Yields are on their respective Bollinger Bands/Keltner Channel bands (yellow circle on weekly chart) which often acts as resistance causing a rubberband.snap-back effect.
  3. Seasonal tendency to Sell Bonds starts Jan 31st.
  4. Nomura’s Charlie McElligott  “1m Price Reversal” trade has run its course (1.94 drop to 1.64 in 10 yr yield since Dec 18th)
  5. Duration infatuation” (the safety-trade) often kicks in at the first sign of trouble, but then unwinds.
  6. The “normal” viral drag on US10Yr has the following tendency – yields fall then bounce back sharply.
  7. Fed won’t want the yield curve inversion which already erased half of the Q4 steepening.
  8. UPDATED PRE FOMC: Fed may need to guide inflation above target … which in turn supports a steeper curve, SO there is strong potential for final 2020 rate cut to CAUSE inflation expectations to rise.
  9. And the best reason potentially of all: Stocks are now Yielding More Than Bonds Again

“In the early summer of last year, the 10-Year Treasury Note was bid up considerably, resulting in it yielding less than the S&P 500’s dividend yield. In fact, at the point of the largest divergence between the two in late August, the dividend yield of the S&P 500 was 56.9 bps higher than the yield on the 10-Year Treasury. Although the disparity between the two has shrunk from that August peak, that trend has generally continued in the months since then, though equities’ surge into the end of the year saw bonds briefly yielding more in December. Since the start of the new year, stocks once again hold a higher yield, especially today as worries about the coronavirus have resulted in the selling of risk assets (raising the S&P 500’s yield) and subsequent buying of safe-havens (lowering the 10-Year Treasury yield). Now, the spread between the S&P 500’s dividend yield and that of the 10-Year is at its widest level in favor of the S&P 500 since October 10th.” –  DATATREK

I am nothing if not persistent.

Here is my client post from January 24th on this related subject: All Alone With My Higher Yield Thesis:

High Yield corporate debt is in trouble with Oil dropping 20% since Jan 7th and Shale companies facing their biggest loan refinancing wall in 20 years. When HY credit passes 358 bp then Momentum will very likely sell off – like happened in early September 2019 – and Value will finally catch a sustainable bid! And when Hedge Funds cover their Value shorts,  they sell Bonds! And when bonds get sold, with momentum selling off too, rates rip and we have a perfect storm set up for a massive VIX spike and gamma flipping.”

That is still my baseline projection. Market just doesn’t see it yet.


LaDuc Trading/LaDuc Capital LLC Is Not a Financial Advisor, RIA or Broker/Dealer.  Trading Stocks, Options, Futures and Forex includes significant financial risk. We teach and inform. You enter trades at your own risk. Learn more.

#MacroView: Debt, Deficits & The Path To MMT.

In September 2017, when the Trump Administration began promoting the idea of tax cut legislation, I wrote a series of articles discussing the fallacy that tax cuts would lead to higher tax collections, and a reduction in the deficit. To wit:

“Given today’s record-high levels of debt, the country cannot afford a deficit-financed tax cut. Tax reform that adds to the debt is likely to slow, rather than improve, long-term economic growth.

The problem with the claims that tax cuts reduce the deficit is that there is NO evidence to support the claim. The increases in deficit spending to supplant weaker economic growth has been apparent with larger deficits leading to further weakness in economic growth. In fact, ever since Reagan first lowered taxes in the ’80’s both GDP growth and the deficit have only headed in one direction – higher.”

That was the deficit in September 2017.

Here it is today.

As opposed to all the promises made, economic growth failed to get stronger. Furthermore, federal revenues as a percentage of GDP declined to levels that have historically coincided with recessions.

Why Does This Matter?

President Trump just proposed his latest $4.8 Trillion budget, and not surprisingly, suggests the deficit will decrease over the next 10-years.

Such is a complete fantasy and was derived from mathematical gimmickry to delude voters to the contrary. As Jim Tankersley recently noted:

The White House makes the case that this is affordable and that the deficit will start to fall, dropping below $1 trillion in the 2021 fiscal year, and that the budget will be balanced by 2035. That projection relies on rosy assumptions about growth and the accumulation of new federal debt — both areas where the administration’s past predictions have proved to be overconfident.

The new budget forecasts a growth rate for the United States economy of 2.8 percent this year — or, by the metric the administration prefers to cite, a 3.1 percent rate. That is more than a half percentage point higher than forecasters at the Federal Reserve and the Congressional Budget Office predict.

It then predicts growth above 3 percent annually for the next several years if the administration’s economic policies are enacted. The Fed, the budget office and others all see growth falling below 2 percent annually in that time. By 2030, the administration predicts the economy will be more than 15 percent larger than forecasters at the budget office do.

Past administrations have also dressed up their budget forecasts with economic projections that proved far too good to be true. In its fiscal year 2011 budget, for example, the Obama administration predicted several years of growth topping 4 percent in the aftermath of the 2008 financial crisis — a number it never came close to reaching even once.

Trump’s budget expectations also contradict the Congressional Budget Office’s latest deficit warning:

“CBO estimates a 2020 deficit of $1.0 trillion, or 4.6 percent of GDP. The projected gap between spending and revenues increases to 5.4 percent of GDP in 2030. Federal debt held by the public is projected to rise over the ­coming decade, from 81 percent of GDP in 2020 to 98 percent of GDP in 2030. It continues to grow ­thereafter in CBO’s projections, reaching 180 percent of GDP in 2050, well above the highest level ever recorded in the United States.”

“With unprecedented trillion-dollar deficits projected as far as the eye can see, this country needs a serious budget. Unfortunately, that cannot be said of the one the President just submitted to Congress, which is filled with non-starters and make-believe economics.” – Maya Macguineas

Debt Slows Economic Growth

There is a long-standing addiction in Washington to debt. Every year, we continue to pile on more debt with the expectation that economic growth will soon follow.

However, excessive borrowing by companies, households or governments lies at the root of almost every economic crisis of the past four decades, from Mexico to Japan, and from East Asia to Russia, Venezuela, and Argentina. But it’s not just countries, but companies as well. You don’t have to look too far back to see companies like Enron, GM, Bear Stearns, Lehman, and a litany of others brought down by surging debt levels and simple “greed.” Households, too, have seen their fair share of debt burden related disaster from mortgages to credit cards to massive losses of personal wealth.

It would seem that after nearly 40-years, some lessons would have been learned.

Such reckless abandon by politicians is simply due to a lack of “experience” with the consequences of debt.

In 2008, Margaret Atwood discussed this point in a Wall Street Journal article:

“Without memory, there is no debt. Put another way: Without story, there is no debt.

A story is a string of actions occurring over time — one damn thing after another, as we glibly say in creative writing classes — and debt happens as a result of actions occurring over time. Therefore, any debt involves a plot line: how you got into debt, what you did, said and thought while you were in there, and then — depending on whether the ending is to be happy or sad — how you got out of debt, or else how you got further and further into it until you became overwhelmed by it, and sank from view.”

The problem today is there is no “story” about the consequences of debt in the U.S. While there is a litany of other countries which have had their own “debt disaster” story, those issues have been dismissed under the excuse of “yes, but they aren’t the U.S.”

But this lack of a “story,” is what has led us to the very doorstep of “Modern Monetary Theory,” or “MMT.” As Michael Lebowitz previously explained:

“MMT theory essentially believes the government spending can be funded by printing money. Currently, government spending is funded by debt, and not the Fed’s printing press. MMT disciples tell us that when the shackles of debt and deficits are removed, government spending can promote economic growth, full employment and public handouts galore.

Free healthcare and higher education, jobs for everyone, living wages and all sorts of other promises are just a few of the benefits that MMT can provide. At least, that is how the theory is being sold.”

What’s not to love?

Oh yes, it’s that deficit thing.

Deficits Are Not Self-Financing

The premise of MMT is that government “deficit” spending is not a problem because the spending into “productive investments” pay for themselves over time.

But therein lies the problem – what exactly constitutes “productive investments?”

For government “deficit” spending to be effective, the “payback” from investments made must yield a higher rate of return than the interest rate on the debt used to fund it. 

Examples of such investments range from the Hoover Dam to the Tennessee River Valley Authority. Importantly, “infrastructure spending projects,” must have a long-term revenue stream tied to time. Building roads and bridges to “nowhere,” may create short-term jobs, but once the construction is complete, the economic benefit turns negative.

The problem for MMT is its focus on spending is NOT productive investments but rather social welfare which has a negative rate of return. 

Of course, the Government has been running a “Quasi-MMT” program since 1980.

According to the Center On Budget & Policy Priorities, roughly 75% of every current tax dollar goes to non-productive spending. (The same programs the Democrats are proposing.)

To make this clearer, in 2019, the Federal Government spent $4.8 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.6 Trillion was financed by Federal revenues, and $1.1 trillion was financed through debt.

In other words, if 75% of all expenditures go to social welfare and interest on the debt, those payments required $3.6 Trillion, or roughly 99% of the total revenue coming in. 

There is also clear evidence that increasing debts and deficits DO NOT lead to either stronger economic growth or increasing productivity. As Michael Lebowitz previously showed:

“Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4 to 6%. While there is no exact measure of productivity, total factor productivity (TFP) is considered one of the best measures. Data for TFP can found here.

The graph below plots a simple index we created based on total factor productivity (TFP) versus the ten-year average growth rate of TFP. The TFP index line is separated into green and red segments to highlight the change in the trend of productivity growth rate that occurred in the early 1970’s. The green dotted line extrapolates the trend of the pre-1972 era forward.”

“The plot of the 10-year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line) is telling.”

“This reinforces the message from the other debt-related graphs – over the last 30-years the economy has relied more upon debt growth and less on productivity to generate economic activity.

The larger the balance of debt has become, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments.

Since 2008, the economy has been growing well below its long-term exponential trend. Such has been a consistent source of frustration for both Obama, Trump, and the Fed, who keep expecting higher rates of economic only to be disappointed.

The relevance of debt growth versus economic growth is all too evident. When debt issuance exploded under the Obama administration, and accelerated under President Trump, it has taken an ever-increasing amount of debt to generate $1 of economic growth.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has been no organic economic growth.

For the 30-years, from 1952 to 1982, the economic surplus fostered a rising economic growth rate, which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been higher. If you subtract the debt, there has not been any organic economic growth since 1990. 

What is indisputable is that running ongoing budget deficits that fund unproductive growth is not economically sustainable long-term.

The End Game Cometh

Over the last 40-years, the U.S. economy has engaged in increasing levels of deficit spending without the results promised by MMT.

There is also a cost to MMT we have yet to hear about from its proponents.

The value of the dollar, like any commodity, rises and falls as the supply of dollars change. If the government suddenly doubled the money supply, one dollar would still be worth one dollar but it would only buy half of what it would have bought prior to their action.

This is the flaw MMT supporters do not address.

MMT is not a free lunch.

MMT is paid for by reducing the value of the dollar and ergo your purchasing power. MMT is a hidden tax paid by everyone holding dollars. The problem, as Michael Lebowitz outlined in Two Percent for the One Percent, inflation tends to harm the poor and middle class while benefiting the wealthy.

This is why the wealth gap is more pervasive than ever. Currently, the Top 10% of income earners own nearly 87% of the stock market. The rest are just struggling to make ends meet.

As I stated above, the U.S. has been running MMT for the last three decades, and has resulted in social inequality, disappointment, frustration, and a rise in calls for increasing levels of socialism.

It is all just as you would expect from such a theory put into practice, and history is replete with countries that have attempted the same. Currently, the limits of profligate spending in Washington has not been reached, and the end of this particular debt story is yet to be written.

But, it eventually will be.

SOTM 2020: State Of The Markets

“I am thrilled to report to you tonight that our economy is the best it has ever been.” – President Trump, SOTU

In the President’s “State of the Union Address” on Tuesday, he used the podium to talk up the achievements in the economy and the markets.

  • Low unemployment rates
  • Tax cuts
  • Job creation
  • Economic growth, and, of course,
  • Record high stock markets.

While it certainly is a laundry list of items he can claim credit for, it is the claim of record-high stock prices that undermines the rest of the story.

Let me explain.

The stock market should be a reflection of actual economic growth. Since corporate earnings are derived primarily from consumptive spending, corporate investments, and imports and exports, actual economic activity should be reflected in the price investors are willing to pay for the earnings being generated.

For the majority of the 20th century, this was indeed the case as corporate earnings were reflective of economic activity. The chart below shows the annual change in reported earnings, nominal GDP, and the price of the S&P 500.

Not surprisingly, as the economy grew at 6.47% annually, earnings also grew at 6.68% annually as would be expected. Since investors are willing to a premium for earnings growth, the S&P 500 grew at 9% annually over that same period.

Importantly, note that long-term economic growth has averaged 6% annually. However, as shown in the lower panel, economic growth has been running below the long-term average since 2000, but has been substantially weaker since 2007, growing at just 2% annually.

The next chart shows this weaker growth more clearly. Since the financial crisis, economic growth has failed to recover back to its long-term exponential growth trend. However, reported earnings are exceedingly deviated from what actual underlying economic growth can generate. This is due to a decade of accounting gimmickry, share buybacks, wage suppression, low interest rates, and high corporate debt levels.

The next chart looks at the deviation by looking at the market itself versus long-term economic growth. The S&P 500 and GDP have been scaled to 100, and displayed on a log-scale for comparative purposes.

The current growth trend of the economy is running well below its long-term exponential trend, but the S&P 500 is currently at the most significant deviation from that growth on record. (It should be noted that while these deviations from economic growth can last for a long-time, the eventual mean reversion always occurs.)

The Spending Mirage

Take a look at the following chart.

While the President’s claims of an exceptionally strong economy rely heavily on historically low unemployment and jobless claims numbers, historically high levels of asset prices, and strong consumer spending trends, there is an underlying deterioration which goes unaddressed.

