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Technical Measures And Valuations. Does Any Of It Matter?

Technical measures and valuations all suggest the market is expensive, overbought, and exuberant. However, none of it seems to matter as investors pile into equities to chase risk assets higher. A recent BofA report shows that the increase in risk appetite has been the largest since March 2021.

Risk Appetite Index

Of course, as prices increase faster than underlying earnings growth, valuations also increase. However, as discussed in “Valuations Suggest Caution,” valuations are a better measure of psychology in the short term. To wit:

“Valuation metrics are just that – a measure of current valuation. More importantly, when valuation metrics are excessive, it is a better measure of ‘investor psychology’ and the manifestation of the ‘greater fool theory.’ As shown, there is a high correlation between our composite consumer confidence index and trailing 1-year S&P 500 valuations.”

Consumer confidence vs valuations

When investors are exuberant and willing to overpay for future earnings growth, valuations increase. The increase in valuations, also known as “multiple expansion,” is a crucial support for bull markets. As shown, the increase in multiples coincides with rising markets. Of course, the opposite, known as “multiple contractions,” is also true. With a current Shiller CAPE valuation multiple of 34x earnings, such suggests that investor confidence is elevated.

Valuation Model

As noted, valuations are terrible market timing indicators and should not be used for such. While valuations provide the basis for calculating future returns, technical measures are more critical for managing near-term portfolio risk.

Technical Measures Are Getting Extreme

As noted, investors are again becoming exuberant over stock ownership. Such is vital to creating multiple expansions and fueling bull market advances. High valuations, bullish sentiment, and leverage are meaningless if the underlying equities are not owned. As discussed in Household Equity Allocations,” the current levels of household equity ownership have reverted to near-record levels. Historically, such exuberance has been the mark of more important market cycle peaks.

Household equity ownership vs SP500

While household equity ownership is critical to expanding the bull market, the technical measures provide an understanding of when excesses are reached. One measure we focus on is the deviation of price from long-term means. The reason is that markets are bound to long-term means over time. For a “mean” or “average” to exist, prices must trade above and below that price over time. Therefore, we can determine when deviations are approaching more extreme levels by viewing past deviations. Currently, the deviation of the market from its underlying 2-year average is one of the largest in history. Notably, there have certainly been more significant deviations in the past, suggesting the current deviation from the mean can grow further. However, such deviations have crucially been a precursor to an eventual mean-reverting event.

Technical Model

The following analysis uses quarter data and evaluates the market using valuation and technical measures. From a long-term perspective, the market is trading at more extreme levels. The quarterly Relative Strength (RSI) measure is above 70, the deviation is close to a historical record, and the market trades nearly 3 standard deviations above its quarterly mean. As noted, while these valuation and technical measures can undoubtedly become more extreme, the ingredients for an eventual mean reverting event are present.

Quarterly risk based market model

Of course, the inherent problem with long-term analysis is that while valuations and long-term technical measures are more extreme, they can remain that way for much longer than logic suggests. However, we can construct a valuation and technical measures model using the data above. As shown, the model triggered a “risk off” warning in early 2022 when high valuations collided with an extreme deviation of the market above the 24-month moving average. That signal was reversed in January 2023, as the market began to recover. While a new signal has not yet been triggered, the ingredients of valuations and deviations are present.

Fundamental and Technical Model
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The Ingredients Are Missing A Catalyst

The problem with long-term technical measures and valuations is that they move slowly. Therefore, the general assumption is that if high valuations do not lead to an immediate market correction, the measure is flawed.

In the short term, “valuations” have little relevance to what positions you should buy or sell. It is only momentum, the direction of the price, that matters. Managing money, either “professionally” or “individually,” is a complicated process over the long term. It seems exceedingly easy in the short term, particularly amid a speculative mania. However, as with every bull market, a strongly advancing market forgives investors’ many investing mistakes. The ensuing bear market reveals them in the most brutal and unforgiving of outcomes. 

There is a clear advantage to providing risk management to portfolios over time. The problem is that most individuals cannot manage their own money because of “short-termism.” As shown by shrinking holding periods.

Holding periods for investors

While “short-termism” currently dominates the investor mindset, the ingredients for a reversion exist. However, that does not mean one will happen tomorrow, next month, or even this year.

Think about it this way. If I gave you a bunch of ingredients such as nitrogen, glycerol, sand, and shell, you would probably stick them in the garbage and think nothing of it. They are innocuous ingredients and pose little real danger by themselves. However, you make dynamite using a process to combine and bind them. However, even dynamite is safe as long as it is stored properly. Only when dynamite comes into contact with the appropriate catalyst does it become a problem. 

“Mean reverting events,” bear markets, and financial crises result from a combined set of ingredients to which a catalyst ignites. Looking back through history, we find similar elements every time.

Like dynamite, the individual ingredients are relatively harmless but dangerous when combined.

Leverage + Valuations + Psychology + Ownership + Momentum = “Mean Reverting Event”

Importantly, this particular formula remains supportive of higher asset prices in the short term. Of course, the more prices rise, the more optimistic investors become.

While the combination of ingredients is dangerous, they remain “inert” until exposed to the right catalyst.

What causes the next “liquidation cycle” is currently unknown. It is always an unexpected, exogenous event that triggers a “rush for the exits.”

Many believe that “bear markets” are now a relic of the past, given the massive support provided by Central Banks. Maybe that is the case. However, remembering that such beliefs were always present before more severe mean-reverting events is worth remembering.

To quote Irving Fisher in 1929, “Stocks are at a permanently high plateau.” 

Retirement Crisis Faces Government And Corporate Pensions

It is long past the time that we face the fact that Social Security” is facing a retirement crisis. In June 2022, we touched on this issue, discussing the stark realities confronting Social Security.

“The program’s payouts have exceeded revenue since 2010, but the recent past is nowhere near as grim as the future. According to the latest annual report by Social Security’s trustees, the gap between promised benefits and future payroll tax revenue has reached a staggering $59.8 trillion. That gap is $6.8 trillion larger than it was just one year earlier. The biggest driver of that move wasn’t Covid-19, but rather a lowering of expected fertility over the coming decades.” – Stark Realities

Note the last sentence.

When President Roosevelt first enacted social security in 1935, the intention was to serve as a safety net for older adults. However, at that time, life expectancy was roughly 60 years. Therefore, the expectation was that participants would not be drawing on social security for very long on an actuarial basis. Furthermore, according to the Social Security Administration, roughly 42 workers contributed to the funding pool for each welfare recipient in 1940.

Of course, given that politicians like to use government coffers to buy votes, additional amendments were added to Social Security to expand participation in the program. This included adding domestic labor in 1950 and widows and orphans in 1956. They lowered the retirement age to 62 in 1961 and increased benefits in 1972. Then politicians added more beneficiaries, from disabled people to immigrants, farmers, railroad workers, firefighters, ministers, federal, state, and local government employees, etc.

While politicians and voters continued adding more beneficiaries to the welfare program, workers steadily declined. Today, there are barely 2-workers for each beneficiary. As noted by the Peter G. Peterson Foundation:

Social Security has been a cornerstone of economic security for almost 90 years, but the program is on unsound footing. Social Security’s combined trust funds are projected to be depleted by 2035 — just 13 years from now. A major contributor to the unsustainability of the current Social Security program is that the number of workers contributing to the program is growing more slowly than the number of beneficiaries receiving monthly payments. In 1960, there were 5.1 workers per beneficiary; that ratio has dropped to 2.8 today.”

Ratio of workers to SSI Beneficiaries

As we will discuss, the collision of demographics and math is coming to the welfare system.

A Massive Shortfall

The new Financial Report of the United States Government (February 2024) estimates that the financial position of Social Security and Medicare are underfunded by roughly $175 Trillion. Treasury Secretary Janet Yellin signed the report, but the chart below details the problem.

Four layers of massive debt and liabilities

The obvious problem is that the welfare system’s liabilities massively outweigh taxpayers’ ability to fund it. To put this into context, as of Q4-2023, the GDP of the United States was just $22.6 trillion. In that same period, total federal revenues were roughly $4.8 trillion. In other words, if we applied 100% of all federal revenues to Social Security and Medicare, it would take 36.5 years to fill the gap. Of course, that is assuming that nothing changes.

However, therein lies the actuarial problem.

All pension plans, whether corporate or governmental, rely on certain assumptions to plan for future obligations. Corporate pensions, for example, rely on certain portfolio return assumptions to fund planned employee retirements. Most pension plans assume that portfolios will return 7% a year. However, a vast difference exists between “average returns” and “compound returns” as shown.

Difference between compound and actual returns

Social Security, Medicare, and corporate pension plans face a retirement crisis. A shortfall arises if contributions and returns don’t meet expectations or demand increases on the plans.

For example, given real-world return assumptions, pension funds SHOULD lower their return estimates to roughly 3-4% to potentially meet future obligations and maintain some solvency. However, they can’t make such reforms because “plan participants” won’t let them. Why? Because:

  1. It would require a 30-40% increase in contributions by plan participants they can not afford.
  2. Given many plan participants will retire LONG before 2060, there isn’t enough time to solve the issues and;
  3. Any bear market will further impede the pension plan’s ability to meet future obligations without cutting future benefits.

Social Security and Medicare face the same intractable problem. While there is ample warning from the Trustees that there are funding shortfalls to the plans, politicians refuse to make the needed changes and instead keep adding more participants to the rolls.

