Tag Archives: economics

#WhatYouMissed On RIA This Week: 03-27-20

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#WhatYouMissed On RIA This Week: 03-20-20

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Michael Lebowitz, CFA and I dig into the financial markets, the Fed’s bailouts, and what potentially happens next and what we are looking for. (Also, our take on corporate bailouts, and why, I can’t believe I am saying this, we mostly agree with Elizabeth Warren.)

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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.”

#WhatYouMissed On RIA This Week: 03-13-20

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Danny Ratliff, CFP and Lance Roberts, CIO discuss the importance of having a process during a market decline, and the importance of financial advisor to ensure you don’t make emotionally driven mistakes.

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#WhatYouMissed On RIA This Week: 03-06-20

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Mike Lebowitz and I dig into the wild market swings, COVID-19, and what, if anything, the Fed can do about it.

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#WhatYouMissed On RIA: Week Of 02-24-20

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Mike Lebowitz and I dig into the market, COVID-19, and what, if anything, the Fed can do about it.

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#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.

#WhatYouMissed On RIA: Week Of 02-17-20

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Quick 4-minute review of the markets back to extreme deviations from long-term averages which suggested the correction we saw on Thursday and Friday were likely.

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#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.

#WhatYouMissed On RIA: Week Of 02-10-20

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#WhatYouMissed On RIA: Week Of 02-03-20

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#WhatYouMissed On RIA: Week Of 01-27-20

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Seth Levine and I dig into the markets, the Fed, Repo in a wide ranging discussion on the current investment environment.

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#WhatYouMissed On RIA: Week Of 01-20-20

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Yes, Rates Are Still Going To Zero

“If the U.S. economy entered a recession soon and interest rates fell in line with levels seen during the moderate recessions of 1990 and 2001, yields on even longer-dated Treasury securities could fall to or below zero.” – Senior Fed Economist, Michael Kiley – January 20, 2020

I was emailed this article no less than twenty times within a few hours of it hitting the press. Of course, this was not a surprise to us. To wit:

“Outside of other events such as the S&L Crisis, Asian Contagion, Long-Term Capital Management, etc. which all drove money out of stocks and into bonds pushing rates lower, recessionary environments are especially prone at suppressing rates further. Given the current low level of interest rates, the next recessionary bout in the economy will very likely see rates near zero.” 

That article was written more than 3-years ago in August 2016. 

Of course, three-years ago, as the “Bond Gurus,” like Jeff Gundlach and Bill Gross, were flooding the media with talk about how the “bond bull market was dead,” and “interest rates were going to rise to 4%, or more,” I repeatedly penned why this could not, and would not, be the case.

While it seemed a laughable concept at the time, particularly as the Fed was preparing to hike rates and reduce their balance sheet, the critical aspect of leverage was overlooked.

“There is an assumption that because interest rates are low, that the bond bull market has come to its inevitable conclusion. The problem with this assumption is three-fold:

  1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields, which pushes rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
  2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largesse in the future, the budget deficit is set to swell above $1 Trillion in coming years. This will require more government bond issuance to fund future expenditures, which will be magnified during the next recessionary spat as tax revenue falls.
  3. Central Banks will continue to be a buyer of bonds to maintain the current status quo, but will become more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion which will push the 10-year yield towards zero.”

Of course, since the penning of that article, let’s take a look at where we currently stand:

  1. Negative yielding debt surged past $17 trillion pushing more dollars into positive yielding U.S. Treasuries which led to rates hitting decade lows in 2019.
  2. The budget deficit has indeed swelled to $1 Trillion and will exceed that mark in 2020 as unbridled Government largesse continues to run amok in Washington.
  3. The Federal Reserve, following a very short period of trying to hike rates and reduce the bloated balance sheet, completely reversed the policy stance by cutting rates and flooding the system with liquidity by ramping up bond purchases.

The biggest challenge the Fed faces currently is how to deal with a recession. Given the current expansion is the longest on record; a downturn at some point is inevitable. Over the last decade, as shown in the chart below, the Federal Reserve has kept rates at extremely low levels, and flooded the system with liquidity, which did NOT have the effect of fostering either economic growth or inflation to any significant degree. (As noted the composite index is of inflation, GDP, wages, and savings which has closely tracked the long-term trend of interest rates.)

Naturally, at any point monetary accommodation is removed, an economic, and market downturn is almost immediate. This is why it is feared central banks do not have enough tools to fight the next recession. During and after the financial crisis, they responded with a mixture of conventional interest-rate cuts and, when these reached their limit, with experimental measures, such as bond-buying (“quantitative easing”, or QE) and making promises about future policy (“forward guidance”).