So, here’s your pop quiz?

If consumer spending is strong, AND unemployment is near the lowest levels on record, AND interest rates are low, AND job creation is high – then why is the economy only growing at 2%?

Furthermore, if the economy was doing as well as government statistics suggest, then why does the Federal Reserve need to continue providing the economy with “emergency measures,” cutting rates, and giving “verbal guidance,” to keep the markets from crashing?

The reality is that if it wasn’t for the Government running a massive trillion-dollar fiscal deficit, economic growth would actually be recessionary.

In GDP accounting, consumption is the largest component. Of course, since it is impossible to “consume oneself to prosperity,” the ability to consume more is the result of growing debt. Furthermore, economic growth is also impacted by Government spending, as government transfer payments, including Medicaid, Medicare, disability payments, and SNAP (previously called food stamps), all contribute to the calculation.

As shown below, between the Federal Reserve’s monetary infusions and the ballooning government deficit, the S&P 500 has continued to find support.

However, nothing is “produced” by those transfer payments. They are not even funded. As a result, national debt rises every year, and that debt adds to GDP.

Another way to look at this is through tax receipts as a percentage of GDP.  If the economy was indeed “the strongest ever,” then we should see an increase in wage growth commensurate with increased economic activity. As a result of higher wages, there should be an increase in the taxes collected by the Government from wages, consumption, imports, and exports.

See the problem here?

Clearly, this is not the case as tax receipts as a percentage of GDP peaked in 2012, and have now declined to levels which historically are more coincident with economic recessions, rather than expansions. Yet, currently, because of the artificial interventions, the stock market remains well detached from what economic data is actually saying.

Corporate Profits Tell The Real Story

When it comes to the state of the market, corporate profits are the best indicator of economic strength.

The detachment of the stock market from underlying profitability guarantees poor future outcomes for investors. But, as has always been the case, the markets can certainly seem to “remain irrational longer than logic would predict,” but it never lasts indefinitely.

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly.” – Jeremy Grantham

As shown, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP, we see a clear process of mean-reverting activity over time. Of course, those mean reverting events are always coupled with recessions, crises, or bear markets.

More importantly, corporate profit margins have physical constraints. Out of each dollar of revenue created, there are costs such as infrastructure, R&D, wages, etc. Currently, the biggest contributors to expanding profit margins has been the suppression of employment, wage growth, and artificially suppressed interest rates, which have significantly lowered borrowing costs. Should either of the issues change in the future, the impact to profit margins will likely be significant.

The chart below shows the ratio overlaid against the S&P 500 index.

I have highlighted peaks in the profits-to-GDP ratio with the green vertical bars. As you can see, peaks, and subsequent reversions, in the ratio have been a leading indicator of more severe corrections in the stock market over time. This should not be surprising as asset prices should eventually reflect the underlying reality of corporate profitability.

It is often suggested that, as mentioned above, low interest rates, accounting rule changes, and debt-funded buybacks have changed the game. While that statement is true, it is worth noting that each of those supports are artificial and finite.

Another way to look at the issue of profits as it relates to the market is shown below. When we measure the cumulative change in the S&P 500 index as compared to the level of profits, we find again that when investors pay more than $1 for a $1 worth of profits, there is an eventual mean reversion.

The correlation is clearer when looking at the market versus the ratio of corporate profits to GDP. (Again, since corporate profits are ultimately a function of economic growth, the correlation is not unexpected.) 

It seems to be a simple formula for investors that as long as the Fed remains active in supporting asset prices, the deviation between fundamentals and fantasy doesn’t matter. 

However, investors are paying more today than at any point in history for each $1 of profit, which history suggests will not end well.

While the media is quick to attribute the current economic strength, or weakness, to the person who occupies the White House, the reality is quite different.

The political risk for President Trump is taking too much credit for an economic cycle which was already well into recovery before he took office. Rather than touting the economic numbers and taking credit for liquidity-driven financial markets, he should be using that strength to begin the process of returning the country to a path of fiscal discipline rather than a “drunken binge” of government spending.

With the economy, and the financial markets, sporting the longest-duration in history, simple logic should suggest time is running out.

This isn’t doom and gloom, it is just a fact.

Politicians, over the last decade, failed to use $33 trillion in liquidity injections, near-zero interest rates, and surging asset prices to refinance the welfare system, balance the budget, and build surpluses for the next downturn.

Instead, they only made the deficits worse, and the U.S. economy will enter the next recession pushing a $2 Trillion deficit, $24 Trillion in debt, and a $6 Trillion pension gap, which will devastate many in their retirement years.

While Donald Trump talked about “Yellen’s big fat ugly bubble” before he took office, he has now pegged the success of his entire Presidency on the stock market.

It will likely be something he eventually regrets.

“Then said Jesus unto him, Put up again thy sword into his place: for all they that take the sword shall perish with the sword.” – Matthew 26, 26:52

Jerome Powell & The Fed’s Great Betrayal

“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

John Maynard Keynes – The Economic Consequences of Peace 1920

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.” –Jerome Powell January 29, 2020.

With that one seemingly innocuous statement, Chairman Powell revealed an alarming admission about the supply of money and your wealth. The current state of monetary policy explains why so many people are falling behind and why wealth inequality is at levels last seen almost 100 years ago. 

REALity

 “Real” is a very important concept in the field of economics. Real generally refers to an amount of something adjusted for the effects of inflation. This allows economists to measure true organic growth or decline.

Real is equally important for the rest of us. The size of our paycheck or bank account balance is meaningless without an understanding of what money can buy. For instance, an annual income of $25,000 in 1920 was about eight times the national average. Today that puts a family of four below the Federal Poverty Guideline. As your grandfather used to say, a dollar doesn’t go as far as it used to.

Real wealth and real wage growth are important for assessing your economic standing and that of the nation.

Here are two facts:

  • Wealth is largely a function of the wages we earn
  • The wages we earn are predominately a function of the growth rate of the economy

These facts establish that the prosperity and wealth of all citizens in aggregate is meaningfully tied to economic growth or the output of a nation. It makes perfect sense.

Now, let us consider inflation and the role it plays in determining our real wages and real wealth.

If the rate of inflation is less than the rate of wage growth over time, then our real wages are rising and our wealth is increasing. Conversely, if inflation rises at a pace faster than wages, wealth declines despite a larger paycheck and more money in the bank.

With that understanding of “real,” let’s discuss inflation.

What is Inflation?

Borrowing from an upcoming article, we describe inflation in the following way:

“One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. Most people, when asked to define inflation, would say “rising prices” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation defined is, in fact, a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The price of cars, cheeseburgers, movie tickets, and all the other goods and services we consume are chiefly based on supply and demand. Demand is a function of both our need and desire to own a good and, equally importantly, how much money we have. The amount of money we have in aggregate, known as money supply, is governed by the Federal Reserve. Therefore, the supply of money is a key component of demand and therefore a significant factor affecting prices.

With the linkage between the supply of money and inflation defined, let us revisit Powell’s recent revelation.

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.”

In plain English, Powell states that the supply of money is based on the demand for money and not the economic growth rate.  To clarify, one of the Fed’s largest liabilities currently are bank reserves. Banks are required to hold reserves for every loan they make. Therefore, they need reserves to create money to lend. Ergo, “demand for our liabilities,” as Powell states, actually means bank demand for the seed funding to create money and make loans.

The relationship between money supply and the demand for money may, in fact, be aligned with economic growth. If so, then the supply of money should rise with the economy. This occurs when debt is predominately employed to facilitate productive investments.

The problem occurs when money is demanded for consumption or speculation. For example:

  • When hedge funds demand billions to leverage their trading activity
  • When Apple, which has over $200 billion in cash, borrows money to buy back their stock  
  • When you borrow money to buy a car, the size of the economy increases but not permanently as you are not likely to buy another car tomorrow and the next day

Now ask, should the supply of money increase because of those instances?

The relationship between the demand for money and economic activity boils down to what percentage of the debt taken on is productive and helps the economy and the populace grow versus what percentage is for speculation and consumption.

While there is no way to quantify how debt is used, we do know that speculative and consumptive debt has risen sharply and takes up a much larger percentage of all debt than in prior eras.  The glaring evidence is the sharp rise of debt to GDP.

Data Courtesy St. Louis Federal Reserve

If most of the debt were used productively, then the level of debt would drop relative to GDP. In other words, the debt would not only produce more economic growth but would also pay for itself.  The exact opposite is occurring as growth languishes despite record levels of debt accumulation.

The speculative markets provide further evidence. Without presenting the long list of asset valuations that stand at or near record levels, consider that since the last time the S&P 500 was fairly valued in 2009, it has grown 375%. Meanwhile, total U.S. Treasury debt outstanding is up by 105% from $11 trillion to $22.5 trillion and corporate debt is up 55% from $6.5 trillion to $10.1 trillion. Over that same period, nominal GDP has only grown 46% and Average Hourly Earnings by 29%.

When the money supply is increased for consumptive and speculative purposes, the Fed creates dissonance between our wages, wealth, and the rate of inflation. In other words, they generate excessive inflation and reduce our real wealth.  

If this is the case, why is the stated rate of inflation less than economic growth and wage growth?

The Wealth Scheme

This scheme works like all schemes by keeping the majority of people blind to what is truly occurring. To perpetuate such a scheme, the public must be convinced that inflation is low and their wealth is increasing.

In 2000, a brand new Ford Taurus SE sedan had an original MSRP of $18,935. The 2019 Ford Taurus SE has a starting price of $27,800.  Over the last 19 years, the base price of the Ford Taurus has risen by 2.05% a year or a total of 47%. According to the Bureau of Labor Statics (BLS), since the year 2000, the consumer price index for new vehicles has only risen by 0.08% a year and a total of 1.68% over the same period.

For another instance of how inflation is grossly underreported, we highlighted flaws in the reporting of housing prices in MMT Sounds Great in Theory But…  To wit: 

“Since then, inflation measures have been tortured, mangled, and abused to the point where it scarcely equates to the inflation that consumers deal with in reality. For example, home prices were substituted for “homeowners equivalent rent,” which was falling at the time, and lowered inflationary pressures, despite rising house prices.

Since 1998, homeowners equivalent rent has risen 72% while house prices, as measured by the Shiller U.S. National Home Price Index has almost doubled the rate at 136%. Needless to say, house prices, which currently comprise almost 25% of CPI, have been grossly under-accounted for. In fact, since 1998 CPI has been under-reported by .40% a year on average. Considering that official CPI has run at a 2.20% annual rate since 1998, .40% is a big misrepresentation, especially for just one line item.”

Those two obscene examples highlight that the government reported inflation is not the same inflation experienced by consumers. It is important to note that we are not breaking new ground with the assertion that the government reporting of inflation is low. As we have previously discussed, numerous private assessments quantify that the real inflation rate could easily be well above the average reported 2% rate. For example, Shadow Stats quantifies that inflation is running at 10% when one uses the official BLS formula from 1980.

Despite what we may sense and a multitude of private studies confirming that inflation is running greater than 2%, there are a multitude of other government-sponsored studies that argue inflation is actually over-stated. So, the battle is in the trenches, and the devil is in the details.

As defined earlier, inflation is “a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The following graph shows that the supply of money, measured by M2, has grown far more than the rate of economic growth (GDP) over the last 20 years.

Data St. Louis Federal Reserve

Since 2000, M2 has grown 234% while GDP has grown at half of that rate, 117%. Over the same period, the CPI price index has only grown by 53%. M2 implies an annualized inflation rate over the last 20 years of 6.22% which is three times that of CPI. 

Dampening perceived inflation is only part of the cover-up. The scheme is also perpetuated with other help from the government. The government borrows to boost temporary economic growth and help citizens on the margin. This further limits people’s ability to detect a significant decline in their standard of living.

As shown below, when one strips out the change in government debt (the actual increase in U.S. Treasury debt outstanding) from the change in GDP growth, the organic economy has shrunk for the better part of the last 20 years. 

Data St. Louis Federal Reserve

It doesn’t take an economist to know that a 6.22% inflation rate (based on M2) and decade long recession would force changes to our monetary policy and send those responsible to the guillotines. If someone suffering severe headaches is diagnosed with a brain tumor, the problem does not go away because the doctor uses white-out to cover up the tumor on the x-ray film.

Despite crystal clear evidence, the mirages of economic growth and low inflation prevent us from seeing reality.

Summary

Those engaging in speculative ventures with the benefit of cheap borrowing costs are thriving. Those whose livelihood and wealth are dependent on a paycheck are falling behind. For this large percentage of the population, their paychecks may be growing in line with the stated government inflation rate but not the true inflation rate they pay at the counter. They fall further behind day by day as shown below.

While this may be hard to prove using government inflation data, it is the reality. If you think otherwise, you may want to ask why a political outsider like Donald Trump won the election four years ago and why socialism and populism are surging in popularity. We doubt that it is because everyone thinks their wealth is increasing. To quote Bill Clinton’s 1992 campaign manager James Carville, “It’s the economy, stupid.”

That brings us back to Jerome Powell and the Fed. The U.S. economy is driven by millions of individuals making decisions in their own best interests. Prices are best determined by those millions of people based on supply and demand – that includes the price of money or interest rates. Any governmental interference with that natural mechanism is a recipe for inefficiency and quite often failure.

If monetary policy is to be set by a small number of people in a conference room in the Eccles Building in Washington, D.C. who think they know what is best for us based on flawed data, then they should prepare themselves for even more radical social and political movements than we have already seen.

Retired Or Retiring Soon? Yes, Worry About A Correction

When I was growing up, my father used to tell me I should “never take advice from anyone who hasn’t succeeded at what they are advising.” 

The most truth of that statement is found in the financial press, which consists mostly of people writing articles and giving advice on topics where they have little experience, and in general, have achieved no success.