However, all current actuarial forecasts depend on a steady and predictable pace of age and retirement. But that is not what is currently happening.

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A Retirement Crisis In The Making

The single biggest threat that faces all pension plans is demographics. That single issue can not be fixed as it takes roughly 25 years to grow a taxpayer. So, even if we passed laws today that required all women of birthing age to have a minimum of 4 children over the next 5 years, we would not see any impact for nearly 30 years. However, the problem is running in reverse as fertility rates continue to decline.

Interestingly, researchers from the Center For Sexual Health at Indiana University put forth some hypotheses behind the decline in sexual activity:

  • Less alcohol consumption (not spending time in bars/restaurants)
  • More time on social media and playing video games
  • Lower wages lead to lower rates of romantic relationships
  • Non-heterosexual identities

The apparent problem with less sex and non-heterosexual identities is fewer births.

Fertility rate of women

No matter how you calculate the numbers, the problem remains the same. Too many obligations and a demographic crisis. As noted by official OECD estimates, the aging of the population relative to the working-age population has already crossed the “point of no return.”

Working age vs Elderly Population

To compound that situation, there has been a surge in retirees significantly higher than estimates. As noted above, actuarial tables depend on an expected rate of retirees drawing from the system. If that number exceeds those estimates, a funding shortfall increases to provide the required benefits.

Sharp uptick in retirements

The decline in economic prosperity discussed previously is caused by excessive debt and declining income growth due to productivity increases. Furthermore, the shift from manufacturing to a service-based society will continue to lead to reduced taxable incomes.

This employment problem is critical.

By 2025, each married couple will pay Social Security retirement benefits for one retiree and their own family’s expenses. Therefore, taxes must rise, and other government services must be cut.

Back in 1966, each employee shouldered $555 of social benefits. Today, each employee has to support more than $18,000 in benefits. The trend is unsustainable unless wages or employment increases dramatically, and based on current trends, such seems unlikely.

The entire social support framework faces an inevitable conclusion where wishful thinking will not change that outcome. The question is whether elected leaders will make needed changes now or later when they are forced upon us.

For now, we continue to “Whistle past the graveyard” of a retirement crisis.

Blackout Of Buybacks Threatens Bullish Run

With the last half of March upon us, the blackout of stock buybacks threatens to reduce one of the liquidity sources supporting the bullish run this year. If you don’t understand the importance of corporate share buybacks and the blackout periods, here is a snippet of a 2023 article I previously wrote.

“The chart below via Pavilion Global Markets shows the impact stock buybacks have had on the market over the last decade. The decomposition of returns for the S&P 500 breaks down as follows:

  • 6.1% from multiple expansions (21% at Peak),
  • 57.3% from earnings (31.4% at Peak),
  • 9.1% from dividends (7.1% at Peak), and
  • 27% from share buybacks (40.5% at Peak)
Buyback contribution

Yes, buybacks are that important.

As John Authers pointed out:

“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”

In other words, between the Federal Reserve injecting massive liquidity into the financial markets and corporations buying back their shares, there have been no other real buyers in the market. 

Given the increasing amount of corporate share buybacks, with 2024 expected to set a record, the importance of that activity has been a critical support for asset prices. As we noted in October 2023, near the bottom of the summer correction:

“Three primary drivers will likely drive markets from the middle of October through year-end. The first is earnings season, which kicks off in two weeks, negative short-term sentiment, and the corporate share buyback window reopens from blackout in November.”

Notably, since 2009, and accelerating starting in 2012, the percentage change in buybacks has far outstripped the increase in asset prices.

Share buybacks vs SP500

As we will discuss, it is more than just a casual correlation, and the upcoming blackout window may be more critical to the rally than many think.

A High Correlation

Unsurprisingly, the market rally that began in November correlated with a strong surge in corporate share repurchases. Interestingly, while the media touts the strong earnings growth shown in the recent reporting period, such would not have been the case without the surge in buybacks.

Share buybacks vs earnings

The result is not surprising given that the majority of earnings growth for the quarter came from the companies that are the most aggressive with share repurchases. However, given current valuation levels, it should make one question precisely what you are paying for.

Nonetheless, the buyback surge has supported the market surge since the October 2023 lows. We saw the same at the bottom of the market in October 2022. The chart shows the 4-week percentage change in share buybacks versus the S&P 500.

Share buybacks 4-week percent change versus the market.

The end of October tends to be the inflection point for the market, particularly over the last few years, because that is when the blackout period for share buybacks fully ends. While many argue that buybacks have little to do with market movements, a high correlation exists between the 4-week percentage change in buybacks versus the stock market. More importantly, since the act of share repurchases provides a buyer for those shares, the .85 correlation between the two suggests this is more than just a casual relationship.

Correlation of share repurchases 4-week percentage change to the S&P 500.

Investors Are Really Bullish

Currently, investors are very exuberant about the current investing environment. As discussed in “Market Top or Bubble?”, little seems to deter investor enthusiasm.

“The ongoing ‘can’t stop, won’t stop’ bullish trend remains firmly intact.

Investor sentiment is once again very bullish. Historically, when retail investor sentiment is exceedingly bullish combined with low volatility, such has generally corresponded to short-term market peaks.

Sentiment vs the market.

At the same time, professional managers are also very bullish and are leveraging portfolios to chase returns. When professional investor allocations exceed 97%, such has historically been close to short-term market peaks.

Professional managers buy tops.

The risk to these more optimistic investors is that with the blackout period beginning, corporate demand, the largest buyers of equities, will drop by 35%. Therefore, given the correlation between buybacks and the market, a reversal of that corporate demand could lead to a market decline. Any decline will likely lead to a reversal of positioning by investors, further exacerbating that correction process.

While there is no guarantee of anything in the markets, it is likely a short-term risk worth paying attention to.

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The Fed Will Support Buybacks

While the blackout of share buybacks may lead to a short-term market correction, the Federal Reserve may provide additional support over the long term.

The Federal Reserve has been transparent and likely done with hiking interest rates for this cycle. Given the massive surge in the Fed funds rate, the economy has withstood that impact quite well. Of course, the reason was the enormous surge in fiscal support through deficit spending and a massive increase in the M2 money supply as a percentage of GDP.

m2 and the deficit as a percentage of the economy.

However, if the Federal Reserve lowers interest rates, it will reduce corporate borrowing costs, which has historically been a boon for share buybacks. Such is particularly the case for large corporations like Apple (AAPL), which can borrow several billion dollars at low rates and buy back outstanding shares. As shown, share buybacks rose sharply following the “Financial Crisis” but slowed during periods of higher rates. Corporations are now “front-running” the Federal Reserve in anticipation of increased monetary accommodation.

Buybacks vs the Fed funds rate

With corporate buybacks on track to set a new record this year, exceeding $1 Trillion, corporations will need lower rates to finance the purchases.

Goldman Sachs estimates of share repurchases.

Conclusion

As we have discussed for the last month, the market is exceptionally bullish, extended, and deviated from long-term means. With the beginning of the “buyback blackout,” removing an essential buyer of equities is a risk worth watching.

Even if you are incredibly bullish on the markets, healthy bull markets must occasionally be corrected. Without such corrections, excesses are built, leading to more destructive outcomes.

What causes such a correction is always unknown. While the removal of buybacks temporarily may lead to a price reversal, those buybacks will return soon enough. And with $1 trillion in anticipated purchases, that is a lot of support for asset prices this year.

Does this mean the market will never face another “bear market?”

Of course not. There is a consequence for buying back shares at a premium. As Warren Buffet recently wrote:

“The math isn’t complicated: When the share count goes down, your interest in our many businesses increases. Every small bit helps if repurchases are made at value-accretive prices.

Just as surely, when a company overpays for repurchases, the continuing shareholders lose. At such times, gains flow only to the selling shareholders and to the friendly, but expensive, investment banker who recommended the foolish purchases.

Eventually, the detachment of the financial markets from underlying economic realities will be reverted.

However, that is not likely a problem we will face between now and year-end.

Household Equity Allocations Suggests Caution

Household equity allocations are again sharply rising, as the “Fear Of Missing Out” or “F.O.M.O.” fuels a near panic mentality to chase markets higher. As Michael Hartnett from Bank of America recently noted:

“Stocks are up a ferocious +25% in 5 months, which has happened just 10 times since the 1930s. Normally, such surges occur from recession lows (1938, 1975, 1982, 2009, 2020), but, of course, we did not have a recession in 2023, according to the Biden administration. These surges also occur at the start of bubbles (Jan’99).”

25% increase in 10-months.

As discussed in the recent Bull Bear Report, we can only identify bubbles in hindsight. Such is the problem with trying to “time” a market top, as they can last much longer than logic would predict. George Soros explained this well in his theory of reflexivity.

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

Every bubble has two components:

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

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

In simplistic terms, Soros says that once the bubble inflates, it will remain inflated until some unexpected, exogenous event causes a reversal in the underlying psychology. That reversal then reverses psychology from “exuberance” to “fear.”

What will cause that reversion in psychology? No one knows.

However, the important lesson is that market tops and bubbles are a function of “psychology.” The manifestation of that “psychology” manifests itself in asset prices and valuations that exceed economic growth rates.

Once again, investors are piling into equities and “writing checks that the economy can’t cash.”

An Economic Underpinning

To understand the problem, we must first realize from which capital gains are derived.