The trouble currently is that global short-term interest rates are still close to, or below zero, and cannot be cut much more, which has deprived central banks of their main lever if a recession strikes.

The Fed Is Trapped

While the Fed talks about wanting higher rates of inflation, as shown above, they can’t run the risk that rates will rise. Simply, in an economy that requires $5 of debt to create $1 of economic growth, the leverage ratio requires rates to remain low or “bad things” happen economically.

1) The Federal Reserve has been buying bonds for the last 10- years in an attempt to keep interest rates suppressed to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.

2) Rising interest rates immediately slows the housing market, taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs, which leads to lower profit margins for corporations. This will negatively impact the stock market given that a bulk of the “share buybacks” have been completed through the issuance of debt.

4) One of the main arguments of stock bulls over the last 10-years has been the stocks are cheap based on low interest rates. When rates rise, the market becomes overvalued very quickly.

5) The massive derivatives market will be negatively impacted, leading to another potential credit crisis as interest rate spread derivatives go bust.

6) As rates increase, so does the variable rate interest payments on credit cards. With the consumer being impacted by stagnant wages, higher credit card payments will lead to a rapid contraction in disposable income and rising defaults. 

7) Rising defaults on debt service will negatively impact banks, which are still not adequately capitalized and still burdened by large levels of risky debt.

8) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in. (Such may already be underway.)

9) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits have already crumbled as the deficits have already surged to $1 Trillion and will continue to climb.

10) Rising interest rates will negatively impact already massively underfunded pension plans leading to insecurity about the ability to meet future obligations. With a $7 Trillion funding gap, a “run” on the pension system becomes a high probability.

I could go on but you get the idea.

The issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. This is because the vast majority of Americans are living paycheck-to-paycheck.

However, since average American’s requires roughly $3000 in debt annually to maintain their standard of living, interest rates are an entirely different matter.

As I noted last week, this is a problem too large for the Fed to bail out, which is why they are terrified of an economic downturn.

The Fed’s End Game

The ability of the Fed to use monetary policy to combat recessions is at an end. A recent article by the WSJ agrees with our assessment above.

“In many countries, interest rates are so low, even negative, that central banks can’t lower them further. Tepid economic growth and low inflation mean they can’t raise rates, either.

Since World War II, every recovery was ushered in with lower rates as the Fed moved to stimulate growth. Every recession was preceded by higher interest rates as the Fed sought to contain inflation.

But with interest rates now stuck around zero, central banks are left without their principal lever over the business cycle. The eurozone economy is stalling, but the European Central Bank, having cut rates below zero, can’t or won’t do more. Since 2008, Japan has had three recessions with the Bank of Japan, having set rates around zero, largely confined to the sidelines.

The U.S. might not be far behind. ‘We are one recession away from joining Europe and Japan in the monetary black hole of zero rates and no prospect of escape,’ said Harvard University economist Larry Summers. The Fed typically cuts short-term interest rates by 5 percentage points in a recession, he said, yet that is impossible now with rates below 2%.”

This too sounds familiar as it is something we wrote in 2017 prior to the passage of the tax reform bill:

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

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

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

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

It’s good news the WSJ, and mainstream economists, are finally catching up to analysis we have been producing over the last several years.

The only problem is that it is likely too little, too late.Save

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#WhatYouMissed On RIA: Week Of 01-13-20

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#WhatYouMissed On RIA: Week Of 01-06-20

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#WhatYouMissed On RIA: Week Of 12-30-19

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#WhatYouMissed On RIA: Week Of 12-23-19

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#WhatYouMissed On RIA: Week Of 12-16-19

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#WhatYouMissed On RIA: Week Of 12-09-19

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  • What do Decennial Cycles, Presidential Cycles have to do with markets?
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#WhatYouMissed On RIA: Week Of 12-02-19

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Hedge Fund Telemetry founder Thomas Thornton reveals his secret sauce for tracking the markets, indicators he likes best, and what the charts are saying about the 2020 elections.

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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?

#WhatYouMissed On RIA: Week Of 11-25-19

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Economist Daniel LeCalle’s new book, “Freedom or Equality,” will be released in March 2020, and we get a preview of his thoughts on the difference between equality and equal opportunity, whitewashing interventionism; capitalism isn’t broken, but it’s been warped by corporate stock buy-backs; four reasons US Healthcare is the way it is; why our challenges cannot by solved by destroying the greatness of the US; why you cannot equalize-up, only equalize-down to the lowest-common denominator.

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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.

#WhatYouMissed On RIA: Week Of 11-11-19

We know you get busy and don’t check on our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything that you might have missed.