The best example came last week in an email quoting:

“You recently suggested that you took profits from your portfolios; however, I read an article saying retirees shouldn’t change their strategies. ‘If you’ve got a thoughtful financial plan and a diversified investment portfolio, the general rule is to leave everything alone.'” 

This seems to be an entirely different approach to what you are suggesting. Also, since corrections can’t be predicted, it seems to make sense.” 

One of the biggest reasons why investors consistently underperform over the long-term is due to flawed investment advice.

Let me explain.

Corrections & Bear Markets Matter

It certainly seems logical, by looking the 120-year chart of the market, that one should just stay invested regardless of what happens. Eventually, as the financial media often suggests, the markets always get back to even. One such chart is the percentage gain/loss chart over the long-term, as shown below.

This is one of the most deceptive charts an advisor can show a client, particularly one that is close to, or worse in, retirement.

The reality is that you DIED long before ever achieving that 8% annualized long-term return you were promised. Secondly, math is a cruel teacher.

Visually, percentage drawdowns seem to be inconsequential relative to the massive percentage gains that preceded them. That is, until you convert percentages into points and reveal an uglier truth.

It is important to remember that a 100% gain on a $1000 investment, followed by a 50% loss, does not leave you with $1500. A 50% loss wipes out the previous 100% gain, leaving you with a 0% net return.

For retirees, this is a critically important point.

In 2000, the average “baby boomer” was around 45-years of age. The “dot.com” crash was painful, but with 20-years to go before retirement, there was time to recover. In 2010, following the financial crisis, the time to retirement for the oldest boomers was depleted, and the average boomer only had 10-years to recover. During both of these previous periods, portfolios were still in accumulation mode. However, today, only the youngest tranche of “boomers,” have the luxury of “time” to work through the next major market reversion. (This also explains why the share of workers over the age of 65 is at historical highs.) 

With the majority of “boomers” now faced with the implications of a transition into the distribution phase of the investment cycle, such has important ramifications during market declines. The following example shows a $1 million portfolio with, and without, an annualized 4% withdrawal rate. (We are going into much deeper analysis on this in a moment.)

While a 10% decline in the market will reduce a portfolio from $1 million to $900,000, when combined with an assumed monthly withdrawal rate, the portfolio value is reduced by almost 14%. This is the result of taking distributions during a period of declining market values. Importantly, while it ONLY requires a non-withdrawal portfolio an 11.1% return to break even, it requires nearly a 20% return for a portfolio in the distribution phase to attain the same level.

Impairments to capital are the biggest challenges facing pre- and post-retirees currently. 

This is an important distinction. Most articles written about retirees, or those ready to retire, is an unrealized assumption of an indefinite timeline.

While the market may not be different than it has been in the past. YOU ARE!

Starting Valuations Matter

As I have discussed previously, without understanding the importance of starting valuations on your investment returns, you can’t understand the impact the market will have on psychology, and investor behavior.

Over any 30-year period, beginning valuation levels have a tremendous impact on future returns.

As valuations rise, future rates of annualized returns fall. This should not be a surprise as simple logic states that if you overpay for an asset today, the future returns must, and will, be lower.

This is far less than the 8-10% rates of return currently promised by the Wall Street community. It is also why starting valuations are critical for individuals to understand when planning for both the accumulation and distribution, phases of the investment life-cycle.

Let’s elaborate on our example above.

We know that markets go up and down over time, therefore when advisors use “average” or “annualized” rates of return, results often deviate far from reality. However, we do know from historical analysis that valuations drive forward returns, so using historical data, we calculated the 4-periods where starting valuations were either above 20x earnings, or below 10x earnings. We then ran a $1000 investment going forward for 30-years on a total-return, inflation-adjusted, basis. 

The results were not surprising.

At 10x earnings, the worst performing period started in 1918 and only saw $1000 grow to a bit more than $6000. The best performing period was actually not the screaming bull market that started in 1980 because the last 10-years of that particular cycle caught the “dot.com” crash. It was the post-WWII bull market that ran from 1942 through 1972 that was the winner. Of course, the crash of 1974, just two years later, extracted a good bit of those returns.

Conversely, at 20x earnings, the best performing period started in 1900, which caught the rise of the market to its peak in 1929. Unfortunately, the next 4-years wiped out roughly 85% of those gains. However, outside of that one period, all of the other periods fared worse than investing at lower valuations. (Note: 1993 is still currently running as its 30-year period will end in 2023.)

The point to be made here is simple and was precisely summed up by Warren Buffett:

“Price is what you pay. Value is what you get.” 

To create our variable return assumption model, we averaged each of the 4-periods above into a single total return, inflation-adjusted, index. We could then see the impact of $1000 invested in the markets at both valuations BELOW 10x trailing earnings, and ABOVE 20x. Investing at 10x earnings yields substantially better results.

Starting Valuations Are Critical To Withdrawal Rates

With a more realistic return model, the impact of investing during periods of high valuations becomes more evident, particularly during the withdrawal phase of retirement.

Let’s start with our $1 million retirement portfolio. The chart below shows various “spend down” assumptions of a $1 million retirement portfolio adjusted for an 8% annualized return, the impact of inflation at 3%, and the effect of taxation on withdrawals.

By adjusting the annualized rate of return for the impact of inflation and taxes, the life expectancy of a portfolio grows considerably shorter. Unfortunately, this is what “really happens” to investors over time, but is never discussed in mainstream analysis.

To understand “real outcomes,” we must adjust for variable rates of returns. There is a significant difference between 8% annualized rates of return and 8% real rates of return. 

When we adjust the spend down structure for elevated starting valuation levels, and include inflation and taxes, a far different, and less favorable, outcome emerges. Retirees will run out of money not in year 30, but in year 18.

With this understanding, let’s revisit what happens to “buy and hold” investors over time. The chart below shows $3000 invested annually into the S&P 500 inflation-adjusted, total return index at 10% compounded annually, and both 10x and 20x valuation starting levels. I have also shown $3000 saved annually and “stuffed in a mattress.”

The red line is 10% compounded annually. While you don’t get compounded returns, it is there for comparative purposes to the real returns received over the 30-year investment horizon starting at 10x and 20x valuation levels. The shortfall between the promised 10% annual rates of return and actual returns are shown in the two shaded areas. In other words, if you are banking on some advisor’s promise of 10% annual returns for retirement, you aren’t going to make it.

Questions Retirees Need To Ask About Plans

What this analysis reveals is that “retirees” SHOULD be worried about bear markets. 

Taking the correct view of your portfolio, and the risks being undertaken is critical when entering the retirement and distribution phase of the portfolio life cycle.

Most importantly, when building and/or reviewing your financial plan, these are the questions you must ask and have concrete answers for:

  • What are the expectations for future returns going forward given current valuation levels? 
  • Should the withdrawal rates be downwardly adjusted to account for potentially lower future returns? 
  • Given a decade long bull market, have adjustments been made for potentially front-loaded negative returns? 
  • Has the impact of taxation been carefully considered in the planned withdrawal rate?
  • Have future inflation expectations been carefully considered?
  • Have drawdowns from portfolios during declining market environments, which accelerates principal bleed, been considered?
  • Have plans been made to harbor capital during up years to allow for reduced portfolio withdrawals during adverse market conditions?
  • Has the yield chase over the last decade, and low interest rate environment, which has created an extremely risky environment for retirement income planning, been carefully considered?
  • What steps should be considered to reduce potential credit and duration risk in bond portfolios?
  • Have expectations for compounded annual rates of returns been dismissed in lieu of a plan for variable rates of future returns?

 If the answer is “no” to the majority of these questions. then feel free to contact one of the CFP’s in our office who take all of these issues into account. 

Yes, not only should you worry about bear markets, you should worry about them a lot.

7-Difficult Trading Rules To Follow In Bull Markets

As we wrap up the last two-trading days of the decade, I am wrapping up the recent series on “investing rules” (see here and here). The purpose of this series is to remind investors of the importance of having an investment discipline to protect investment capital when market volatility eventually comes.

I know…I know…volatility seems to be a thing of the past, particularly given the amount of exuberance currently embedded in the markets. This was a point I made in the most recent newsletter:

I have written many articles previously on investing, portfolio and risk management, and the fallacy of long-term “average” rates of returns. Unfortunately, few heed these warnings until it is generally far too late.

The biggest problems facing investors over the long-term are falling prey to the various psychological behaviors which impede our investing success. From herding to recency bias, to the “gambler’s fallacy,” these behaviors create critical errors in our portfolio management process, which ultimately leads to the destruction of our investment capital.

As I have addressed many times previously, the major problem is the loss of “time” to achieve your investment goals. When a major correction occurs in the financial markets, which occur quite frequently, getting back to even is NOT the real problem. While capital can be recovered following a destructive event, the time to reach your investment goals is permanently lost. 

The problem is that most mainstream commentators continue to suggest that “you can not manage” your money. If you sell, then you are going to “miss out” on some level of the bull market advance. The problem is they fail to tell you what happens when you lose a large chunk of your capital by chasing the bull market to its inevitable conclusion. (See “Math Of Loss”)

While investing money is easy, it is the management of the inherent “risks” that are critical to your long-term success. This is why every great investor in history is defined by the methods which dictate both the “buy”, but most importantly, “the sell” process.

The difference between a successful long term investor, and an unsuccessful one, comes down to following very simple rules. Yes, I said simple rules, and they are; but they are incredibly difficult to follow in the midst of a bull market. Why? Because of the simple fact that they require you to do the exact OPPOSITE of what your basic human emotions tell you to do:

  • Buy stuff when it is being liquidated by everyone else, and;
  • Sell stuff when it is going to the moon.


The 7 Impossible Trading Rules To Follow:

Here are the rules – they are not unique or new. They are time tested, and successful investor, approved. If you follow them you succeed – if you don’t, you won’t.

1) Sell Losers Short: Let Winners Run:

It seems like a simple thing to do, but when it comes down to it the average investor sells their winners and keeps their losers hoping they will come back to even.

2) Buy Cheap And Sell Expensive: 

You haggle, negotiate, and shop extensively for the best deals on cars and flat-screen televisions. However, you will pay any price for a stock because someone on TV told you too. Insist on making investments when you are getting a “good deal” on it. If it isn’t – it isn’t, don’t try and come up with an excuse to justify overpaying for an investment. In the long run, overpaying will end in misery.

3) This Time Is Never Different:

As much as our emotions, and psychological makeup, want to always hope for the best; this time is never different than the past. History may not repeat exactly, but it often rhymes extremely well.

4) Be Patient:

As with item number 2; there is never a rush to make an investment, and there is NOTHING WRONG with sitting on cash until a good deal, a real bargain, comes along. Being patient is not only a virtue, it is a good way to keep yourself out of trouble.

5) Turn Off The Television: 

Any good investment is NEVER dictated by day to day movements of the market, which are nothing more than noise. If you have done your homework, made a good investment at a good price, and have confirmed your analysis to be correct; then the day to day market actions will have little, if any, bearing on the longer-term success of your investment. The only thing you achieve by watching the television is increasing your blood pressure.

6) Risk Is Not Equal To Your Return: 

Taking RISK in an investment, or strategy, is not equivalent to how much money you will make. It only equates to the permanent loss of capital which will be incurred when you are wrong. Invest conservatively, and grow your money over time with the LEAST amount of risk possible.

7) Go Against The Herd: 

The populous is generally “right” in the middle of a move up in the markets, but they are seldom correct at major turning points. When everyone agrees on the direction of the market due to any given set of reasons, generally something else happens. However, this also cedes to points 2) and 4); in order to buy something cheap or sell something at the best price, you are generally buying when everyone is selling, and selling when everyone else is buying.

These are the rules. They are simple and impossible to follow for most. However, if you can incorporate them you will succeed in your investment goals over the long run. You most likely WILL NOT outperform the markets on the way up, but you will not lose as much on the way down. This is important because it is much easier to replace a lost opportunity in investing. It is impossible to replace lost “time.”

As an investor, it is simply your job to step away from your “emotions” for a moment, and look objectively at the market around you. Is it currently dominated by “greed” or “fear?” Your long-term returns will depend greatly not only on how you answer that question, but how you manage the inherent risk.

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham

Democrats Stop Worrying & Learn To Love Deficits

I was stunned by a recent article from Marshall Auerback via The Nation entitled “Why Democrats Need To Stop Worrying And Love The Deficit.”

“Delivering on big progressive ideas like Medicare for All and the Green New Deal will never happen until Democrats get over their fear of red ink.”

While the article is long, winding, and a convoluted mess of ideas, the following is the all you really need to read:

The perceived problem:

“In an environment increasingly characterized by slowing global economic growth, businesses are understandably hesitant to invest in a way that creates high-quality, high-paying jobs for the bulk of the domestic workforce. The much-vaunted Trump corporate “tax reform” may have been sold to the American public on that basis, but corporations have largely used their tax cut bonanza to engage in share buybacks, which fatten executive compensation but have done nothing for the rest of us. At the same time, private households still face constraints on their consumption because of stagnant wages, rising health care costs, declining job security, poorer employment benefits, and rising debt levels.

Instead of solving these problems, the reliance on extraordinary monetary policy from the Federal Reserve via programs such as quantitative easing has exacerbated them. In contrast to properly targeted fiscal spending, the Federal Reserve’s misguided monetary policies have fueled additional financial speculation and asset inflation in stock markets and real estate, which has made housing even less affordable for the average American.”

The Non-Solution

According to Mr.  Auerback is the solution is simple:

“Democrats should embrace the ‘extremist’ spirit of Goldwater and eschew fiscal timidity (which, in any case, is based on faulty economics). After all, Republicans do it when it suits their legislative agenda. Likewise, Democrats should go big with deficits—as long as they are used for the transformative programs that progressives have long talked about and now have the chance to deliver.”

This is essentially the adoption of Modern Monetary Theory (MMT), which, as discussed previously, is the assumption debt and deficits “don’t matter,” as long as there is no inflation.