Capital gains from markets are primarily a function of market capitalization, nominal economic growth, plus dividend yield. Using John Hussman’s formula, we can mathematically calculate returns over the next 10-year period as follows:

(1+nominal GDP growth)*(normal market cap to GDP ratio / actual market cap to GDP ratio)^(1/10)-1

Therefore, IF we assume that GDP could maintain 2% annualized growth in the future, with no recessions ever, AND IF current market cap/GDP stays flat at 2.0, AND IF the dividend yield remains at roughly 2%, we get forward returns of:

But there are a “whole lotta ifs” in that assumption. Most importantly, we must also assume the Fed can get inflation to its 2% target, reduce current interest rates, and, as stated, avoid a recession over the next decade.

Yet, despite these essential fundamental factors, retail investors again throw caution to the wind. As shown, the current levels of household equity ownership have reverted to near-record levels. Historically, such exuberance has been the mark of more important market cycle peaks.

Household equity ownership vs SP500

If economic growth is reversed, the valuation reduction will be quite detrimental. Again, such has been the case at previous peaks where expectations exceed economic realities.

Household equity vs valuations

Bob Farrell once quipped investors tend to buy the most at the top and the least at the bottom. Such is simply the embodiment of investor behavior over time. Our colleague, Jim Colquitt, previously made an important observation.

The graph below compares the average investor allocation to equities to S&P 500 future 10-year returns. As we see, the data is very well correlated, lending credence to Bob Farrell’s Rule #5. Note the correlation statistics at the top left of the graph.”

The 10-year forward returns are inverted on the right scale. This suggests that future returns will revert toward zero over the next decade from current levels of household equity allocations by investors.

Household equity allocations vs 10-year forward returns

The reason is that when investor sentiment is extremely bullish or bearish, such is the point where reversals have occurred. As Sam Stovall, the investment strategist for Standard & Poor’s, once stated:

“If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”

Everyone is very optimistic about the market. Bank of America, one of the world’s largest asset custodians, monitors risk positioning across equities. Currently, “risk love” is in the 83rd percentile and at levels that have generally preceded short-term corrective actions.

Global Equity risk

The only question is what eventually reverses that psychology.

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A Disappointment Of Hopes

In January 2022, Jeremy Grantham made headlines with his market outlook titled “Let The Wild Rumpus Begin.” The crux of the article is summed up in the following paragraph.

“All 2-sigma equity bubbles in developed countries have broken back to trend. But before they did, a handful went on to become superbubbles of 3-sigma or greater: in the U.S. in 1929 and 2000 and in Japan in 1989. There were also superbubbles in housing in the U.S. in 2006 and Japan in 1989. All five of these superbubbles corrected all the way back to trend with much greater and longer pain than average.

Today in the U.S. we are in the fourth superbubble of the last hundred years.”

While the market corrected in 2022, the reversion needed to reverse the excess deviation from the long-term growth trends was not achieved. Therefore, unless the Federal Reverse is committed to a never-ending program of zero interest rates and quantitative easing, the eventual reversion of returns to their long-term means remains inevitable.

Such will result in profit margins and earnings returning to levels that align with actual economic activity. As Jeremy Grantham once noted:

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

Historically, real profits have always eventually reverted to underlying economic realities.

Cumulative change in profits vs the market

Many things can go wrong in the months and quarters ahead. Such is particularly the case at a time when deficit spending is running amok, and economic growth is slowing.

While investors cling to the “hope” that the Fed has everything under control, there is a reasonable chance they don’t.

The reality is that the next decade could be a disappointment to overly optimistic expectations.

Digital Currency And Gold As Speculative Warnings

Over the last few years, digital currencies and gold have become decent barometers of speculative investor appetite. Such isn’t surprising given the evolution of the market into a “casino” following the pandemic, where retail traders have increased their speculative appetites.

“Such is unsurprising, given that retail investors often fall victim to the psychological behavior of the “fear of missing out.” The chart below shows the “dumb money index” versus the S&P 500. Once again, retail investors are very long equities relative to the institutional players ascribed to being the “smart money.””

Dumb money index vs market

“The difference between “smart” and “dumb money” investors shows that, more often than not, the “dumb money” invests near market tops and sells near market bottoms.”

Net Smart Dumb Money vs Market

That enthusiasm has increased sharply since last November as stocks surged in hopes that the Federal Reserve would cut interest rates. As noted by Sentiment Trader:

“Over the past 18 weeks, the straight-up rally has moved us to an interesting juncture in the Sentiment Cycle. For the past few weeks, the S&P 500 has demonstrated a high positive correlation to the ‘Enthusiasm’ part of the cycle and a highly negative correlation to the ‘Panic’ phase.”

Investor Enthusiasm

That frenzy to chase the markets, driven by the psychological bias of the “fear of missing out,” has permeated the entirety of the market. As noted in This Is Nuts:”

“Since then, the entire market has surged higher following last week’s earnings report from Nvidia (NVDA). The reason I say “this is nuts” is the assumption that all companies were going to grow earnings and revenue at Nvidia’s rate. There is little doubt about Nvidia’s earnings and revenue growth rates. However, to maintain that growth pace indefinitely, particularly at 32x price-to-sales, means others like AMD and Intel must lose market share.”

Nvidia Price To Sales

Of course, it is not just a speculative frenzy in the markets for stocks, specifically anything related to “artificial intelligence,” but that exuberance has spilled over into gold and cryptocurrencies.

Birds Of A Feather

There are a couple of ways to measure exuberance in the assets. While sentiment measures examine the broad market, technical indicators can reflect exuberance on individual asset levels. However, before we get to our charts, we need a brief explanation of statistics, specifically, standard deviation.

As I discussed in “Revisiting Bob Farrell’s 10 Investing Rules”:

“Like a rubber band that has been stretched too far – it must be relaxed in order to 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.”

The idea of “stretching the rubber band” can be measured in several ways, but I will limit our discussion this week to Standard Deviation and measuring deviation with “Bollinger Bands.”

“Standard Deviation” is defined as:

“A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of the variance.”

In plain English, this means that the further away from the average that an event occurs, the more unlikely it becomes. As shown below, out of 1000 occurrences, only three will fall outside the area of 3 standard deviations. 95.4% of the time, events will occur within two standard deviations.

Standard Deviation Chart

A second measure of “exuberance” is “relative strength.”

“In technical analysis, the relative strength index (RSI) is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can read from 0 to 100.

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.” – Investopedia

With those two measures, let’s look at Nvidia (NVDA), the poster child of speculative momentum trading in the markets. Nvidia trades more than 3 standard deviations above its moving average, and its RSI is 81. The last time this occurred was in July of 2023 when Nvidia consolidated and corrected prices through November.

NVDA chart vs Bollinger Bands

Interestingly, gold also trades well into 3 standard deviation territory with an RSI reading of 75. Given that gold is supposed to be a “safe haven” or “risk off” asset, it is instead getting swept up in the current market exuberance.

Gold vs Bollinger Bands

The same is seen with digital currencies. Given the recent approval of spot, Bitcoin exchange-traded funds (ETFs), the panic bid to buy Bitcoin has pushed the price well into 3 standard deviation territory with an RSI of 73.

Bitcoin vs Bollinger Bands

In other words, the stock market frenzy to “buy anything that is going up” has spread from just a handful of stocks related to artificial intelligence to gold and digital currencies.

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It’s All Relative

We can see the correlation between stock market exuberance and gold and digital currency, which has risen since 2015 but accelerated following the post-pandemic, stimulus-fueled market frenzy. Since the market, gold and cryptocurrencies, or Bitcoin for our purposes, have disparate prices, we have rebased the performance to 100 in 2015.

Gold was supposed to be an inflation hedge. Yet, in 2022, gold prices fell as the market declined and inflation surged to 9%. However, as inflation has fallen and the stock market surged, so has gold. Notably, since 2015, gold and the market have moved in a more correlated pattern, which has reduced the hedging effect of gold in portfolios. In other words, during the subsequent market decline, gold will likely track stocks lower, failing to provide its “wealth preservation” status for investors.

SP500 vs Gold

The same goes for cryptocurrencies. Bitcoin is substantially more volatile than gold and tends to ebb and flow with the overall market. As sentiment surges in the S&P 500, Bitcoin and other cryptocurrencies follow suit as speculative appetites increase. Unfortunately, for individuals once again piling into Bitcoin to chase rising prices, if, or when, the market corrects, the decline in cryptocurrencies will likely substantially outpace the decline in market-based equities. This is particularly the case as Wall Street can now short the spot-Bitcoin ETFs, creating additional selling pressure on Bitcoin.

SP500 vs Bitcoin

Just for added measure, here is Bitcoin versus gold.

Gold vs Bitcoin

Not A Recommendation

There are many narratives surrounding the markets, digital currency, and gold. However, in today’s market, more than in previous years, all assets are getting swept up into the investor-feeding frenzy.

Sure, this time could be different. I am only making an observation and not an investment recommendation.

However, from a portfolio management perspective, it will likely pay to remain attentive to the correlated risk between asset classes. If some event causes a reversal in bullish exuberance, cash and bonds may be the only place to hide.

Presidential Elections And Market Corrections

Presidential elections and market corrections have a long history of companionship. Given the rampant rhetoric between the right and left, such is not surprising. Such is particularly the case over the last two Presidential elections, where polarizing candidates trumped policies.