The Week In Blogs


The Best Of “The Lance Roberts Show”

Video Of The Week

Interview with Pedro Da Costa from the Economic Policy Institute on the Fed, monetary policy, and the “Greatest Economy Ever.”

Our Best Tweets Of The Week


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What You Missed At RIA Pro

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See you next week!

Technically Speaking: A Correction Is Coming, Just Don’t Tell The Bulls…Yet.

In this past weekend’s newsletter, I discussed the rather severe extensions of the market above both the longer-term bullish trend and the 200-dma. To wit:

“Currently, it will likely pay to remain patient as we head into the end of the year. With a big chunk of earnings season now behind us, and economic data looking weak heading into Q4, the market has gotten a bit ahead of itself over the last few weeks.

On a short-term basis, the market is now more than 6% above its 200-dma. These more extreme price extensions tend to denote short-term tops to the market, and waiting for a pull-back to add exposures has been prudent..”

But it isn’t just the more extreme advance of the market over the past 5-weeks which has us a bit concerned in the short-term, but a series of other indications which typically suggest short- to intermediate-terms corrections in the market. 

Not surprisingly, whenever I discuss the potential of a market correction, it is almost always perceived as being “bearish.” Therefore, by extension, such must mean I am either all in cash or shorting the market. In either case, it is assumed I “missed out” on the previous advance.

If you have been reading our work for long, you already know we have remained primarily invested in the markets, but hedge our risk with fixed income and cash, despite our “bearish” views. I am reminded of something famed Morgan Stanley strategist Gerard Minack said once:

The funny thing is there is a disconnect between what investors are saying and what they are doing. No one thinks all the problems the global financial crisis revealed have been healed. But when you have an equity rally like you’ve seen for the past four or five years, then everybody has had to participate to some extent.

What you’ve had are fully invested bears.”

While the mainstream media continues to misalign individual’s expectations by chastising them for “not beating the market,” which is actually impossible to do, the job of a portfolio manager is to participate in the markets with a preference toward capital preservation. This is an important point:

“It is the destruction of capital during market declines that have the greatest impact on long-term portfolio performance.”

It is from that view, as a portfolio manager, the idea of “fully invested bears” defines the reality of the markets that we live with today. Despite this understanding, the markets are overly bullish, extended, and overvalued and portfolio managers must stay invested or suffer potential “career risk” for underperformance. What the Federal Reserve’s ongoing interventions have done is push portfolio managers to chase performance despite concerns of potential capital loss.

Managing portfolios for both risk adjusted returns while protecting capital is a delicate balance. Each week in the Real Investment Report (click here for free weekly e-delivery) we discuss the risks and challenges of the current market environment and report on how we are adjusting our exposures to the market over time.

In this past weekend’s missive, we discussed how to “play” the latest round of the Fed’s QE program, along with what sectors and markets tend to perform the best.

However, I wanted to share a few charts which suggests that being patient currently, will likely yield a much better entry point for investors in the not-so-distant future.

Overbought And Extended

By the majority of measures that we track from momentum, to price, and deviation, the market’s sharp advance has pushed the totality of those indicators back to overbought.

Historically, when all of the indicators are suggesting the market has likely encompassed the majority of its price advance, a correction to reverse those conditions is often not far away. Regardless of the timing of that correction, it is unlikely there is much upside remaining in the current advance, and taking on additional equity exposure at these levels will likely yield a poor result.

Overly Complacent

The post-Fed rate cut and QE driven advance in the market has also pushed investors back to levels of extreme complacency.

Such extremely low levels of volatility, combined with investors piling into record “short positions” on the VIX, provides all the “fuel” necessary for a fairly sharp 3-5% correction given the proper catalyst.

Given that investors are “all in,” as discussed last week, there is plenty of room for investors to get forced out of holdings and push markets lower over the next few weeks. However, it isn’t just individual investors that are “all in,” but professionals as well.

Eurodollar Sends A Warning

Eurodollar positioning is also sending a major warning. (“Eurodollar” refers to U.S. dollar-denominated deposits at foreign banks, or at the overseas branches of American banks.)

When the ECB launched QE following the 2016 selloff, foreign banks liquidated Eurodollar deposits as it was deemed less risky to hold foreign denominated deposits. Currently, that view has reversed sharply as the global economy slows, and foreign banks are “hedging” their risk by flooding money into U.S. dollar denominated deposits. Historically, when you have an extremely sharp reversal in Eurodollars, it has preceded more troubling market events.

With Eurodollar deposits at record levels, do foreign banks know something we don’t?

Earnings Vs. Profits

The deviation between corporate GAAP earnings and corporate profits is currently at record levels. It is also entirely unsustainable. Either corporate profits will catch up with earnings, or vice-versa. Historically, profits have never caught up with earnings, it is always the other way around.