“Modern Monetary Theory is a macroeconomic theory that contends that a country that operates with a sovereign currency has a degree of freedom in their fiscal and monetary policy, which means government spending is never revenue constrained, but rather only limited by inflation.” – Kevin Muir

However, the solution isn’t really a solution.

Mr. Auerback suggests the Democrats should go big with deficits to fund the “transformative programs” they have long talked about. These programs are, as we know, socialistic from government-run healthcare to more social welfare, to free college.

The problem is that these progressive programs lack an essential component of what is required for “deficit” spending to be beneficial – a “return on investment.” 

This was a point addressed by Dr. Woody Brock previously in “American Gridlock;”

Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.

There is no disagreement about the need for government spending. The disagreement is with the abuse and waste of it.

John Maynard Keynes’ was correct in his theory that in order for government “deficit” spending to be effective, the “payback” from investments being made through debt must yield a higher rate of return than the debt used to fund it.

Currently, the U.S. is “Country A.” 

The programs that Mr. Auerback suggests the Democrats pursue with deficit spending, only exacerbate the current problem. According to the Center On Budget & Policy Priorities, roughly 75% of every current tax dollar goes to non-productive spending. (The same programs the Democrats are proposing.)

To make this clearer, in 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues, and $986 billion was financed through debt.

In other words, if 75% of all expenditures go to social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of the total revenue coming in. 

Currently, because of corporate tax cuts, a slowing economic environment, and weak wage growth, tax revenues have declined as federal expenditures have surged.

The result of unbridled fiscal largesse is a surging deficit that must be met by growing debt issuance.

Debt Begets Debt

There used to be an actual debate between “Austerity” and “Spending.” Conservatives in Government used to at least talk a “good game” about cutting spending, budgeting, and debt reduction. Now, that is no longer the case as during the past several Administrations, both “conservative” and “liberal” have opted for more “fiscal largesse.”

The irony is that increases in debt only lead to further increases in debt as economic growth must be funded with further debt. As this money is used for servicing debt, entitlements, and welfare, instead of productive endeavors, there is no question that high debt-to-GDP ratios reduce economic prosperity over time. In turn, the Government tries to fix the “economic problem” by adding on more “debt.” The Lowest Common Denominator provides more information on the accumulation of debt and its consequences.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has been no organic economic growth.

For the 30-year period, from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been greater. If you subtract the debt, there has not been any organic economic growth since 1990. 

What is indisputable is that running ongoing budget deficits that fund unproductive growth is not economically sustainable long-term.

Whistling Past The Graveyard

Let me be clear.

As Dr. Brock notes, deficit spending can be beneficial when the debt is used in a productive manner. The U.S. has the labor, resources, and capital for a resurgence of a “Marshall Plan” which could foster the development of infrastructure with high rates of return on each dollar spent.

However, that isn’t what Mr. Auerback, the Democrats, are suggesting or offering. The Government has already delved into the MMT pool over the last 40-years spending trillions bailing out banks, boosting welfare support, supporting Wall Street, and reducing corporate tax rates, which all have a negative rate of return.

The results have been disappointing, and suggesting that more of the same will produce a different result is the precise definition of “insanity.” 

In the meantime, the aging of the population continues to exacerbate the underfunded problems of Social Security, Medicare, and Medicaid, which is roughly $70 trillion and growing. It is simply a function of demographics and math.

As Dr. Brock noted:

“Mathematics and Sex create performance anxiety in men – because you can’t fake the outcome of either.”

Two recent studies show the problem clearly.

Demographics is an easy problem to see and mathematically calculate. The ratio of workers per retiree, as retirees are living longer (increasing the relative number of retirees), and lower birth rates (decreasing the relative number of workers), present a massive headwind to economic solvency. 

The Institute for Family Studies, published a report showing the decline in the fertility ratio to the lowest levels since 1970,

With fertility rates low, the future “support-ratio” will continue to be a problem.

The second, and more immediate, problem is the vastly underfunded savings of the “baby boomer” generation heading into retirement. To wit:

” Anxiety over retirement and how to support oneself after calling it a career is impacting many Americans. A recent poll found that one in three adults has less than $5,000 in retirement savings.”

This is simple math.

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached or will reach retirement age between 2011 and 2030. A vast majority of them are “under saved” and primarily unhealthy.

This combination ensures the demand on the health care system, along with Medicaid and Medicare, will increase at a rate faster than it can supply. Bankruptcy, without substantive changes, is inevitable.

Of course, it isn’t just the social welfare and healthcare system that is effectively “broken,” but the economic model itself.

The current path we are on is unsustainable. The remedies being applied today is akin to using aspirin to treat cancer. Sure, it may make you feel better for the moment, but it isn’t curing the problem.

Unfortunately, the actions being taken have been repeated throughout history as those elected into office are more concerned about satiating the mob with bread and games” rather than suffering the short-term pain for the long-term survivability of the empire.

In the end, every empire throughout history fell to its knees under the weight of debt and the debasement of their currency.

As Dr. Brock suggests – it is truly “American Gridlock” as the real crisis lies between the choices of “austerity” and continued government “largesse.”

One choice leads to long-term economic prosperity for all, the other doesn’t.

“Today we are borrowing our children’s future with debt. We are witnessing the ‘hosing’ of the young.”

“The Art Of The Deal” & How To Lose A “Trade War.”

This past Monday, on the #RealInvestmentShow, I discussed that it was exceedingly likely that Trump would delay, or remove, the tariffs which were slated to go into effect this Sunday, On Thursday, that is exactly what happened.

Not only did the tariffs get delayed, but on Friday, it was reported that China and the U.S. reached “Phase One” of the trade deal, which included “some” tariff relief and agricultural purchases. To wit:

“The U.S. plans to scrap tariffs on Chinese goods in phases, a priority for Beijing, Vice Commerce Minister Wang Shouwen said. However, Wang did not detail when exactly the U.S. would roll back duties.

President Donald Trump later said his administration would cancel its next round of tariffs on Chinese goods set to take effect Sunday. In tweets, he added that the White House would leave 25% tariffs on $250 billion in imports in place, while cutting existing duties on another $120 billion in products to 7.5%.

China will also consider canceling retaliatory tariffs set for Dec. 15, according to Vice Finance Minister Liao Min. 

Beijing will increase agricultural purchases significantly, Vice Minister of Agriculture and Rural Affairs Han Jun said, though he did not specify by how much. Trump has insisted that China buy more American crops as part of a deal, and cheered the commitment in his tweets.”

Then from the USTR:

The United States will be maintaining 25 percent tariffs on approximately $250 billion of Chinese imports, along with 7.5 percent tariffs on approximately $120 billion of Chinese imports.”

Not surprisingly, the market initially rallied on the news, but then reality begin to set in.

Art Of The Deal Versus The Art Of War

Over the past 18-months we have written numerous articles about the ongoing “trade war,” which was started by Trump against China. As I wrote previously:

“This is all assuming Trump can actually succeed in a trade war with China. Let’s step back to the G-20 meeting between President Trump and President Xi Jinping. As I wrote then:

‘There is a tremendous amount of ‘hope’ currently built into the market for a ‘trade war truce’ this weekend. However, as we suggested previously, the most likely outcome was a truce…but no deal.  That is exactly what happened.

While the markets will likely react positively next week to the news that ‘talks will continue,’ the impact of existing tariffs from both the U.S. and China continue to weigh on domestic firms and consumers.

More importantly, while the continued ‘jawboning’ may keep ‘hope alive’ for investors temporarily, these two countries have been ‘talking’ for over a year with little real progress to show for it outside of superficial agreements.

Importantly, we have noted that Trump would eventually ‘cave’ into the pressure from the impact of the ‘trade war’ he started.

The reasons, which have been entirely overlooked by the media, is that China’s goals are very different from the U.S. To wit:

  1. China is playing a very long game. Short-term economic pain can be met with ever-increasing levels of government stimulus. The U.S. has no such mechanism currently, but explains why both Trump and Vice-President Pence have been suggesting the Fed restarts QE and cuts rates by 1%.
  2. The pressure is on the Trump Administration to conclude a “deal,” not on China. Trump needs a deal done before the 2020 election cycle AND he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk-off electoral losses rise. China knows this and are willing to “wait it out” to get a better deal.
  3. China is not going to jeopardize its 50 to 100-year economic growth plan on a current President who will be out of office within the next 4-years at most. It is unlikely as the next President will take the same hard-line approach on China that President Trump has, so agreeing to something that won’t be supported in the future is doubtful.”

As noted in the second point above, on Friday, Trump caved to get the “Trade Deal” off the table before the election. As noted in September, China had already maneuvered Trump into a losing position.

“China knows that Trump needs a way out of the “trade war” he started, but that he needs something he can “boast” as a victory to a largely economically ignorant voter base. Here is how a “trade deal” could get done.

Understanding that China has already agreed to 80% of demands for a trade deal, such as buying U.S. goods, opening markets to U.S. investors, and making policy improvements in certain areas, Trump could conclude that ‘deal’ at the October meeting.”

Read the highlighted text above and compare it to the statement from  the WSJ: on Thursday:

“The U.S. side has demanded Beijing make firm commitments to purchase large quantities of U.S. agricultural and other products, better protect U.S. intellectual-property rights and widen access to China’s financial-services sector.”

What is missing from the agreement was the most critical 20%:

  • Cutting the share of the state in the overall economy from 38% to 20%,
  • Implementing an enforcement check mechanism; and,
  • Technology transfer protections

These are the “big ticket” items that were the bulk of the reason Trump launched the “trade war” to begin with. Unfortunately, for China, these items are seen as an infringement on its sovereignty, and requires a complete abandonment the “Made in China 2025” industrial policy program.

The USTR did note that the Phase One deal:

“Requires structural reforms and other changes to China’s economic and trade regime in the areas of intellectual property, technology transfer, agriculture, financial services, and currency and foreign exchange.”

However, since there is no actual enforcement mechanism besides merely pushing tariffs back to where they were, none of this will be implemented.

All of this aligns with our previous suggestion the only viable pathway to a “trade deal” would be a full surrender.

“However, Trump can set aside the last 20%, drop tariffs, and keep market access open, in exchange for China signing off on the 80% of the deal they already agreed to.”

Which is precisely what Trump agreed to.

This Is The Only Deal

This is NOT a “Phase One” trade-deal.

This is a “Let’s get a deal on the easy stuff, call it a win, and go home,” deal.

It is the strategy we suggested was most likely:

“For Trump, he can spin a limited deal as a ‘win’ saying ‘China is caving to his tariffs’ and that he ‘will continue working to get the rest of the deal done.’ He will then quietly move on to another fight, which is the upcoming election, and never mention China again. His base will quickly forget the ‘trade war’ ever existed.

Kind of like that ‘Denuclearization deal’ with North Korea.”

Speaking of the “fantastic deal with N. Korea,” here is the latest on that failed negotiation:

“Reuters reported Thursday via Korean Central News Agency (KCNA) that, even if denuclearization talks resumed between both countries, the Trump administration has nothing to offer.

North Korea’s foreign ministry criticized the Trump administration for meeting with officials at the UN Security Council and suggested that it would be ready to respond to any corresponding measures that Washington imposes. ‘The United States said about corresponding measure at the meeting, as we have said we have nothing to lose and we are ready to respond to any corresponding measure that the US chooses,’ said KCNA citing a North Korean Foreign Ministry spokesperson.”

While Trump has announced he will begin to “immediately” work on “Phase Two,” any real agreement is highly unlikely. However, what Trump understands, is that he gets another several months of “tweeting” a “trade deal is coming” to keep asset markets buoyed to support his re-election campaign.

Not Really All That Amazing

While Trump claimed this was an “amazing deal” with China, and that America’s farmers need to get ready for a $50 billion surge in agricultural exports, neither is actually the case.

China did not agree to buy any specific amount of goods from the U.S. What they said was, according to Bloomberg, was:

  • CHINA PLANS TO IMPORT U.S. WHEAT, RICE, CORN WITHIN QUOTAS

Furthermore, there is speculation the agreement is primarily verbal in terms of purchases, and the actual agreement of the entire trade deal will never be made public.

But let’s put some hard numbers to this.

Currently, China is buying about $10 billion of farm produce in 2018. That is down from a peak of $25 billion in 2012, which was long before the trade war broke out.

Since the trade war was started, China has sourced deals from Brazil and Argentina for pork and soybeans to offset the shortfall in imports from the U.S. These agreements, and subsequent imports, won’t be cancelled to shift to the U.S. since at any moment Trump could reinstate tariffs.

More importantly, as noted by Zerohedge on Friday, if this “deal” was as amazing as claimed, the agricultural commodity index should be screaming higher.

Importantly, even if China agrees to double their exports in the coming year, which would be a realistic goal, it would only reset the trade table to where it was before the tariffs started.

While China may have “agreed” to buy more, it is extremely unlikely China will meet such levels. Given they have already sourced products from other countries, they will import what they require.

Since most don’t pay attention to the long-game, while there will be excitement over a short-term uptick in agricultural purchases, those purchases will fade. However, with time having passed, and the focus of the media now elsewhere, Trump will NOT go back to the table and restart the “trade war” again. As I wrote on May 24, 2018:

China has a long history of repeatedly reneging on promises it has made to past administrations. What the current administration fails to realize is that China is not operating from short-term political-cycle driven game plan.

As we stated in Art Of The Deal vs. The Art Of War:”

“While Trump is operating from a view that was a ghost-written, former best-seller, in the U.S. popular press, XI is operating from a centuries-old blueprint for victory in battle.”

Trump lost the “trade war,” he just doesn’t realize it, yet.

No More “Trade Tweets?”

Since early 2018, and more importantly since the December lows of last year, the market has risen on the back of continued “hopes” of Federal Reserve easing, and the conclusion of a “trade deal.”