From a portfolio management perspective, we must understand what happens during election years concerning the stock market and investor returns.

Since 1833, the S&P 500 index has gained an average of 10.03% in the year of a presidential election. By contrast, the first and second years following a Presidential election see average gains of 6.15% and 6.94%, respectively. There are notable exceptions to positive election-year returns, such as in 2008, when the S&P 500 sank nearly 37%. (Returns are based on price only and exclude dividends.) However, overall, the win rate of Presidential election years is a very high 76.6%

Since President Roosevelt’s victory in 1944, there have only been two losses during presidential election years: 2000 and 2008. Those two years corresponded with the “Dot.com Crash” and the “Financial Crisis.” On average, the second-best performance years for the S&P 500 are in Presidential election years.

Presidential Election Stock Market Cycle

For investors, with a “win ratio” of 76%, the odds are high that markets will most likely finish the 2024 Presidential election year higher. However, given the current economic underpinnings, I would caution completely dismissing the not-so-insignificant 24% chance that a more meaningful correction could reassert itself. Given the recent 15-year duration of the ongoing bull market, the more extreme deviations from long-term means, and ongoing valuation issues, a “Vegas handicapper” might increase those odds a bit.

Deviation of SP500 from 200-DMA

That deviation is more significant when looking at the 1-year moving average. Current deviation levels from the 52-week moving average have generally preceded short-term market corrections or worse.

Deviation of market from 52-Week M/A

However, as stated, while the market will likely end the year higher than where it started, Presidential election years have a correctional bias to them during the summer months.

Will Policies Matter

The short answer is “Yes.” However, not in the short term.

Presidential platforms are primarily “advertising” to get your vote. As such, a politician will promise many things that, in hindsight, rarely get accomplished. Therefore, while there is much debate about whose policies will be better, it doesn’t matter much as both parties have an appetite for “providing bread and games to the masses” through continuing increases in debt.

GDP growth vs debt issuance

However, regarding the financial markets, Wall Street tends to abhor change. With the incumbent President, Wall Street understands the “horse the riding.” The risk to elections is a policy change that may undermine current trends. Those policy changes could be an increase in taxes, restrictive trade policies, cuts to spending, etc., which would potentially be unfriendly to financial markets in the short term.

This is why markets tend to correct things before the November elections. A look at all election years since 1960 shows that markets did rise during election years. However, notice that the market tends to correct during September and October.

Average election year market performance.

Notably, that data is heavily skewed by the decline during the 2008 “Financial Crisis,” also a Presidential election year. If we extract that one year, returns jump to 7.7% annually in election years. However, in both cases, returns still slump during September and October. The chart below shows that 2024 is running well ahead of historical norms.

Election year performance ex-2008 compared with YTD.

Lastly, while policies matter over a longer-term period, as changes to spending and regulation impact economic outcomes, market performance during SECULAR market periods varies greatly. During secular (long-term) bull markets, as we have now since 2009, Presidential election years tend to average almost 14% annually. That is opposed to secular bear markets, which tend to decline by 7% on average.

Election Year Performance bull and bear periods

However, one risk that has taken shape since the “Financial Crisis” could have an outside effect on the markets in 2024.

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The Great Divide

While you may feel strongly about one party or the other regarding politics, it doesn’t matter much regarding your money.

Such is particularly the case today. As we head into November, for the third election in a row, voters will cast ballots for the candidate they dislike less, not whose policies they like more. More importantly, most voters are going to the polls with large amounts of misinformation from social media commentators pushing political agendas.

Notably, the market already understands that with the parties more deeply divided than at any other point in history, the likelihood of any policies getting passed is slim. (2017 was the latest data from a 2019 report. Currently, that gap is even more significant as Social Media continues to fuel the divide.)

Political Division in the US

The one thing markets do seem to prefer – “political gridlock.”

“A split Congress historically has been better for stocks, which tend to like that one party doesn’t have too much sway. Stocks gained close to 30% in 1985, 2013 and 2019, all under a split Congress, according to LPL Financial. The average S&P 500 gain with a divided Congress was 17.2% while GDP growth averaged 2.8%.” – USA Today

Gridlock stock market performance

What we can derive from the data is the odds suggest the market will end this year on a positive note. However, such says little about next year. If you go back to our data table above, the 1st year of a new Presidential cycle is roughly a 50/50 outcome. It is also the lowest average return year, going back to 1833.

Furthermore, from the election to 2025, outcomes have been overly dependent on many things continuing to go “right.”

  1. Avoidance of a “double-dip” recession. (Without more Fiscal stimulus, this is a plausible risk.)
  2. The Fed drastically expands monetary policy. (Such won’t come without a recession.)
  3. The consumer will need to expand their current debt-driven consumption. (This is a risk without more fiscal stimulus or sustainable economic growth.)
  4. There is a marked improvement in both corporate earnings and profitability. (This will likely be the case as mass layoffs benefit bottom-line profitability. However, top-line sales remain at risk due to items #1 and #3.)
  5. Multiple expansions continue. (The problem is that a lack of earnings growth in the bottom 490 stocks eventually disappoints)

These risks are all undoubtedly possible.

However, when combined with the longest-running bull market in history, high valuations, and excessive speculation, the risks of something going wrong have risen.

So, how do you position your portfolio for the election?

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Portfolio Positioning For An Unknown Election Outcome

Over the last few weeks, we have repeatedly discussed reducing risk, hedging, and rebalancing portfolios. Part of this was undoubtedly due to the exaggerated rise from the November lows and the potential for an unexpected election outcome. As we noted in “Tending The Garden:” 

“Taking these actions has TWO specific benefits depending on what happens in the market next.

  1. If the market corrects, these actions clear out the ‘weeds’ and allow for protection of capital against a subsequent decline.
  2. If the market continues to rally, then the portfolio has been cleaned up, and new positions can be added to participate in the next leg of the advance.

No one knows for sure where markets are headed in the next week, much less the next month, quarter, year, or five years. What we do know is not managing ‘risk’ to hedge against a decline is more detrimental to the achievement of long-term investment goals.”

That advice continues to play well in setting up your portfolio for the election. As outlined, the historical odds suggest that markets will rise regardless of the electoral outcome. However, those are averages. In 2000 and 2008, investors didn’t get the “average.”

Such is why it is always important to prepare for the unexpected. While you certainly wouldn’t speed down a freeway “blindfolded,” it makes little sense not to be prepared for an unexpected outcome.

Holding a little extra cash, increasing positioning in Treasury bonds, and adding some “value” to your portfolio will help reduce the risk of a sharp decline in the months ahead. Once the market signals an “all clear,” you can take “your foot off the brake” and speed to your destination.

Of course, it never hurts to always “wear your seatbelt.” 

Valuation Metrics And Volatility Suggest Investor Caution

Valuation metrics have little to do with what the market will do over the next few days or months. However, they are essential to future outcomes and shouldn’t be dismissed during the surge in bullish sentiment. Just recently, Bank of America noted that the market is expensive based on 20 of the 25 valuation metrics they track. As BofA’s Chief Equity Strategist stated:

“The S&P 500 is egregiously expensive vs. history. It’s hard to be bullish based on valuation

BofA Valuation Measures

Since 2009, repeated monetary interventions and zero interest rate policies have led many investors to dismiss any measure of “valuation.” Therefore, investors reason the indicator is wrong since there was no immediate correlation.

The problem is that valuation models are not, and were never meant to be, market timing indicators.” The vast majority of analysts assume that if a measure of valuation (P/E, P/S, P/B, etc.) reaches some specific level, it means that:

  1. The market is about to crash, and;
  2. Investors should be in 100% cash.

Such is incorrect. Valuation metrics are just that – a measure of current valuation. More importantly, when valuation metrics are excessive, it is a better measure of “investor psychology” and the manifestation of the “greater fool theory.” As shown, there is a high correlation between our composite consumer confidence index and trailing 1-year S&P 500 valuations.

Consumer confidence vs valuations

What valuations do provide is a reasonable estimate of long-term investment returns. It is logical that if you overpay for a stream of future cash flows today, your future return will be low.

 I previously quoted Cliff Asness on this issue in particular:

“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.

If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations.”

We can prove that by looking at forward 10-year total returns versus various levels of PE ratios historically.

Valuations and forward returns

Asness continues:

“It [Shiller’s CAPE] has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/E’s are high without a good reason — and in my view, the critics have not provided a good reason this time around — I think you are making a mistake.”

Which brings me to Warren Buffett.

Market Cap To GDP

In our most recent newsletter, I discussed Warren Buffet’s dilemma with his $160 billion cash pile.

The problem with capital investments is that they take time to generate a profitable return that accretes to the business’s bottom line. The same goes for acquisitions. More importantly, concerning acquisitions, they must both be accretive to the company and reasonably priced. Such is Berkshire’s current dilemma.

“There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others. Some we can value; some we can’t. And, if we can, they have to be attractively priced.”

This was an essential statement. Here is one of the most intelligent investors in history, suggesting that he cannot deploy Berkshire’s massive cash hoard in meaningful size due to an inability to find acquisition targets that are reasonably priced. With a $160 war chest, there are plenty of companies that Berkshire could either acquire outright, use a stock/cash offering, or acquire a controlling stake in. However, given the rampant increase in stock prices and valuations over the last decade, they are not reasonably priced.