Expectations for corporate earnings going forward are still way to elevated, and with corporate share buybacks slowing, this leaves lots of room for disappointment.

Deviation

I have written many times in the past that the financial markets are not immune to the laws of physics.

There is a simple rule for markets:

“What goes up, must, and will, eventually comes down.”

The example I use most often is the resemblance to “stretching a rubber-band.” Stock prices are tied to their long-term trend which acts as a gravitational pull. When prices deviate too far from the long-term trend they will eventually, and inevitably, “revert to the mean.”

See Bob Farrell’s Rule #1

Currently, the market is not only more than 6% above its 200-dma, as shown in the opening of this missive, but is currently more than 15% above its 3-year moving average.

More importantly, the market is currently extremely deviated above it long-term bullish trend. During this entire decade-long bull market advance, the trendline is retested with some regularity from such extreme extensions.

Sentiment

Lastly, is sentiment. When sentiment is heavily skewed toward those willing to “buy,” prices can rise rapidly and seemingly “climb a wall of worry.” However, the problem comes when that sentiment begins to change and those willing to “buy” disappear.

This “vacuum” of buyers leads to rapid reductions in prices as sellers are forced to lower their price to complete a transaction. The problem is magnified when prices decline rapidly. When sellers panic, and are willing to sell “at any price,” the buyers that remain gain almost absolute control over the price they will pay. This “lack of liquidity” for sellers leads to rapid and sharp declines in price, which further exacerbates the problem and escalates until “sellers” are exhausted.

Currently, there is a scarcity of “bears.”

See Bob Farrell’s Rule #6

As we discussed just recently, consumer and investor confidence are both closely tied and are extremely elevated. However, CEO confidence is pushing record lows. A quick look at history shows this level of disparity is not unusual around market peaks and recessionary onsets.

Another way to analyze confidence data is to look at the consumer expectations index minus the current situation index in the consumer confidence report.

This measure also is signaling a correction/recession is coming. The differential between expectations and the current situation, as you can see below, is worse than the last cycle, and only slightly higher than prior to the “dot.com” crash. Recessions start after this indicator bottoms, which has already started happening.

Currently, the bottoming process, and potential turn higher, which signals a recession and bear market, appears to be in process.

None of this should be surprising as we head into 2020. With near-record low levels of unemployment and jobless claims, combined with record high levels of sentiment, job openings, and record asset prices, it seems to be just about as “good as it can get.”

Does this mean the current bull market is over?

No.

However, it does suggest the “risk” to investors is currently to the downside, and some caution with respect to equity-based exposure should be considered.

What Are We Doing About It?

Given the fact that the short, intermediate, and long-term indicators have all aligned, the risk of running portfolios without a hedge is no longer optimal. As such, we added an “inverse” S&P 500 position to all of our portfolios late yesterday afternoon. 

While none of the charts above necessarily mean the next “great bear market” is coming, they do suggest a modest correction is likely. The reason we hedge against declines is that one day, and we never know when, a modest correction will turn into a more significant decline.

Remaining fully invested in the financial markets without a thorough understanding of your “risk exposure” will likely not have the desirable end result you have been promised. All of the charts above have linkages to each other, and when one breaks, they all break.

So pay attention to the details.

As I stated above, my job, like every portfolio manager, is to participate when markets are rising. However, it is also my job to keep a measured approach to capital preservation.

SO, why shouldn’t you show these charts to the bulls?

Because you need someone to “sell to” first.

#WhatYouMissed On RIA: Week Of 11-04-19

We know you get busy and don’t check on our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything that you might have missed.

The Week In Blogs


The Best Of “The Lance Roberts Show”

Video Of The Week

John Dorfman On Value Investing

Sometimes it’s good to get back to the basics: The essence of value trading, and what makes a value stock so; commentary on the rise of ETF’s, and the myth of passive investing; the price distortion in share buy backs; how to factor in the Fed.

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#WhatYouMissed On RIA: Week Of 10-28-19

We know you get busy and don’t check on our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything that you might have missed.

The Week In Blogs


The Best Of “The Lance Roberts Show”

Video Of The Week

What the Fed really said. Interview with Michael Lebowitz on latest Fed statement.

Our Best Tweets Of The Week

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What You Missed At RIA Pro

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#WhatYouMissed On RIA: Week Of 10-25-19

We know you get busy and don’t check on our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything that you might have missed.

The Week In Blogs


The Best Of “The Lance Roberts Show”

Video Of The Week

Our Best Tweets Of The Week


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What You Missed At RIA Pro

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See you next week!