With the Fed now signaling that they are effectively done lowering rates through next year, and President Trump concluding a “trade deal,” what will be the next driver of the markets. While will the “algo’s” do without daily “trade tweets” to push stock markets higher?

While I am a bit sarcastic, there is also a lot of truth to the statement.

However, what is important is that while the Trump administration are rolling back 50% of the tariffs, they are not “removing” all of them. This means there is still some drag being imposed by tariffs, just at a reduced level.

More importantly, the rollback of tariffs do not immediately undo the damage which has already occurred.

  • Economic growth has weakened globally
  • Corporate profit growth has turned negative.
  • Tax cuts are fully absorbed into the economy
  • The “repo” market is suggesting that something is “broken.”
  • All of which is leading to rising recession risk.

In other words, while investors have hung their portfolios hopes of a “trade deal,” it may well be too little, too late.

Over the next couple of months, we will be able to refine our views further as we head into 2020. However, the important point is that since roughly 40% of corporate profits are a function of exports, the damage caused already won’t easily be reversed.

Furthermore, the Fed’s massive infusions of liquidity into the overnight lending market signal that something has “broken,” but few are paying attention.

Our suspicion is that the conclusion of the “trade deal” could well be a “buy the rumor, sell the news” type event as details are likely to be disappointing. Such would shift our focus from “risk taking” to “risk control.” Also, remember “cash” is a valuable asset for managing uncertainty.

With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. 

I am not suggesting you do anything, but just something to consider when the media tells you to ignore history and suggests “this time may be different.” 

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

Dimon’s View Of Economic Reality Is Still Delusional

“This is the most prosperous economy the world has ever seen and it’s going to be a very prosperous economy for the next 100 years.” – Jamie Dimon

That’s what the head of JP Morgan Chase told viewers in a recent “60-Minutes” interview.

“The consumer, which is 70% of the U.S. economy, is quite strong. Confidence is very high. Their balance sheets are in great shape. And you see that the strength of the American consumer is driving the American economy and the global economy. And while business slowed down, my current view is that, no, it just was a slowdown, not a petering out.” – Jamie Dimon

If you’re in the top 1-2% of income earners, like Jamie, I am sure it feels that way.

For everyone else, not so much.

This isn’t the first time that I have discussed Dimon’s distorted views, and just as we discussed then, even just marginally scratching the surface on the economy and the “household balance sheet,” reveals an uglier truth.

The Most Prosperous Economy

Let’s start with the “most prosperous economy in the world” claim.

As we recently discussed in “Socialism Rises,” 

“How did a country which was once the shining beacon of ‘capitalism’ become a country on the brink of ‘socialism?’

Changes like these don’t happen in a vacuum. It is the result of years of a burgeoning divide between the wealthy and everyone else. It is also a function of a 40-year process of capitalism morphing an entire population into ‘debt slaves’ to sustain economic prosperity. 

It is a myth that the economy has grown by roughly 5% since 1980. In reality, economic growth rates have been on a steady decline over the past 40 years, which has been supported by a massive push into deficit spending by consumers.”

With the slowest average annual growth rate in history, it is hard to suggest the economy has been the best it has ever been.

However, if an economy is truly prosperous it should benefit the majority of economic participants, which brings us to claim about “household balance sheet” health.

For Billionaires, The Grass Is Always Green

If you are in the upper 20% of income earners, not to mention the top .01% like Mr. Dimon, I am quite sure the “economic grass is very green.”  If you are in the bottom 80%, the “view” is more akin to a “dirt lot.” Since 1980, as noted by a recent study from Chicago Booth Review, the wealth gap has progressively gotten worse.

“The data set reveals since 1980 a ‘sharp divergence in the growth experienced by the bottom 50 percent versus the rest of the economy,’ the researchers write. The average pretax income of the bottom 50 percent of US adults has stagnated since 1980, while the share of income of US adults in the bottom half of the distribution collapsed from 20 percent in 1980 to 12 percent in 2014. In a mirror-image move, the top 1 percent commanded 12 percent of income in 1980 but 20 percent in 2014. The top 1 percent of US adults now earns on average 81 times more than the bottom 50 percent of adults; in 1981, they earned 27 times what the lower half earned.

The issue is the other 80% are just struggling to get by as recently discussed in the Wall Street Journal:

The American middle class is falling deeper into debt to maintain a middle-class lifestyle.

Cars, college, houses and medical care have become steadily more costly, but incomes have been largely stagnant for two decades, despite a recent uptick. Filling the gap between earning and spending is an explosion of finance into nearly every corner of the consumer economy.

Consumer debt, not counting mortgages, has climbed to $4 trillion—higher than it has ever been even after adjusting for inflation. Mortgage debt slid after the financial crisis a decade ago but is rebounding.”WSJ

The ability to simply “maintain a certain standard of living” has become problematic for many, which forces them further into debt.

“The debt surge is partly by design, a byproduct of low borrowing costs the Federal Reserve engineered after the financial crisis to get the economy moving. It has reshaped both borrowers and lenders. Consumers increasingly need it, companies increasingly can’t sell their goods without it, and the economy, which counts on consumer spending for more than two-thirds of GDP, would struggle without a plentiful supply of credit.” – WSJ

I show the “gap” between the “standard of living” and real disposable incomes below. Beginning in 1990, incomes alone were no longer able to meet the standard of living, so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $2600 annual deficit that cannot be filled. (Note: this deficit accrues every year which is why consumer credit keeps hitting new records.)

But this is where it gets interesting.

Mr. Dimon claims the “household balance sheet” is in great shape. However, this suggestion, which has been repeated by much of the mainstream media, is based on the following chart.

The problem with the chart is that it is an illusion created by the skew in disposable incomes by the top 20% of income earners, needless to say, the top 5%. The Wall Street Journal exposed this issue in their recent analysis.

“Median household income in the U.S. was $61,372 at the end of 2017, according to the Census Bureau. When inflation is taken into account, that is just above the 1999 level. Without adjusting for inflation, over the three decades through 2017, incomes are up 135%.” – WSJ

“The median net worth of households in the middle 20% of income rose 4% in inflation-adjusted terms to $81,900 between 1989 and 2016, the latest available data. For households in the top 20%, median net worth more than doubled to $811,860. And for the top 1%, the increase was 178% to $11,206,000.

Put differently, the value of assets for all U.S. households increased from 1989 through 2016 by an inflation-adjusted $58 trillion. A third of the gain—$19 trillion—went to the wealthiest 1%, according to a Journal analysis of Fed data.

‘On the surface things look pretty good, but if you dig a little deeper you see different subpopulations are not performing as well,’ said Cris deRitis, deputy chief economist at Moody’s Analytics.” – WSJ


With this understanding, we need to recalibrate the “debt to income” chart above to adjust for the bottom 80% of income earnings versus those in the top 20%. Clearly, the “household balance sheet” is not nearly as healthy as Mr. Dimon suggests.

Of course, the only saving grace for many American households is that artificially low interest rates have reduced the average debt service levels. Unfortunately, those in the bottom 80% are still having a large chunk of their median disposable income eaten up by debt payments. This reduces discretionary spending capacity even further.

The problem is quite clear. With interest rates already at historic lows, the consumer already heavily leveraged, and wage growth stagnant, the capability to increase consumption to foster higher rates of economic growth is limited.

With respect to those who say “the debt doesn’t matter,” I respectfully argue that you looking at a very skewed view of the world driven by those at the top.

Mr. Dimon’s Last Call

What Mr. Dimon tends to forget is that it was the U.S. taxpayer who bailed out the financial system, him included, following the financial crisis. Despite massive fraud in the major banks related to the mortgage crisis, only small penalties were paid for their criminal acts, and no one went to jail. The top 5-banks which were 40% of the banking system prior to the financial crisis, became 60% afterwards. Through it all, Mr. Dimon became substantially wealthier, while the American population suffered the consequences.

Yes, “this is the greatest economy ever” if you are at the top of heap.

With household debt, corporate debt, and government debt now at records, the next crisis will once again require taxpayers to bail it out. Since it was Mr. Dimon’s bank that lent the money to zombie companies, households again which can’t afford it, and took on excessive risks in financial assets, he will gladly accept the next bailout while taxpayers suffer the fallout. 

For the top 20% of the population that have money actually invested, or directly benefit from surging asset prices, like Mr. Dimon, life is great. However, for the vast majority of American’s, the job competition is high, wages growth is stagnant, and making “ends meet” is a daily challenge.

While Mr. Dimon’s view of America is certainly uplifting, it is delusional. But of course, give any person a billion dollars and they will likely become just as detached from economic realities.

Does America have “greatest hand ever dealt.”

The data certainly doesn’t suggest such. However, that can change.

We just have to stop hoping that we can magically cure a debt problem by adding more debt, and then shuffling it between Central Banks. 

But then again, such a statement is also delusional.

The Most Important & Overlooked Economic Number

Every month, and quarter, economists, analysts, the media, and investors pour over a variety of mainstream economic indicators from GDP, to employment, to inflation to determine what the markets are likely to do next.

While economic numbers like GDP, or the monthly non-farm payroll report, typically garner the headlines, the most useful statistic, in my opinion, is the Chicago Fed National Activity Index (CFNAI). It often goes ignored by investors and the press, but the CFNAI is a composite index made up of 85 sub-components, which gives a broad overview of overall economic activity in the U.S.

The markets have run up sharply over the last couple of months due to the Federal Reserve once again intervening into the markets. However, the hopes are that U.S. economic growth is going to accelerate going into 2020, which should translate into a resurgence of corporate earnings. However,  if recent CFNAI readings are any indication, investors may want to alter their growth assumptions heading into next year.

While most economic data points are backward-looking statistics, like GDP, the CFNAI is a forward-looking metric that gives some indication of how the economy is likely to look in the coming months.

Importantly, understanding the message that the index is designed to deliver is critical. From the Chicago Fed website:

“The Chicago Fed National Activity Index (CFNAI) is a monthly index designed to gauge overall economic activity and related inflationary pressure. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate above-average growth.

The overall index is broken down into four major sub-categories which cover:

  • Production & Income
  • Employment, Unemployment & Hours
  • Personal Consumption & Housing
  • Sales, Orders & Inventories

To get a better grasp of these four major sub-components, and their predictive capability, I have constructed a 4-panel chart showing each of the four CFNAI sub-components compared to the four most common economic reports of Industrial Production, Employment, Housing Starts and Personal Consumption Expenditures. To provide a more comparative base to the construction of the CFNAI, I have used an annual percentage change for these four components.

The correlation between the CFNAI sub-components and the underlying major economic reports do show some very high correlations. This is why, even though this indicator gets very little attention, it is very representative of the broader economy. Currently, the CFNAI is not confirming the mainstream view of an “economic soft patch” that will give way to a stronger recovery by next year.

The CFNAI is also a component of our RIA Economic Output Composite Index (EOCI). The EOCI is even a broader composition of data points including Federal Reserve regional activity indices, the Chicago PMI, ISM, National Federation of Independent Business Surveys, and the Leading Economic Index. Currently, the EOCI further confirms that “hopes” of an immediate rebound in economic activity is unlikely. To wit:

“The problem is there is not a ‘major shift’ coming for the economy, at least not yet, as shown by the readings from our Economic Output Composite Index (EOCI).”

“There are a couple of important points to note in this very long-term chart.

  1. Economic contractions tend to reverse fairly frequently from high peaks and those contractions tend to revert towards the 30-reading on the chart. Recessions are always present with sustained readings below the 30-level.
  2. The financial markets generally correct in price as weaker economic data weighs on market outlooks. 

Currently, the EOCI index suggests there is more contraction to come in the coming months, which will likely weigh on asset prices as earnings estimates and outlooks are ratcheted down heading into 2020.”

It’s In The Diffusion

The Chicago Fed also provides a breakdown of the change in the underlying 85-components in a “diffusion” index. As opposed to just the index itself, the “diffusion” of the components give us a better understanding of the broader changes inside the index itself.

There two important points of consideration:

  1. When the diffusion index dips below zero have coincided with weak economic growth and outright recessions. 
  2. The S&P 500 has a history of corrections, and outright bear markets, which correspond with negative reading in the diffusion index.

The second point should not be surprising since the stock market is ultimately a reflection of economic growth. The chart below simply compares the annual rate of change in the S&P 500 and the CFNAI index. Again, the correlation should not be surprising.

Investors should also be concerned about the high level of consumer confidence readings. There have been numerous headlines touting the “strength of consumer” as support for the ongoing “bull market.”

Overly Confident In Confidence

As we discussed just recently. 

“The chart below shows our composite confidence index, which combines both the University of Michigan and Conference Board measures. The chart compares the composite index to the S&P 500 index with the shaded areas representing when the composite index was above a reading of 100.

On the surface, this is bullish for investors. High levels of consumer confidence (above 100) have correlated with positive returns from the S&P 500.”

The issue is the divergence between “consumer” confidence and that of “CEO’s.” 

“Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company who is watching sales, prices, managing inventory, dealing with collections, paying bills, and managing changes to the economic landscape on a daily basis?”

Notice that CEO confidence leads consumer confidence by a wide margin. This lures bullish investors, and the media, into believing that CEO’s really don’t know what they are doing. Unfortunately, consumer confidence tends to crash as it catches up with what CEO’s were already telling them.

What were CEO’s telling consumers that crushed their confidence?

“I’m sorry, we think you are really great, but I have to let you go.” 

The CFNAI also tells the same story with large divergences in consumer confidence eventually “catching down” to the underlying index.

This chart suggests that we will begin seeing weaker employment numbers and rising layoffs in the months ahead, if history is any guide to the future.

This last statement is key to our ongoing premise of weaker than anticipated economic growth despite the Federal Reserve’s ongoing liquidity operations. The current trend of the various economic data points on a broad scale are not showing indications of stronger economic growth but rather a continuation of a sub-par “muddle through” scenario of the last decade.