One of Warren Buffett’s favorite valuation measures is the market capitalization to GDP ratio. I have modified it slightly to use inflation-adjusted numbers. The simplicity of this measure is that stocks should not trade above the value of the economy. This is because economic activity provides revenues and earnings to businesses.

Market Cap to GDP Ratio

The “Buffett Indicator” confirms Mr. Asness’ point. The chart below uses the S&P 500 market capitalization versus GDP and is calculated on quarterly data.

Market Cap to GDP ratio to S&P 500 market correlation

Not surprisingly, like every other valuation measure, forward return expectations are substantially lower over the next ten years than in the past.

Market Cap To GDP Ratio vs forward 10-year Returns

None of this should be surprising. Logics suggests that overpaying for any asset in the present inherently will generate lower future expected returns versus buying assets at a discount. Or, as Warren Buffett stated:

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

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F.O.M.O. Trumps Fundamentals

In the “heat of the moment,” fundamentals don’t matter. In a market where momentum drives participants due to the “Fear Of Missing Out (F.O.M.O.),” fundamentals are displaced by emotional biases. Such is the nature of market cycles and one of the primary ingredients necessary to create the proper environment for an eventual reversion.

Notice, I said eventually.

As David Einhorn once stated:

“The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.

There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen.”

Furthermore, as James Montier previously stated:

Current arguments as to why this time is different are cloaked in the economics of secular stagnation and standard finance workhorses like the equity risk premium model. Whilst these may lend a veneer of respectability to those dangerous words, taking arguments at face value without considering the evidence seems to me, at least, to be a common link with previous bubbles.

As BofA noted in its analysis, stocks are far from cheap. Based on Buffett’s preferred valuation model and historical data, return expectations for the next ten years are as likely to be close to zero or negative. Such was the case for ten years following the late ’90s.

Investors would do well to remember the words of the then-chairman of the SEC, Arthur Levitt. In a 1998 speech entitled “The Numbers Game,” he stated:

“While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.”

Regardless, there is a straightforward truth.

“The stock market is NOT the economy. But the economy is a reflection of the very thing that supports higher asset prices: earnings.”

The economy is slowing down following the pandemic-related spending spree. It is also doubtful the Government can continue spending at the same clip over the next decade as it did in the last.

While current valuations are expensive, it does NOT mean the markets will crash tomorrow, next quarter, or even next year.

However, there is a more than reasonable expectation of disappointment in future market returns.

That is probably something investors need to come to grips with sooner rather than later.

Dumb Money Almost Back To Even, Making The Same Mistakes

After over two years, retail investors, also known as the “dumb money,” are almost back to breakeven. A recent chart by Vanda Research shows that the average retail “dumb money” investor portfolio still sports a drawdown despite the markets making new all-time highs.

Retail investors gain loss in portfolios.

Such is unsurprising, given that retail investors often fall victim to the psychological behavior of the “fear of missing out.” The chart below shows the “dumb money index” versus the S&P 500. Once again, retail investors are very long equities relative to the institutional players ascribed to being the “smart money.”

Dumb money index vs market

The difference between “smart” and “dumb money” investors shows that, more often than not, the “dumb money” invests near market tops and sells near market bottoms.

Net Smart Dumb Money vs Market

We can confirm the “smart/dumb money” analysis by looking at the allocations of retail investors in stocks, bonds, and cash. With markets overvalued and hitting all-time highs, it is unsurprising that retail investor equity allocations are at very high historical levels with low holdings of cash and bonds.

AAII Investor Allocations

Of course, it isn’t that retail investors are chasing the markets higher; it is what the “dumb money” is chasing that is most interesting.

Chasing The Russell 2000

Last week, I discussed the relationship between the NFIB data and the Russell 2000 index. As I noted:

“The recent exuberance for small-cap equities is also unsurprising, given the long period of underperformance relative to the S&P 500 market-capitalization-weighted index. The hope of a “catch-up” trade as a “rising tide lifts all boats” is a perennial bet by investors, and as shown, small and mid-cap stocks have indeed rallied with a lag to their large capitalization brethren.”

Small and Midcap Stocks relative to the SP500 market

We see that exuberance in capital inflows into small-capitalization companies following the 2020 stimulus checks, which fueled an entire generation of “meme stock” traders on Reddit and the Robinhood app. The hopes for quick riches from a small-cap stock “going to the moon,” along with a lot of hype on social media apps, has increased the speculative craze.

Retail inflows into markets

At the same time, to leverage their bets, these retail traders have piled into call options. The risk with speculative call options is they are either a “win” or a complete “bust.” Therefore, the speculative risk in trading options is dramatically higher than buying the underlying companies.

Call options

However, retail investors are directly piling money into small-cap stocks, as shown by increasing weekly inflows.

Small cap inflows

Particularly into small-cap growth stocks versus value, with a substantial acceleration starting in November 2023 and increasing in 2024.

Cumulative flows for small cap growth

As noted above, this degree of speculative risk-taking by retail investors has always ended badly. This is why the financial market considers retail investors as “dumb money.”

Of course, this brings us to whether investors are again making the same mistakes.

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A Small Problem May Turn Out To Be Big

Over the past decade, the Fed’s ongoing interventions have led to a massive increase in the leveraging of U.S. corporations. Of course, with repeated financial interventions combined with a zero-interest policy, why would corporations increase the use of cheap debt?

Corporate debt vs GDP

The increased debt load doesn’t provide an inherent risk for large capitalization companies with massive revenues. However, for small-cap companies, it is a very different story. Weaker economic growth continues to increase in the number of “zombie firms.” What is a “zombie” in the financial world? To wit:

“‘Zombies’ are firms whose debt servicing costs are higher than their profits but are kept alive by relentless borrowing. 

Such is a macroeconomic problem because zombie firms are less productive. Their existence lowers investment in and employment at more productive firms. In short, one side effect of central banks keeping rates low for a long time is that it keeps more unproductive firms alive, which ultimately lowers the long-run growth rate of the economy.” – Axios

The chart below from our friends at Kailash Concepts shows the problem facing the “dumb money” crowding in small caps.

Russell 2000 companies with negative earnings.

With nearly 40% of the Russell 2000 index sporting negative earnings, many have issued debt to sustain operations. Unlike many companies in the S&P 500 that refinanced debt at substantially lower rates, many of the Russell 2000 were unable. The risk is that if higher interest rates remain when that “debt wall” matures, such could further impair survivability.

Debt wall for companies

Interestingly, since the beginning of the year, we are seeing borrowers return to the market for refinancing. As shown, there has been a surge in B-minus (junk) rated borrowers, who are already taking on debt at higher rates to refinance old debt. While we are very early in the cycle, the risk to underlying balance sheets is rising.

B-minus debt loan volumes

As we concluded previously:

“There are risks to assuming a solid economic and employment recovery over the next couple of quarters. With consumers running out of savings, the risk of further disappointment in sales expectations will likely continue to weigh on small business owners. This is why we keep a close eye on the NFIB reports.”

At the moment, the “dumb money” is chasing momentum amid a bullish frenzy. Unfortunately, such will likely again prove disappointing when expectations eventually collide with fundamental realities.

This Is Nuts – An Entire Market Chasing One Stock

“When you sit down with your portfolio management team, and the first comment made is ‘this is nuts,’ it’s probably time to think about your overall portfolio risk. On Friday, that was how the investment committee both started and ended – ‘this is nuts.’” – January 11th, 2020.

I revisited that original post a couple of weeks ago as the market approached its 5000 psychological milestone. Since then, the entire market has surged higher following last week’s earnings report from Nvidia (NVDA). The reason I say “this is nuts” is the assumption that all companies were going to grow earnings and revenue at Nvidia’s rate.

Even one of the “always bullish” media outlets took notice, which is notable.

“In a normal functioning market, Nvidia doing amazingly is bad news for competitors such as AMD and Intel. Nvidia is selling more of its chips, meaning fewer sales opportunities for rivals. Shouldn’t their stocks drop? Just because Meta owns and uses some new Nvidia chips, how is that going to positively impact its earnings and cash flow over the next four quarters? Will it at all?

‌The point is that investors are acting irrationally as Nvidia serves up eye-popping financial figures and the hype machine descends on social media. It makes sense until it doesn’t, and that is classic bubble action.” – Yahoo Finance

As Brian Sozzi notes in his article, we may be at the “this is nuts” stage of market exuberance. Such usually coincides with Wall Street analysts stretching to “justify” why paying premiums for companies is “worth it.”

Earnings Growth Justification

We Can’t All Be Winners

Of course, that is the quintessential underpinning for a market that has reached the “this is nuts” stage. There is little doubt about Nvidia’s earnings and revenue growth rates. However, to maintain that growth pace indefinitely, particularly at 32x price-to-sales, means others like AMD and Intel must lose market share.

Nvidia Price To Sales

However, as shown, numerous companies in the S&P 1500 alone are trading well above 10x price-to-sales. (If you don’t understand why 10x price-to-sales is essential, read this.) Many companies having nothing to do with Nvidia or artificial intelligence, like Wingstop, trade at almost 22x price-to-sales.

Stocks trading above 10x to sales

Again, if you don’t understand why “this is nuts,” read the linked article above.

However, in the short term, this doesn’t mean the market can’t keep increasing those premiums even further. As Brian concluded in his article:

“Nothing says ‘investing bubble’ like unbridled confidence. It’s that feeling that whatever stock you buy — at whatever price and at whatever time — will only go up forever. This makes you feel like an investing genius and inclined to take on more risk.”