While this is not the end of the world, economically speaking, such weak levels of economic growth do not support stronger employment, higher wages, or justify the markets rapidly rising valuations. The weaker level of economic growth will continue to weigh on corporate earnings, which like the economic data, appears to have reached their peak for this current cycle.

The CFNAI, if it is indeed predicting weaker economic growth over the next couple of quarters, also doesn’t support the recent rotation out of defensive positions into cyclical stocks that are more closely tied to the economic cycle. The current rotation is based on the premise that economic recovery is here, however, the data hasn’t confirmed it as of yet.

Either the economic data is about to take a sharp turn higher, or the market is set up for a rather large disappointment when the expected earnings growth in the coming quarters doesn’t appear. From all of the research we have done lately, the latter point seems most likely as a driver for the former seems lacking.

Maybe the real question is why we aren’t paying closer attention to what this indicator has to tell us?

Need A Break From The Inlaws? Your “Turkey Day” Reading List

It’s “Thanksgiving Day,” and after the annual indulging into too much Turkey and dressing, cranberry sauce, and pecan pie, you might just need a break from the family to “do some research.”

We are happy to oblige with a few of our most important articles over the last few months as they relate to where we are in the current economic and market cycle.


Consumers Are Keeping The U.S. Out Of Recession? Don’t Count On It.

“[Who is a better measure of economic strength?] Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company who is watching sales, prices, managing inventory, dealing with collections, paying bills, and managing changes to the economic landscape on a daily basis? A quick look at history shows this level of disparity (between consumer and CEO confidence) is not unusual. It happens every time prior to the onset of a recession.

The Corporate Maginot Line

“We believe investors are being presented with a window to sidestep risk while giving up little to do so. If a great number of BBB-rated corporate bonds are downgraded, it is highly likely the prices of junk debt will plummet as supply will initially dwarf demand. It is in these types of events, as we saw in the sub-prime mortgage market ten years ago, that investors who wisely step aside can both protect themselves against losses and set themselves up to invest in generational value opportunities.”

Corporate Profits Are Worse Than You Think

“If the economy is slowing down, revenue and corporate profit growth will decline also. However, it is this point which the ‘bulls’ should be paying attention to. Many are dismissing currently high valuations under the guise of ‘low interest rates,’ however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the market and corporate profits after tax. The only other time in history the difference was this great was in 1999.”

Who Is Funding Uncle Sam

“Unfortunately, two of the largest buyers/holders of U.S. Treasury debt (China and the Federal Reserve) are no longer pulling their weight. More concerning, this is occurring as the amount of Treasury debt required to fund government spending is growing rapidly. The consequences of this drastic change in the supply and demand picture for U.S. Treasury debt are largely being ignored.”

The Disconnect Between The Markets & Economy Has Grown

“The stock market has returned almost 103.6% since the 2007 peak, which is more than 4-times the growth in GDP and nearly 3-times the increase in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not AS subject to manipulation.)

The all-time highs in the stock market have been driven by the $4 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, and valuation (PE) expansion. With Price-To-Sales ratios and median stock valuations near the highest in history, one should question the ability to continue borrowing from the future?”

Investors Are Grossly Underestimating The Fed – RIA PRO UNLOCKED

“The market has a long history of grossly underestimating, in both directions, what the Fed will do. The implications to stocks and bonds can be meaningful. To the extent one is inclined and so moved to exercise prudence, now seems to be a unique opportunity to have a plan and take action when necessary.”

Happy Thanksgiving!

Your Appreciative & Thankful Team At RIA Advisors

Powell’s Fantasy: The Economy Should Grow Faster Than Debt

In recent testimony to Congress’s Joint Economic Committee, Jerome Powell stated:

“The debt is growing faster than the economy — that’s unsustainable. It’s not the Fed’s job to say how the government should cut the deficit, but we need to get the economy to grow faster than the debt. Otherwise, future generations will be paying more of their taxes to cover the government’s debt costs than for other things like health care, etc.

I think the new normal now is low interest rates, low inflation and probably lower growth. Even with the lower interest on its debt, the government still needs to reduce its budget deficit.” 

Interestingly, these were not the first time we heard these words. In 2012, then-Fed Chair Ben Bernanke told Congress:

“Rising federal budget deficits are posing a significant threat to the U.S. economy and are likely to cause a crisis if not brought under control. Having a large and increasing level of government debt relative to national income runs the risk of serious economic consequences. Over the longer term, the current trajectory of federal debt threatens to crowd out private capital formation and thus reduce productivity growth.”

Looking back now, it was clear that Bernanke was correct. Over the last 30-years, the rising level of Federal Debt relative to National Income has retarded Productivity in the U.S.

Of course, just as is the case today, Congress didn’t listen then either. Just a couple of months later in July, 2012, as Congress was feuding over a “debt ceiling limit funding deal,” Ben Bernanke testified before the Senate Banking committee stating that “fiscal policy” needed to take over for “monetary policy.”

The response from Congress?

“Given the political realities of this year’s election, I believe the Fed is the only game in town. I would urge you, now more than ever, to take whatever actions are warranted. So, get to work, Mr. Chairman.” – Sen. Charles Schumer, D-N.Y.

Almost 8-years later, with the deficit once again approaching $1 Trillion, the Federal Reserve remains the “only game in town.” Such was the case following Jerome Powell’s plea to Congress to enact some responsibility, but all Wall Street heard was: “More QE is coming.”

Such should not be surprising. Regardless of political affiliation, the idea of “fiscal responsibility” in Washington has been replaced by all-out “socialist” leanings. However, you are mistaken if you believe this to be a new mentality in Washington.

It isn’t.

Like a “frog being boiled in water,” the temperature has been slowly rising for the last 20+ years as deficits grew to support unbridled largesse in Washington.

What is most important to understand is that this surging deficit is occurring during the longest economic expansion on record. Naturally, given the lack of immediate negative consequences, many have come to believe that debts, and deficits, don’t matter.

However, the evidence, should those in Washington D.C. care to examine, is using debt to “pull forward consumption” has had long-term negative effects on economic prosperity.

The current expansion is the weakest in U.S. history.

Here is a little different way to look at it. The chart below shows the deficit, 10-year average GDP growth, and the annual change in Federal Debt.

The problem should be obvious. Since the Federal government began ramping up debt, and running an annual deficit, economic growth has continued to deteriorate. This is not just a coincidence.

With the government already running a massive deficit, and expected to issue another $1.5-2 Trillion in debt during the next fiscal year, the efficacy of “deficit spending” in terms of its impact to economic growth has been greatly marginalized.

John Maynard Keynes’ was correct in his economic theory. In order for deficit spending to be effective, the “payback” from investments being made must yield a higher rate of return than the debt used to fund it.

The problem has been two-fold.

  • “Deficit spending” was only supposed to be used during a recessionary period, and reversed to a surplus during the ensuing expansion. However, beginning in the early ’80s, those in power only adhered to “deficit spending part” after all “if a little deficit spending is good, a lot should be better,” right?
  • Secondly, deficit spending shifted away from productive investments, which create jobs (infrastructure and development,) to primarily social welfare and debt service. Money used in this manner has a negative rate of return.

According to the Center On Budget & Policy Priorities, roughly 75% of every tax dollar goes to non-productive spending. 

Here is the real kicker. In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues and $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in. 

Do you see the problem here? (In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.”)

Debt Is The Cause, Not The Cure

I am not saying that all debt is bad.

Debt, if used for productive investments, can be a solution to stimulating economic growth in the short-term and provide a long-term benefit.

The current surge in unbridled deficit spending only succeeds in providing a temporary illusion of economic growth by “pulling forward” future consumption, leaving a void that must be filled.

Since the bulk of the debt issued by the U.S. has been squandered on increases in social welfare programs and debt service, there is a negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments.

In other words, Powell is hoping for a “fantasy” the economy can grow faster than the debt.

The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

However, simply looking at Federal debt levels is misleading.

It is the total debt that weighs on the economy.

It now requires nearly $3.00 of debt to create $1 of economic growth.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has actually been no organic economic growth.

In fact, the economic deficit has never been greater. For the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been greater.

This is why Jerome Powell is “wishing for a Unicorn.”

Interest rates MUST remain low, and debt MUST grow faster than the economy, just to keep the economy from stalling out.

This is the very essence of a “liquidity trap.”

Debt Doesn’t Create Real Growth

The massive indulgence in debt has simply created a “credit-induced boom” which has now reached its inevitable conclusion. While the Federal Reserve believed that creating a “wealth effect” by suppressing interest rates to allow cheaper debt creation would repair the economic ills of the “Great Recession,” it only succeeded in creating an even bigger “debt bubble” a decade later.

This unsustainable credit-sourced boom led to artificially stimulated borrowing which pushed money into diminishing investment opportunities and widespread mal-investments. In 2007, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments which were only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk. Today, we see it again in accelerated stock buybacks, low-quality debt issuance, debt-funded dividends, and speculative investments.

When credit creation can no longer be sustained, the markets must clear the excesses before the next cycle can begin. It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE, to tax cuts, only delay the clearing process. Ultimately, that delay only deepens the process when it begins.

The biggest risk in the coming recession is the potential depth of that clearing process.

Despite Powell’s wishes that Congress will become adults and begin to reduce the Federal debt burden, the reality is the economy can not sustain itself without the debt.

While we do have the ability to choose our future path, taking action today would require more economic pain and sacrifice than elected politicians are willing to inflict upon their constituents. This is why throughout the entirety of history, every empire collapsed eventually collapsed under the weight of its own debt.

Eventually, the opportunity to make tough choices for future prosperity will result in those choices being forced upon us.

Which Secular Bull Market Is It – 1950’s or 1920’s?

The following comment was recently making its way around the “twittersphere” suggesting a “new secular bull market” has started.

This isn’t the first time such a call has been made. 

“Despite concerns in the third quarter, bears never had a strong argument for why stocks were overvalued and the major indexes simply traded sideways for much of the last six months, wrote Robert Sluymer, technical strategist at Fundstrat Global Advisors.

We ‘continue to view the market cycle as being a normal pause in an ongoing secular bull market similar to what developed in 2016, 2011 and the ‘cycle’ pullbacks that developed during the secular bull markets in the 50s-60s and 80s-90s.”

It is an interesting point. The current bull market certainly seems unstoppable, but the question that must be answered, fundamentally, is if this is indeed a “secular bull market,” and if so, “where are we” within that cycle.

What is a “secular market?”

“A secular market trend is a long-term trend which lasts 5 to 25 years and consists of a series of primary trends. A secular bear market consists of smaller bull markets and larger bear markets; a secular bull market consists of larger bull markets and smaller bear markets.”

In a “secular bull’ market, the prevailing trend is “bullish” or upward-moving. In a “secular bear” the market tends to trend sideways with severe drawdowns and sharp rallies.

However, what truly defines long-term secular markets are valuations, and whether those valuations are contracting or expanding.

The chart above shows the history of secular bull market periods going back to 1871 using data from Dr. Robert Shiller. One thing you will notice is that secular bull markets tend to begin with CAPE 10 valuations around 10x earnings or even less. They tend to end around 23-25x earnings or greater. (Over the long-term valuations do matter.)

As noted above, what drives long-term secular “bull” markets is “valuation expansion.” In order to have the magnitude of “valuation expansion” needed to support a secular “bull” market, you must both start at “under-valued” levels and have the economic factors and investor enthusiasm to support a return to “over-valued” levels.

The problem with the idea that we are currently in a secular bull market akin to the 1950’s or 1980’s has everything to do with economic growth. Over the long-term, stocks CAN NOT outgrow the economy, as the stock market is a reflection of the companies engaging in the economy. This is why “valuations” are so important. Investors, in their “exuberance” can pay more than a company can generate over the long-term. When this exuberance is realized, valuations “contract” to reflect reality.

For several reasons, as we will discuss, the current “secular bull market,” if you can call it that, is likely more akin to the very brief cycle of the 1920’s.

Interest Rates & Debt

The argument that the U.S. has entered into another “secular bull market” is because interest rates are low. While the chart clearly shows that interest rates have hit the same levels as last seen in 1946, the view rates will rise strongly from current levels assumes that the same economic drivers exist today.

Rising interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time. If we refer to the GDP chart above, there have been two previous periods in history that have had the necessary ingredients to support rising interest rates. The first was during the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I, and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan, and others were left devastated. It was here that America found its strongest run of economic growth in its history as the “boys of war” returned home to not only start rebuilding the countries that they had just destroyed, but

But that was just the start of it.

Beginning in the late 50’s, America embarked upon its greatest quest in history as man took his first steps into space. The space race that lasted nearly twenty years led to leaps in innovation and technology that paved the wave for the future of America. Combined with the industrial and manufacturing backdrop, America experienced high levels of economic growth and increased savings rates which fostered the required backdrop for higher interest rates.

Currently, the U.S. is no longer the manufacturing powerhouse it once was and globalization has sent jobs to the cheapest sources of labor. Technological advances continue to reduce the need for human labor and suppress wages as productivity increases. Today, the number of workers between the ages of 16 and 54 is at the lowest level relative to that age group since the late 1970’s. This is a structural and demographic problem that continues to drag on economic growth as nearly 1/4th of the American population is now dependent on some form of governmental assistance.

This structural employment problem remains the primary driver as to why “everybody” is still wrong in expecting rates to rise.

However, this is also why whenever there is a discussion of valuations, it is invariably stated that “low rates justify higher valuations.”  The argument is based on an assumption that rates are low BECAUSE the economy is healthy and operating near full capacity.

The reality is quite different. The main contributors to the illusion of permanent prosperity have been a combination of artificial and cyclical factors. Low interest rates, when growth is low, suggests that NO valuation premium is “justified.

Currently, investors are taking on excessive risk, and thereby virtually guaranteeing future losses, by paying the highest S&P 500 price/revenue ratio in history and the highest median price/revenue ratio in history across S&P 500 component stocks.