Looking at some current internals tells us that Brian may be correct.

This Is Nuts” Type Of Exuberance

In momentum-driven markets, exuberance and greed can take speculative actions to increasingly further extremes. As markets continue to ratchet new all-time highs, the media drives additional hype by producing commentary like the following.

“Going back to 1954, markets are always higher one year later – the only exception was 2007.”

That is a correct statement. When markets hit all-time highs, they are usually higher 12 months later due to the underlying momentum of the market. But therein lies the rub: what happened next? The table below from Warren Pies tells the tale.

New Highs and bear Markets

As shown, markets were higher 12 months after new highs were made. However, a lot of money was lost during the next bear market or correction. Except for only four periods, those bear markets occurred within the next 24 to 48 months. Most gains from the previous highs were lost in the subsequent downturn.

Unsurprisingly, investing in the market is not a “risk-free” adventure. While there are many opportunities to make money, there is also a history of wealth devastation. Therefore, understanding the environment you are investing in can help avoid potential capital destruction.

From a technical perspective, markets are exceedingly overbought as investors have rushed back into equities following the correction in 2022. The composite index below comprises nine indicators measured using weekly data. That index is now at levels that have denoted short-term market peaks.

Technical Gauge

Unsurprisingly, speculative money is chasing the Mega-cap growth and technology stocks. The volume of call options on those stocks is at levels that have previously preceded more significant corrections.

Stocks net call volume on Mega Cap Growth and Technology stocks.

Another way to view the current momentum-driven advance in the market is by measuring the divergence between short and long-term moving averages. Given that moving averages smooth price changes over given periods, the divergences should not deviate significantly from each other over more extended periods. However, as shown below, that changed dramatically following the stimulus-fueled surge in the markets post-pandemic. Currently, the deviation between the weekly moving averages is at levels only previously seen when the Government sent checks to households, overnight lending rates were zero, and the Fed bought $120 billion monthly in bonds. Yet, none of that is happening currently.

Weekly composite index measures.

Unsurprisingly, with the surge in market prices, investor confidence has surged along with their allocation to equities. The most recent Schwab Survey of bullish sentiment suggests the same.

More than half of traders have a bullish outlook for the first quarter – the highest level of bullishness since 2021

Yes, quite simply, “This is nuts.”

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Market Measures Advise Caution

In the short term, over the next 12 months, the market will indeed likely finish the year higher than where it started. That is what the majority of analysis tells us. However, that doesn’t mean that stocks can’t, and won’t, suffer a rather significant correction along the way. The chart below shows retail and professional traders’ 13-week average of net bullish sentiment. You will notice that high sentiment readings often precede market corrections while eventually rising to higher levels.

For example, the last time bullish sentiment was this extreme was in late 2021. Even though the market eventually rallied to all-time highs, it was 2-years before investors got back to even.

13-week net bullish sentiment vs the market

Furthermore, the compression of volatility remains a critical near-term concern. While low levels of volatility have become increasingly common since the financial crisis due to the suppression of interest rates and a flood of liquidity, the lack of volatility provides the “fuel” for a market correction.

VIX versus the market

Combining excessive bullish sentiment and low volatility into a single indicator shows that previous levels were warnings to more bullish investors. Interestingly, Fed rate cuts cause excess sentiment to unwind. This is because rate cuts have historically coincided with financial events and recessions.

Net bullish sentiment and vix composite versus the Fed.

While none of this should be surprising, given the current market momentum and bullish psychology, the over-confidence of investors in their decision-making has always had less than desirable outcomes.

No. The markets likely will not crash tomorrow or in the next few months. However, sentiment has reached the “this is nuts” stage. For us, as portfolio managers, such has always been an excellent time to start laying the groundwork to protect our gains.

Lean on your investing experience and all its wrinkles.” – Brian Sozzi

Small Cap Stocks May Be At Risk According To NFIB Data

Recently, retail investors have started chasing small-cap stocks in hopes of both a rate-cutting cycle by the Federal Reserve and avoiding a recession. Such would seem logical given that, historically, small capitalization companies tend to perform best during the early stages of an economic recovery.

Market and Economic Cycles

The recent exuberance for small-cap equities is also unsurprising, given the long period of underperformance relative to the S&P 500 market-capitalization-weighted index. The hope of a “catch-up” trade as a “rising tide lifts all boats” is a perennial bet by investors, and as shown, small and mid-cap stocks have indeed rallied with a lag to their large capitalization brethren.

Small and Midcap Stocks relative to the SP500 market

However, some issues also plague smaller capitalization companies that remain. The first, as noted by Goldman Sachs, remains a fundamental one.

“I’m surprised how easy it is to find someone who wants to call the top in tech and slide those chips into small cap. Aside from the prosect of short-term pain trades, I don’t get the fundamental argument for sustained outperformance of an index where 1-in-3 companies will be unprofitable this year.”

As shown in the chart by Apollo below, in the 1990s, 15% of companies in the Russell 2000 had negative 12-month trailing EPS. Today, that share is 40%.

Companies with negative earnings.

Besides the obvious that retail investors are chasing a rising slate of unprofitable companies that are also heavily leveraged and dependent on debt issuance to stay afloat (a.k.a. Zombies), these companies are susceptible to actual changes in the underlying economy.

Rising shared of companies with debt servicing costs higher than profits.

So, is there a case to be made for small and mid-capitalization companies in the current environment? We can turn to the National Federation of Independent Business (NFIB) for that analysis.

The NFIB Report Tells A Very Different Story

The primary economic data points continue to be very robust. Low unemployment, strong economic growth, and declining rates of inflation. As I have heard recently by more mainstream analysts, “What’s not to love?”

Understanding that small and mid-sized businesses comprise a substantial percentage of the U.S. economy is crucial. Roughly 60% of all companies in the U.S. have less than ten employees.

Small Business Breakdown

Simply, small businesses drive the economy, employment, and wages. Therefore, what the NFIB says is highly relevant to what is happening in the actual economy versus the headline economic data from Government sources.

For example, despite Government data that suggests that the economy is strong and unlikely to enter a recession this year, the NFIB small business confidence survey declined in its latest reading. It remained at levels that have historically been associated with recessionary economies.

NFIB Small Business Confidence

Unsurprisingly, selling a product, good, or service drives business optimism and confidence. If consumer demand is high, the business owners are more confident about the future. However, despite headlines of a strong consumer, both actual and expected sales by small businesses remain weak.

NFIB Sales Expectations vs Actual retail sales.

Furthermore, if the economy and the underlying demand were as strong as recent headlines suggest, the business would be ramping up capital expenditures to meet that demand. However, such is not the case regarding capital expenditures and actual versus planned employment.

NFIB Capex Plans vs Real Private Investment
NFIB Employment plans vs actual

There is an essential disconnect between reported economic data and what is happening within the economy. Of course, this brings us to whether investors are making a mistake by betting on small capitalization stocks.

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The Potential Risk In Small Caps

In the short term, some momentum behind small-cap stocks bolsters the arguments for bets on those companies. However, over a longer time frame, earnings and fundamentals will matter.

As noted above, many companies in the Russell 2000 have little profitability and large debt loads. Unlike many companies in the S&P 500 that refinanced debt at substantially lower rates, many of the Russell 2000 were unable. If interest rates are still elevated when that “debt wall” matures, refinancing debt at higher rates could further impair profitability.

Debt wall for companies

Furthermore, the deep decline in sales expectations may undermine earnings growth estimates for these companies later in the year.

Sales Expectations vs Earnings

Of course, there are arguments for investing in small-cap stocks currently.

  • The economy could return to much more robust rates of growth.
  • Consumer demand could increase, leading to stronger sales and employment outlooks for companies.
  • The Federal Reserve could cut interest rates sharply ahead of the debt-refinancing in 2024.
  • Inflation could drop sharply, boosting profitability for smaller capitalization companies.
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Confidence Matters

Yes, any of those things are possible. If they emerge, such should quickly reflect in the confidence of businesses surveyed by the NFIB. As shown, there is a high correlation between the annual rate of change of NFIB small business confidence and the Russell 2000 index.

NFIB Confidence vs Small Caps

The apparent problem with the wish list for small-cap investors is that more substantial economic growth and consumer demand will push inflationary pressures higher. Such would either keep the Federal Reserve on hold from cutting rates or lead to further increases, neither of which are beneficial for small-cap companies. Lastly, the surge in economic growth over the last two years resulted from a massive increase in Government spending. It is unlikely that the pace of the expenditures can continue, and as monetary supply reverses, economic growth will continue to slow.

M2 as percent of GDP growth

Given this backdrop, assuming current accelerated earnings growth estimates for stocks in the future is a bit unreasonable. On a 2-year forward-looking basis, current valuations for the Russell 2000 are higher than the S&P 500 index, where the top 10 largest companies dominate earnings growth.

Current PE based on 2-year forward estimates

Conclusion

Since debt-driven government spending programs have a dismal history of providing the promised economic growth, disappointment over the next year is almost guaranteed.

However, suppose additional amounts of short-term stimulus deliver higher rates of inflation and higher interest rates. In that case, the Federal Reserve may become contained in its ability to continue to provide an “insurance policy” to investors.

There are risks to assuming a solid economic and employment recovery over the next couple of quarters. With consumers running out of savings, the risk of further disappointment in sales expectations will likely continue to weigh on small business owners. This is why we keep a close eye on the NFIB reports.

However, in the short term, there is nothing wrong with being optimistic, and small-cap stocks benefit from the ongoing speculative frenzy in the market. The optimism can last longer with the Federal Reserve set to cut rates and further ease monetary accommodation.

However, regarding your investment portfolio, keeping a realistic perspective on the data will be essential to navigating the risks to come. For small-cap investors, the time to take profits and move to “safer pastures” is likely closer than you think.

Don’t Fear All-Time Highs, Understand Them

Don’t fear all-time highs in the market. Such is a natural response for investors who are concerned about market risk. However, rather than fearing market exuberance, we must understand what drives it.

There is an essential concept investors should understand about markets when they are hitting “new records.”

“Record levels” of anything are “records for a reason.”

It should be remembered that when records are broken, that is the point where previous limits were reached. Just as in horse racing, sprinting, or car races, the difference between an old record and a new one is often measured in fractions of a second. Yes, while the market is currently hitting all-time highs, it is a function that, in this case, took two years to occur.

Stock market hitting all-time highs

So, while the media is giddy about markets hitting all-time highs, we must remember that “record levels are NOT THE BEGINNING but rather an indication of a well-underway process. While the media has focused on record-low unemployment, record stock market levels, and surging confidence as signs of an ongoing economic recovery, history suggests caution. For investors, everything is always at its best at the end of a cycle rather than the beginning.

Let’s take a look at a long-term chart of the market. Since 1871, there have been FIVE very distinct bull market cycles. During those roughly 15 to 20-year periods, stock prices rose, hitting new highs. Notably, long periods of flat to declining prices follow bullish periods. In other words, 100% of the total market gains came from five distinct historical periods.

Stock market real index price versus CAPE valuations

At the end of those five bullish trends, markets were at all-time highs. For those invested at those all-time highs, it took an average of 20 years before they saw all-time highs again. Note the level of valuations when those peak bull market periods occurred.

With valuations currently elevated and prices surging to all-time highs, does this mean we are in for 20 years of no returns?

What Valuations Do And Don’t Tell Us

The mistake investors repeatedly make is dismissing the data in the short term because there is no immediate impact on price returns. Valuations, by their very nature, are HORRIBLE predictors of 12-month returns. As such, investors should avoid any investment strategy with such a focus. However, valuations are strong predictors of expected returns in the longer term.

Forward 10-year returns based on valuations.

While valuations suggest that returns over the next 10 years will likely be lower than the last decade, psychology drives short-term markets. Unsurprisingly, there is a high correlation between investor sentiment and asset prices. The chart below shows the 13-week moving average of net bullish sentiment (betail and institutional) versus the market. During periods of rising prices, sentiment increases, creating a buying panic for stocks.

13-week bullish sentiment vs the market

Eventually, something changes investors’ sentiment from bullish to bearish, and that creates the eventual reversion in asset prices. So, while valuations are vital in setting expectations for future rates of return, they are of little value in the short term. As such, this is why using some basic technical analysis can help investors navigate short-term market time frames to avoid excessive risk buildup in portfolios. The chart below is a composite of weekly technical indicators (price close as of the end of the week.) In October 2023, with a reading below 20, the deep oversold condition marked the bottom of the market. Such formed our call for a year-end rally. With the current reading above 90, which is exceptionally bullish, risk-taking by investors has swung wildly into bullish territory.

Technical gauge vs the market.

Of course, given the hype of “artificial intelligence” and the ongoing hopes of a reversal in monetary tightening, it is unsurprising that markets have hit all-time highs.

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Don’t Fear All-Time Highs, Understand Them

In the short term, investors should not fear all-time highs as a harbinger of impending doom. When driven by momentum and psychology, bull markets can last longer and go farther than logic would predict. But even during these momentum-driven rallies, 5-10% intrayear corrections are the norm.

Annual and Intra-year returns

History is pretty clear that when markets hit all-time highs, more will follow as investors become more “fearful of missing out.” But such exuberance will eventually give way to fundamental realities.

Real S&P 500 index bull markets.

What will cause such a reversal is unknown. However, given the current deviation of the market from its long-term exponential growth trend, it will become more challenging for stocks to continue to grow faster than the economy. Notably, such deviations have historically led to extended periods of very low to zero rates of return.

Real S&P 500 deviations from exponential growth trend.

Of course, that is what current valuations already tell us. While Wall Street analysts are very bullish on the future, some factors must be considered. The economic cycle is tied closely to demographics, debt, and deficit. If you agree with this premise and the data, then the media’s optimistic views are unlikely. 

We believe rationalizing high valuations today will likely lead to disappointing future outcomes. However, bullish sentiment is becoming contagious in the short term, making continued “new all-time highs” more likely.

Don’t fear all-time highs. Just understand they are the byproduct of exuberance.

Fed Chair Powell Just Said The Quiet Part Out Loud

Regarding the surprisingly strong employment data, Fed Chair Powell said the quiet part out loud. The media hopes you didn’t hear it as we head into a contentious election in November.

Over the last several months, we have seen repeated employment reports from the Bureau of Labor Statistics (BLS) that crushed economists’ estimates and seemed to defy logic. Such is particularly the case when you read commentary about the state of the average American as follows.

“New Yorker Lohanny Santos publicly vented her frustration after her attempts to go door-to-door with her CV in hand in the hope of finally landing a job were unsuccessful.

It would appear that other young jobseekers could relate to Lohanny’s struggles. The USA and Canada rank fifth out of seven when it comes to youth unemployment and third when it comes to total unemployment, according to World Bank data based on an International Labor Organization model for 2020, as per Statista.”Business Insider

Even M.B.A.s are finding it difficult.

“Jenna Starr stuck a blue Post-it Note to her monitor a few months after getting her M.B.A. from Yale University last May. “Get yourself the job,” it read. It wasn’t until last week—when she received a long-awaited offer—that she could finally take it down.

For months, Starr has been one of a large number of 2023 M.B.A. graduates whose job searches have collided with a slowdown in hiring for well-paid, white-collar positions. Her search for a job in sustainability began before graduation, and she applied for more than 100 openings since, including in the field she used to work in—nonprofit fundraising.” – WSJ

These stories are not unique. If you Google “Can’t find a job,” you will get many article links. The question, of course, is why individuals with college degrees, no less, are having such a tough time finding employment. After all, aside from record-smashing employment reports, we also continue to see near-record low jobless claims and high numbers of job openings, as shown below.

Unemployment and jobless claims.

The Washington Post touched on part of the problem and why the unemployment rate for college graduates is higher than for all workers.

“Part of the problem is that the industries with the biggest worker shortages — including restaurants, hotels, daycares, and nursing homes — aren’t necessarily where recent graduates want to work. Meanwhile, the industries where they do want to work — tech, consulting, finance, media — are announcing layoffs and rethinking hiring plans.”

Recent grads are unemployed more than others.

As the Washington Post summed up:

“The result is yet another disruption for a generation of college graduates who have already had crucial years of schooling upended by the pandemic. In interviews, many said they’d struggled to adjust to remote-learning in early 2020 and felt like they had missed out on opportunities to forge connections with professors, employers and other students that could have been crucial in lining up for postgraduate work. Now, as they enter the workforce, they say they’re feeling increasingly disillusioned about the economy, which is fueling political discontent and causing them to rethink the financial independence they thought they’d achieve after college.”

Of course, it isn’t just the shuttering of the economy and the shift to working from home causing the problem. It is also the shift in demand from consumers to more service-oriented conveniences, combined with the need by employers to maintain profitability.

Fed Chair Powell Says The Quiet Part

Since the turn of the century, the U.S. economy has shifted from a manufacturing-based economy to a service-oriented one. There are two primary reasons for this.

The first is that the “cost of labor” in the U.S. to manufacture goods is too high. Domestic workers want high wages, benefits, paid vacations, personal time off, etc. On top of that are the numerous regulations on businesses from OSHA to Sarbanes-Oxley, FDA, EPA, and many others. All those additional costs are a factor in producing goods or services. Therefore, corporations needed to offshore production to countries with lower labor costs and higher production rates to manufacture goods competitively.

During an interview with Greg Hays of Carrier Industries, the reasoning for moving a plant from Mexico to Indiana during the Trump Administration was most interesting.

So what’s good about Mexico? We have a very talented workforce in Mexico. Wages are obviously significantly lower. About 80% lower on average. But absenteeism runs about 1%. Turnover runs about 2%. Very, very dedicated workforce.

Which is much higher versus America. And I think that’s just part of these — the jobs, again, are not jobs on an assembly line that [Amerians] really find all that attractive over the long term.

Fed Chair Powell emphasized this point in a recent 60-Minutes Interview. To wit:

“SCOTT PELLEY: Why was immigration important?

FED CHAIR POWELL: Because, you know, immigrants come in, and they tend to work at a rate that is at or above that for non-immigrants. Immigrants who come to the country tend to be in the workforce at a slightly higher level than native Americans. But that’s primarily because of the age difference. They tend to skew younger.

The suppression of wages, increased productivity to reduce the amount of required labor, and offshoring has been a multi-decade process to increase corporate profitability.