Importantly, when talking about “Secular Bull Markets,” the amount of debt in the system plays an important factor. The last time that debt-to-GDP ratios hit such a peak was going into the “Great Depression.” Since debt retards economic growth by diverting savings into debt payments rather than productive investments, it is hard to suggest a “secular bull market” can gain traction given excessive debt levels.

Earnings Reversions

One of the more significant reasons the markets have likely not entered into the next great “Secular Bull Market” is due to the artificial inflation of earnings from massive share repurchases, corporate tax cuts, and excessive liquidity from Central Bank interventions.

Given the current deviation of both earnings from their long-term growth trend, and the deviation from reported profits, as shown below, the eventual mean reversion will likely be brutal.

The Great 9-Year Secular Bull Market

While the idea of a new “secular bull market” is certainly optimistic, it is also a dangerous concept for investors to “buy” into.

As stated above the stock market, over the long-term, is a reflection of the underlying economic activity. Personal consumption makes up roughly 70% of that activity. Given the consumer is more heavily leveraged than at any other point in history, it is highly unlikely they will be able to become a significantly larger chunk of the economy. With savings low, income growth weak, and debt back at record levels, the fundamental capacity to re-leverage to similar extremes is no longer available.

Let’s also not forget the singular most important fact.

The breakout of the markets in 2013, following the two previous bear markets, was NOT one based on organic economic fundamentals. Rather it was from massive monetary interventions by Central Banks globally. The previous secular bull markets in our history were ones which were derived from extreme under-valuations, washed out financial markets, and extreme negative sentiment.

Such is clearly not the case today.

The “secular bull market” of the 1920’s is probably the best example of the cycle we are in currently. Then banks were lending money to individuals to invest in the IPO’s the banks were bringing to market. Interest rates were falling, economic growth was rising, and valuations were rising faster than underlying earnings and profits.

There was no perceived danger in the markets, and little concern of financial risk as “stocks had reached a permanently high plateau.” 

It all ended rather abruptly.

Currently, it is clear that stock prices can be lofted higher by further monetary tinkering. However, the larger problem remains the inability for the economic variables to “replay the tape” of the ’50s or the ’80s. At some point, the markets and the economy will have to process a “reset” to rebalance the financial equation.

In all likelihood, it is precisely that reversion which will create the “set up” necessary to actually begin the “next great secular bull market.” Unfortunately, as was seen at the bottom of the market in 1974, there will be few individual investors left to enjoy the beginning of that ride.

The One Chart Every Millennial Should Ignore

The media is full of articles about the financial situation of Millennials in today’s economy. According to numerous surveys, they are saddled with too much debt, can’t secure higher wage-paying jobs, and are financially distressed on many fronts. Moreover, this is occurring during the longest financial and economic boom in the history of the United States.

Of course, the media is always there to help by chastising boot-strapped Millennials to dump their savings into the financial markets to chase overvalued, extended, and financially questionable stocks.

To wit:

“Only about half of American families are participating in some way in the stock market, according to research from the St. Louis Fed. When it comes to millennials (ages 23 to 38), about 60% have no direct or indirect exposure to the stock market.

Of course, you don’t definitely don’t have to invest, Erin Lowry, author of ‘Broke Millennial Takes on Investing,’ tells CNBC Make It. It’s not a life requirement. But you should understand what you’re losing out on if you avoid the markets. It’s a shocking amount, Lowry says. ‘You’re going to have to save so much more money to achieve the same goals because the market is helping do some of the work.’”

Great, you have a person with NO financial experience advising Millennials to put their “savings” into the single most difficult game on the planet.

Of course, this is all dependent on the same “myth” we just addressed last week:

“That’s because when you use a high-yield savings account or an investment account with higher returns, you put the magic of compound interest to work for you. When your money earns returns, those returns also generate their own earnings. It’s that simple.”

Here’s the math they use to prove their point.

“Let’s say you have $1,000 and add $100 a month to your savings over the course of 35 years. At the end, you’d have $43,000. Not bad. But if you had invested that money and earned a 10% rate of return, which is in line with average historic levels, you’d have over $370,000.”

Of course, you have to have a cool chart to go along with it.

Here’s a little secret.

It’s a complete fallacy.

From CNBC:

“Of course, investing is not risk-free. Typically, investors see some years where they earn double-digit returns and other years where they experience a loss. Losses happens, on average, about one out of every four years, and can be bad. During a bear market — which is when stocks fall by at least 20% — research shows that the market drops by an average of 30%. That condition typically lasts for about 13 months.

That means if you invested $1,000 and the market lost 30%, your investment would be worth $700. And it may take you more than 13 months to recover the $300 you lost.”

The importance of that statement is that “losses” destroy the “power of compounding.”

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.”

When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over long-term time frames.

Here is another way to look at it.

If you could simply just stick money in the market and it grew by 6% every year, then how is it possible to have 10 and 20-year periods of near ZERO to negative returns?

Morgan Stanley just recently published research on this exact issue:

On our estimates, the expected return of a US 60/40 portfolio of stocks and government bonds will return just 4.1% per year over the next decade, close to the lowest expected return over the last 20 years, and one that has only been worse in 4% of observations since 1950.”

4.1% isn’t 6, 8 or 10%.

There went your savings plan.

The level of valuations when you start your investing journey is all you need to know about where you are going to wind up. Based on current valuations, if you are betting on the last decade of returns to continue 30-years into the future, you are likely going to be very disappointed.

Don’t Forget The Impact Of Inflation

Here’s the second problem.

A recent article from MarketWatch pointed out how much it would cost to retire in each state. Using data from the BLS, Howmuch.net created the following visual.

“The average yearly expenses across the country for someone over the age of 65 is $51,624, but that figure comes in at $44,758 in the low-cost-of-living Mississippi and a whopping $99,170 on the other end of the spectrum in the Aloha State. ‘

This is misleading as the amounts shown above are based on TODAY’s data and what is required if your want to RETIRE TODAY.

What happens if you are a Millennial wanting to retire in 30-years? While $1 million sounds like a lot of money today, and might net you a comfortable retirement in Colorado ($1 million at a 3% annual withdrawal rate nets you $30,000 plus social security), will it be enough in 30-years?

Probably not. Let’s run it backwards.

In 1980, $1 million would generate between $100,000 and $120,000 per year while the cost of living for a family of four in the U.S. was approximately $20,000/year. Today, there is about a $40,000 shortfall between the income $1 million will generate and the cost of living.

This is just a rough calculation based on historical averages. However, the amount of money you need in retirement is based on what you think your income needs will be in the future, not today, and how long you have to reach that goal.

For most, there is a desire to live a similar, or better, lifestyle in retirement. However, over time, our standard of living will increase to reflect our life-cycle stages. Children, bigger houses to accommodate those children, education, travel, etc. all require higher incomes. (Which is the reason the U.S. has the largest retirement savings gap in the world.)

If you are like me with four kids, “a million dollars ain’t gonna cut it.”

The problem with Erin Lowry’s advice to her “millennial cohorts,” is not just the lack of accounting for variable rates of returns, but impact of inflation on future living standards.

Let’s run an easy example.

  • John is 23 years old and earns $40,000 a year.
  • He saves $14 a day 
  • At 67 he will have $1 million saved up (assuming he gets the promised 10% annual rate of return)
  • He then withdraws 4% of the balance to live on matching his $40,000 annual income.

That’s pretty straightforward math.

The problem is that it’s entirely wrong.

The living requirement in 44 years is based on today’s income level, not the future income level required to maintain the SAME living standard. 

Look at the chart below and select your current level of income. The number on the left is your income level today and the number on the right is the amount of income you will need in 30-years to live the same lifestyle you are living today.

This is based on the average inflation rate over the last two decades of 2.1%. However, if inflation runs hotter in the future, these numbers become materially larger.

The chart above exposes two problems with the entire premise:

  1. The required income is not adjusted for inflation over the savings time-frame, and;
  2. The shortfall between the levels of current income and what is actually required at 4% to generate the income level needed.

The chart below takes the inflation-adjusted level of income for each brackets and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. (For comparison purposes, the red bar is the “F.I.R.E. Movement” recommendation of 25x your income.)

If you need to fund a lifestyle of $100,000, or more, in today’s dollars, as Sheriff Brody quipped in “Jaws,”

“You are going to need a bigger boat.”

Not accounting for the future cost of living is going to leave a lot of people short, even including social security. 

While authors like Ms. Lowry are creating a nice income for themselves by selling books to “broke Millennials,” the content is only as good as the current market cycle you are in. Ms. Lowry, and her cohorts, have never been through a bear market.

Mean reverting events expose the fallacies of “buy-and-hold” investment strategies. The “stock market” is NOT the same as a “high yield savings account,” and losses devastate retirement plans. (Ask any “boomer” who went through the dot.com crash or the financial crisis.”)

Unfortunately, for individuals, the results between what is promised and what occurs continues to be two entirely different things, and generally not for the better. 

Corporate Profits Are Worse Than You Think – Addendum

We recently published Corporate Profits Are Worse Than You Think to expose stock prices that have surged well beyond levels that are justified by corporate profits. 

A topic not raised in the article, but a frequent theme of ours, is the role that share buybacks have played in this bull market. Corporations have not only been the largest buyer of stocks over the last few years, but share buybacks result in misleading earnings per share data, which warp valuations and makes stocks look cheaper. Over the last five years, corporations have been heavily leaning on the issuance of corporate debt to facilitate share buybacks. In doing so, earnings per share appear to sustain a healthy upward trajectory, but only because the denominator of the ratio (number of shares) is being reduced as debt on the balance sheet rises. This corporate shell game is one of the most obvious and egregious manifestations of imprudent Federal Reserve policies of the past decade.

Given the importance of debt to share buybacks, we provide two graphs below which question the sustainability of this practice.

The first graph below compares the growth of corporate debt and corporate profits since the early 1950s. The growing divergence, especially as of late, is a clear warning that debt is not being used for productive purposes. If it were, profits would be rising in a manner commensurate or even greater than the debt curve. The unproductive nature of corporate debt is also seen in the rising ratio of corporate debt to GDP, which now stands at all-time highs. Too much debt is being used for buybacks that curtail capital investment, innovation, productivity, and ultimately profits.  

Data Courtesy St. Louis Federal Reserve

The next graph uses the same data but presents the growth rates of profits and debt since 2015. Keep in mind the bump up in corporate profits in 2018 was largely due to tax legislation.

Data Courtesy St. Louis Federal Reserve

Lastly, we present a favorite chart of ours showing how the universe of corporate debt has migrated towards the lower end of the investment-grade bucket. Many investment-grade companies (AAA – BBB-) are issuing debt until they reach the risk of a credit downgrade to junk status (BB+ or lower). We believe many companies are now limited in their use of debt for fear of downgrades, which will naturally restrict their further ability to conduct buybacks. For more on this graph, please read The Corporate Maginot Line.

Bonds Are Stocks Without A Circuit Breaker

We are thrilled to introduce Samantha LaDuc, the Founder of LaDucTrading.com and the CIO at LaDuc Capital LLC. 

Samantha LaDuc is known for timing major inflection points in equities, commodities, bonds/rates, currencies and volatility. As a Macro-to-Micro strategic technical analyst, educator and trader, she makes her insights available to active traders and investors who want to minimize risk while seizing year-making opportunities.  


Don’t Overthink The Market. It’s Not That Smart.

That is what those with Consensus Opinions have done if they have stayed bullish. After all, there is evidence to support their claims:

  • Earnings on the S&P 500 almost tripled between 2009 and 2018 ($56.86 to $143.34) and the dividend grew by 144% ($21.97 to $53.61). The actual index price has more than quadrupled (4.6X) from $666 to $3060!
  • The S&P 500 index (excluding dividends) has compounded at over a 16% annual rate in that time, although the return from 2000 has only compounded 4.5% (and that is including dividends).

But there are those who feel strongly that ignorance is not bliss. We think and overthink the markets against the weight of evidence that is somewhere between Risk-Aware and Risk-Averse. It’s not a fair comparison, but I will use it anyway: Even Bernie Madoff had fabulous returns until he didn’t. In the same way, investors who are full of fear that the next correction will be “The Big One’ feel in large part this way because, like Madoff, there is no real price discovery. There is no way in fact to price risk!

As such, volumes have been historically low which means it is quite easy to move markets in either direction, especially if you are an Algo. The direction, just happens to be up. Nice for bulls that the designers of these algorithms programmed it this way! And that beats the alternative. Bears are not wishing for the markets’ demise. They are just having a hard time to trust these markets as corporate profits are declining, economic data is declining (labor market data are trailing indicators.), debt and deficits are exploding and inversion of yield curve shows big concerns from big investors.

Be Careful What You Ask For Bulls

A higher stock market could actually be its undoing. Money has flown out of equities and into bonds ever since the global financial crisis of 2008/2009, but especially since 2018 when Trump started the Trade War with China. This year has seen this trend continue:

Year-to Date (through October) Capital Flows per Bloomberg, EPFR Global

  • Cash: +$475B
  • Corporate Debt: +$320B
  • Government Bonds: +$60B
  • Global Equities: -$225B

But just as bonds have been bubbly, equities have risen in large part due to stock buybacks, fueled by cheap money made available from Fed monetary policy:

Ned Davis Research: S&P 500 would be 19% lower between 2011 and the first quarter of 2019 without buybacks. The broad market is up more than 125% in that time while net buybacks have totaled about $3.5 trillion.

So equities have risen strongly from a “generational low” in 2009 when Fed introduced QE. Combine higher earnings with consolidation of buying in Large Cap and Tech from passive investing (and a few central banks like Switzerland) and part of the advance can be explained. Include the availability of ‘cheap money’ made available from QE liquidity and Large Cap/Tech heavily weighted in the indices and we have the other part of the equation explaining the 10-year bull run. Now add in stock buybacks, which reduce the number of shares outstanding which inflates a company’s EPS contributing to its P/E expansion, which in turn triggers analysts to recommend these stocks to funds. And yet, actual fund flows favor bonds and cash over equities!

CEO Confidence is at historic lows and why wouldn’t it be? Why would they seek to expand production, risk not getting the return from that investment, when the Fed is communicating danger and Trump’s Trade War represents danger and global trade and earnings are both contracting without a trusted resolution in sight? Same thing goes for chasing all-time-highs in the stock market. So why wouldn’t both fall together in a deleveraging liquidity event?

There are plenty of wealth managers who understand this underlying dynamic and as a result have little to no trust in a market based on a closed-loop system of Fed money, Passive Investment, Algos and Stock Buybacks. Until now, there was also very little reason to jump in front of this train.

Bonds Are The New Stocks

At some point this momentum-driven bond bubble will be unwound. Granted, it is like a fully-loaded locomotive that needs miles and miles of track to even come to a stop so as not to derail, but wouldn’t it be logical, and somewhat ironic, if it is in fact higher equities that triggers the selling of bonds that causes the next market correction?

It’s going to plan perfectly when bonds roll over, structurally forcing rates to pop, then oil spikes with the Reflation trades (think inflation spike), while Momentum stocks are sold off because they’re overvalued relative to Value…and cause indices to correct. This move could be quicker than folks think as liquidity is ‘challenged’ in bonds sell off and Volatility in the bond market spills over into equities.  Samantha LaDuc 

Now let me add some more non-consensus opinion for a Bond Sell-Off: Impeachment prospects pick up and with it Elizabeth Warren’s chance of becoming President.

At risk: the practice of buying back shares as perceived by Presidential candidates to artificially raise prices for the benefit of management. Should this practice be limited or banned by an incoming President opposed to this practice – like Warren or Sanders, as both filed bills to do so and have announced as part of their economic platform in their election campaign – then the market should start to price this in. It hasn’t yet. But unlike stocks, there are no circuit breakers for bonds. And fixed income folks move together in large part so sudden moves can upend markets. Consider even below-investment grade bonds. They don’t trade anywhere near the volume the ETFs they populate. In a fast-moving bond market, those ETFs can sink hard and fast as the underlying collateral moves. But unlike their ETF equivalent that trades on the stock market with a ‘limit-down’ circuit breaker, the bonds will be under more pressure and settle with huge mark downs. Credit spreads will be widened and funding markets can freeze.


Ignorance Is Not Bliss

For over a decade, money has been coming out of equities and going into the bond market as investors continue to anticipate imminent market collapse. Investors were full of fear at the March 2009 lows and they are full of fear at the 2019 highs. Investors are so fearful that today they are willing to accept a 1.8% return on a 10-year U.S. treasury note rather than a near 2% return on the S&P 500. So in essence, ‘risk free money’ has been parked at the same time ‘risk free money’ from Fed policies of monetary easing has flooded markets with liquidity, which in turn has fueled stock buybacks and speculation.

But now there is a sense the Fed may be losing control. Now, Fed liquidity is going into Repo markets to backstop bank liquidity requirements (and concerns) to the tune of $1T to start over the next year, driving up the cost of collateral in their overnight financing activities. Fed liquidity is also needing to be printed to fund ever-growing fiscal deficits which are exploding and showing no signs of slowing. If it wasn’t for the Fed, and corporate stock buybacks, and a mountain in cash which private equity has leveraged, our markets wouldn’t be pushing through all time highs. They would be cut by a third. That is the growing body of fundamental evidence that the bears can point to when growling at the status quo of bulls’ complacency.

The great rotation out of bonds will probably be tested before proven. When bonds roll over, structurally forcing interest rates to pop, look for commodities to spike and the reflation trade to move higher in place of momentum trades. Be aware that as bonds sell off, unlike equities, they don’t experience controlled pockets of selling or slow distribution over weeks and months, and there is no backstop for ‘limit down’ selling which triggers halts. There is but one very teeny, tiny exit door. And their hedging strategies of shorting VIX will not help them. The unwind of the short VIX trade (currently at all time highs) would be unwound violently causing a sudden equity sell-off.

Forced Liquidation will beget forced liquidation in both bonds and equities. Favorites like AAPL and MSFT will need to be sold to meet margin calls. Shorting will not be a six-month ride down the waterfall like in 2008. A liquidity freeze is one thing, but a panic for USD, aka CASH, where there isn’t enough of it, globally, can morph into a liquidity flash crash event and convulse for both stock and bond sell-offs within weeks not months. Risk premiums will be so quickly elevated in this race for liquidity and in this time of quant funds and algos that even those who try to short, let alone protect, in the thick of this downdraft will be played by market makers.

And that’s why Bears are not ready to capitulate, as the risk is too great that a true liquidity crisis – for CASH – creates panic and in panic everything sells off – Even gold and bitcoin are not safe. Only those who are sitting on the sidelines will be in a position to pick up shares on the cheap.


LaDuc Trading/LaDuc Capital LLC Is Not a Financial Advisor, RIA or Broker/Dealer.  Trading Stocks, Options, Futures and Forex includes significant financial risk. We teach and inform. You enter trades at your own risk. Learn more.

Strongest Economy Ever? Americans Receive More In Benefits Than Pay In Taxes

At the beginning of August, I discussed the following tweet from the President:

“But if it is the ‘strongest economy ever,’ then why the need for aggressive rate cuts which are ’emergency measures’ to be utilized to offset recessionary conditions?”

The following chart should quickly put that claim to rest.

While the claims of an exceptionally strong economy rely heavily on historically low unemployment and jobless claims numbers, historically high levels of asset prices, and strong consumer spending trends, there is an underlying deterioration that goes unaddressed.

For example, while reported unemployment is hitting historically low levels, there is a swelling mass of uncounted individuals that have either given up looking for work or are working multiple part-time jobs. This is shown by those “not in labor force” as a percent of the working-age population, which has skyrocketed since the recession.

The employment to population ratio would not still be at levels from the 1980s.

If employment was indeed as strong as reported by government agencies, then social benefits would not be comprising a record high of 22% of real disposable incomes. Here is the breakdown:

  • 40 million Americans on food stamps
  • An estimated 50% of the 330 million Americans in this country get at least one federal benefit, according to the Census Bureau.
  • An estimated 63 million get Social Security; 59.9 million get Medicare; 75 million get Medicaid; 5 million get housing subsidies; and 4 million get Veterans’ benefits.

Those numbers continue to rise.

Without government largesse, many individuals would literally be living on the street. The chart above shows all the government “welfare” programs and current levels to date. While unemployment insurance has hit record lows following the financial crisis, social security, medicaid, veterans’ benefits, and other social benefits have continued to rise and have surged sharply over the last few months.

With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.

In fact, in the ongoing saga of the demise of the American economy U.S. households are now getting more in cash handouts from the government than they are paying in taxes for the first time since the Great Depression. This, of course, at a time when the current administration is more enthralled with trying to find some universe where cutting taxes actually increases tax revenues as a percent of GDP rather than actually cutting spending.

In 2018, households received $2.2 trillion in some form of government transfer payments, which was more than the $1.7 trillion paid in personal income taxes.

“Yes, but wages are now the highest ever.”

Fair enough, but if that were truly the case, then why are transfer payments as a percent of disposable personal income still hanging near its highs from the “Great Recession?”

In the “strongest economy in history,” American’s should be earning a bulk of the income from their labor, rather than from Government handouts. This is why, despite tax cuts, tax revenue growth has waned as the economy has remained weak.

You simply can’t create economic growth by recycling tax dollars. 

In short, Americans have the government, not private enterprise, to thank for their wealth growth – but, of course, there are massive implications to this.

As I noted in our recent discussion on the fallacy of the “savings rate:”

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $2654 annual deficit that cannot be filled.”

That gap explains why consumer debt is at historic highs and growing each year.

Furthermore, if more households have the government to thank for their wealth, does that mean those households are more inclined to re-elect politicians who are pushing for more government handouts? 

The answers to that question is quite obvious if you look at the candidates currently running for President on the Democratic ticket.

The bottom line is that America can’t grow its way back to prosperity on the back of social assistance. The average American is fighting to make ends meet as their cost of living rises while wage growth largely remains stagnant.

This brings us to the hard truth.

The budget deficit is set to grow over the next few years as interest payments alone absorb a chuck of the tax revenue. This comes at a time when that same dollar of tax revenue only covers entitlement spending as 75 million baby boomers begin their migration into the social safety net.

The call by the American people at the last election was a mandate to reduce the size of government and spending, however, that has fallen on deaf ears and weak stomachs. The current electorate is log jammed by personal agendas as the White House elected to cut taxes, increase defense spending, and exacerbate the crony-capitalism which currently plagues the country.

By the way, the only other time government income support exceeded taxes paid was during the “Great Depression” from 1931 to 1936.

Strongest economy ever? Hardly.

But it could be.

Today, we have the ability to choose our battles, make tough choices, and restore the economic balance for future growth. However, 800-years of history tells us that we will fail to make those choices, and at some point, those choices will be forced upon us.

Why The Measure Of “Savings” Is Entirely Wrong

In our recent series on capitalism (Read Here), we were discussing how the implementation of socialism, by its very nature, requires an ability to run unlimited deficits. In that discussion was the following quote:

Deficits are self-financing, deficits push rates down, deficits raise private savings.” – Stephanie Kelton

On the surface, there does seem to be a correlation between surging deficits and increases in private savings, as long as you ignore the long-term trend, or the reality of 80% of Americans in the U.S. today that live paycheck-to-paycheck.

The reality is the measure of “personal savings,” as calculated by the Bureau of Economic Analysis, is grossly inaccurate. However, to know why such is the case, we need to understand how the savings rate is calculated. The website HowMuch.com recently provided that calculation of us. 

As you can see, after the estimated taxes and estimated expenses are paid, there is $6,017 dollars left over for “savings,” or, as the Government figures suggest, an 8%+ savings rate. 

The are multiple problems with the calculation.

  1. It assumes that everyone in the U.S. lives on the budget outlined above
  2. It also assumes the cost of housing, healthcare, food, utilities, etc. is standardized across the country. 
  3. That everyone spends the same percentage and buys the same items as everyone else. 

The cost of living between California and Texas is quite substantial. While the median family income of $78,635 may raise a family of four in Houston, it is probably going to be quite tough in San Francisco.

While those flaws are apparent, the biggest issue is the saving rate is heavily skewed by the top 20% of income earners. This is the same problem that also plagues disposable personal income and debt ratios, as previously discussed  in “America’s Debt Burden Will Fuel The Next Crisis.” To wit:

“The calculation of disposable personal income (which is income less taxes) is largely a guess, and very inaccurate, due to the variability of income taxes paid by households. More importantly, the measure is heavily skewed by the top 20% of income earners, and even more so by the top 5%. As shown in the chart below, those in the top 20% have seen substantially larger median wage growth versus the bottom 80%. (Note: all data used below is from the Census Bureau and the IRS.)”

The interactive graphic below from MagnifyMoney shows the disparity of income versus savings even more clearly.

 

When you look at the data in this fashion, you can certainly begin to understand the calls for “socialism” by political candidates. The reality is the majority of Americans are struggling just to make ends meet, which has been shown in a multitude of studies. 

“The [2019] survey found that 58 percent of respondents had less than $1,000 saved.” – Gobankingrates.com

Or, as noted by the WSJ:

“The American middle class is falling deeper into debt to maintain a middle-class lifestyle.

Cars, college, houses, and medical care have become steadily more costly, but incomes have been largely stagnant for two decades, despite a recent uptick. Filling the gap between earning and spending is an explosion of finance into nearly every corner of the consumer economy.

Consumer debt, not counting mortgages, has climbed to $4 trillion—higher than it has ever been even after adjusting for inflation.”

When looking at the data, it is hard to suggest that Americans are saving 8% or more of their income.

The differential between incomes and the actual “cost of living” is quite substantial. As Researchers at Purdue University found in their study of data culled from across the globe, in the U.S., $132,000 was found to be the optimal income for “feeling” happy for raising a family of four. (I can attest to this personally as a father of a family of six)

A Gallup survey found it required $58,000 to support a family of four in the U.S. (Forget about being happy, we are talking about “just getting by.”) 

So, while the Government numbers suggest the average American is saving 8% of their income annually, the majority of “savings” is coming from the differential in incomes between the top 20% and the bottom 80%.

In other words, if you are in the “Top 20%” of income earners, congratulations, you are probably saving a chunk of money.

If not, it is likely a very different story.

The “gap” between the “standard of living” and real disposable incomes is shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $2654 annual deficit that cannot be filled.

That gap explains why consumer debt is at historic highs and growing each year. If individuals were saving 8% of their money every year, debt balances would at least be flat, if not declining, as they are paid off. 

We can see the inconsistency between the “saving rate” and the requirement to sustain the “cost of living” by comparing the two. Beginning in 2009, it required the entire income of wage earners plus debt just to maintain the standard of living. The gap between the reported savings rate, and reality, is quite telling.

While Stephanie Kelton suggests that running massive deficits increases saving rates, and pose not economic threat as long as their is no inflation, the data clearly suggests this isn’t the case.

Savings rates didn’t fall in the ’80s and ’90s because consumers decided to just spend more. If that was the case, then economic growth rates would have been rising on a year-over-year basis. The reality, is that beginning in the 1980’s, as the economy shifted from a manufacturing to service-based economy, productivity surged which put downward pressure on wage and economic growth rates. Consumers were forced to lever up their household balance sheet to support their standard of living. In turn, higher levels of debt-service ate into their savings rate.

The problem today is not that people are not “saving more money,” they are just spending less as weak wage growth, an inability to access additional leverage, and a need to maintain debt service restricts spending.

That is unless you are in the top 20% of income earners.