Porfits to wages ratio

A Native Problem

Following the pandemic-related shutdown, corporations faced multiple threats to profitability from supply constraints, a shift to increased services, and a lack of labor. At the same time, mass immigration (both legal and illegal) provided a workforce willing to fill lower-wage paying jobs and work regardless of the shutdown. Since 2019, the cumulative employment change has favored foreign-born workers, who have gained almost 2.5 million jobs, while native-born workers have lost 1.3 million. Unsurprisingly, foreign-born workers also lost far fewer jobs during the pandemic shutdown.

Native vs Foreign Born Workers

Given that the bulk of employment continues to be in lower-wage paying service jobs (i.e., restaurants, retail, leisure, and hospitality) such is why part-time jobs have dominated full-time in recent reports. Relative to the working-age population, full-time employment has dropped sharply after failing to recover pre-pandemic levels.

Full Time Employment to Populations

However, as noted, full-time employment has declined since 2000 as services dominate labor-intensive processes such as manufacturing. This is because we “export” our “inflation” and import “deflation.” We do this to buy flat-screen televisions for $299 versus $3,999. Such is also why the economy continues to grow slower, requiring ever-increasing debt levels.

Debt ot GDP growth

For recent college graduates, this all leads to a more dire outlook.

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Immigration Is Needed, But It Has Consequences

To keep an economy growing, you must have population growth. In other words, “demographics are destiny.” As such, there are two ways to obtain more robust population growth rates – natural births and immigration. As shown below, the fertility rate in the United States is problematic in that we aren’t producing enough children to replace an aging workforce.

Fertility Rate

Such is particularly problematic given the rapid aging of older adults versus a declining working-age population. Such means the underfunding of entitlements will continue to grow, requiring more debt issuance to fill the gap.

Working age to elderly population

However, there is a vast difference between immigration policies that import highly skilled workers, capital, and education versus those that don’t. Merit-based immigration policies bring workers who earn higher salaries, create businesses, employ labor, and create tax revenues and other economic contributions. However, current policies are creating a rush of lower-skilled, uneducated labor that will work for cheaper wages, produce less revenue, and are subsidized by tax-payers through welfare programs. As noted above, these workers tend to fill the jobs in the service areas of the economy, thereby displacing native-born workers. Such was a point made by the WSJ:

“Before the pandemic, foreign-born adults were almost as likely as the overall population to hold at least a bachelor’s degree. This was mainly because of higher educational attainment among immigrants from Asia, Africa, and Europe, which offset lower levels of schooling among people from Mexico and Central America.”

Post-pandemic, this has not been the case, which is impacting native-born employment. This is not a new issue, but one addressed by Bill Clinton in the 1995 State of the Union Address:

“The jobs they hold might otherwise be held by citizens or legal immigrants; the public services they use impose burdens on our taxpayers.”

Such is the natural consequence of a change in the economy’s demands and the need for corporations to maintain profitability in an ultimately deflationary environment.

Conclusion

While there is much debate over immigration, most of the arguments do not differentiate between legal and illegal immigration. There are certainly arguments that can be made on both sides. However, what is less debatable is the impact that immigration is having on employment. Of course, as native-born workers continue to demand higher wages, benefits, and other tax-funded support, those costs must be passed on by the companies creating those products and services. At the same time, consumers are demanding lower prices.

That imbalance between input costs and selling price drives companies to aggressively seek options to reduce the highest cost to any business – labor. Such was discussed in our article on the cost and consequences of the demand for increased minimum wages.

  • Reductions in employment would initially be concentrated at firms where higher prices quickly reduce sales. 
  • Over a longer period, however, more firms would replace low-wage workers with higher-wage workers, machines, and other substitutes.
  • As employers pass some of those costs on to consumers, consumers purchase fewer goods and services.
  • Consequently, the employers produce fewer goods and services.
  • When the cost of employing low-wage workers rises, the cost of investing in machines and technology goes down.” – Congressional Budget Office.

Such is why full-time employment has declined since 2000 despite the surge in the Internet economy, robotics, and artificial intelligence. It is also why wage growth fails to grow fast enough to sustain the cost of living for the average American. These technological developments increased employee productivity, reducing the need for additional labor.

Unfortunately, these tales of college graduates expecting high-paying jobs will likely continue to find it increasingly complicated. Particularly as “Artificial Intelligence” becomes cheap enough to displace higher-paid employees.

Divergences And Other Technical Warnings

While the bulls remain entirely in control of the market narrative, divergences and other technical warnings suggest becoming more cautious may be prudent.

In January 2020, we discussed why we were taking profits and reducing risk in our portfolios. At the time, the market was surging, and there was no reason for concern. However, just over a month later, the markets fell sharply as the “pandemic” set in. While there was no evidence at the time that such an event would occur, the markets were so exuberant that only a trigger was needed to spark a correction.

“When you sit down with your portfolio management team, and the first comment made is ‘this is nuts,’ it’s probably time to think about your overall portfolio risk. On Friday, that was how the investment committee both started and ended – ‘this is nuts.'”January 11th, 2020.

As the S&P 500 index approaches another psychological milestone of 5000, we again see numerous warning signs emerging that suggest the risk of a correction is elevated. Does that mean a correction will ensue tomorrow? Of course not. As the old saying goes, “Markets can remain irrational longer than you can remain solvent.” However, just as in 2020, it took more than a month before the warnings became reality.

While discussing the risk of a correction, it was just last October that we discussed why a rally was likely. The reasons at that time were almost precisely the opposite of what we see today. There was extremely bearish investor sentiment combined with negative divergences of technical indicators, and analysts could not cut year-end price targets fast enough.

What happened next was the longest win streak in 52 years that pushed the market to new all-time highs.

Market vs number of weeks of consecutive positive returns

The last time we saw such a rally was between November 1971 and February 1972. Of course, the “Nifty Fifty” rally preceded the 1973-74 bear market. Then, like today, a handful of stocks were driving the markets higher as interest rates were elevated along with inflation.

That 70s show

While there are many differences today versus then, there are reasons for concern.

The “New Nifty 50”

My colleague Albert Edwards at Societe Generale recently discussed the rising capitalization of the technology market.

I never thought we would get back to the point where the value of the US tech sector once again comprised an incredible one third of the US equity market. This just pips the previous all-time peak seen on 17 July 2000 at the height of the Nasdaq tech bubble.

What’s more, this high has been reached with only three of the ‘Magnificant-7’ internet stocks actually being in the tech sector (Apple, Microsoft, and Nvidia)! If you add in the market cap of Amazon, Meta, Alphabet (Google) and Tesla, then the IT and ‘internet’ stocks dominate like never before.”

US Technology Market Cap

Of course, there are undoubtedly important differences between today and the “Dot.com” era. The most obvious is that, unlike then, technology companies generate enormous revenues and profits. However, this was the same with the “Nifty-50” in the early 70s. The problem is always two-fold: 1) the sustainability of those earnings and growth rates and 2) the valuations paid for them. If something occurs that slows earnings growth, the valuation multiples will get revised lower.

While the economic backdrop has seemingly not caught up with technology companies yet, the divergence of corporate profits between the Technology sector and the rest of the market is likely unsustainable.

Technology EPS vs rest of the market

That inability to match the pace of expectations is already occurring. That divergence poses a substantial risk to investors.

US Trailing Technology EPS not keeping pace with estimates

Again, while the risk is somewhat evident, the “bullishness” of the market can last much longer than logic would predict. Valuations, as always, are a terrible market timing device; however, they tell you a lot about long-term returns from markets. Currently, the valuations paid for technology stocks are alarming and hard to justify.

However, despite valuations, those stocks can keep ramping higher in the short term (6-18 months) as the speculative flows continue.

Tech sector absorbing all market inflows.

However, over the next few months, some divergences and indicators suggest caution is advisable.

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Technical Divergences Add To The Risk

Each weekend in the BullBearReport, investor sentiment is something that we track closely. The reason is that when investor sentiment is extremely bullish or bearish, such is the point where reversals have occurred. As Sam Stovall, the investment strategist for Standard & Poor’s, once stated:

“If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”

Currently, everyone is very optimistic about the market. Bank of America, one of the world’s largest asset custodians, monitors risk positioning across equities. Currently, “risk love” is in the 83rd percentile and at levels that have generally preceded short-term corrective actions.

Global Equity risk

At the same time, retail and professional investors are also exuberant, as noted on Tuesday.

“Another measure of bullish sentiment is comparing investor sentiment to the volatility index. Low levels of volatility exist when there is little concern about a market correction. Low volatility and bullish sentiment are often cozy roommates. The chart below compares the VIX/Sentiment ratio to the S&P Index. Once again, this measure suggests that markets are at risk of a short-term price correction.”

Sentiment / Vix ratio versus the market.

However, while everyone is exceedingly bullish on the market, the internal divergence of stocks sends warning signals. Andrei Sota recently showed that market breadth is weakening despite record highs. Note that prior market peaks were accompanied by peaks in the percentage of stocks above their 20, 50, and 200-day moving averages. To further hammer home this point, consider the following Tweet from Jason Goepfert of Sentimentrader:

Man, this is weird. The S&P 500 is within .35% of a 3-year high. Fewer than 40% of its stocks are above their 10-day avg, fewer than 60% above their 50-day, and fewer than 70% above their 200-day. Since 1928, that’s only happened once before: August 8, 1929.

market breadth

That negative divergence between stocks making new highs and the underlying breadth is a good reason to be more cautious with allocations currently.

As I started this commentary, “This is nuts.”

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So Why Not Go To Cash

This analysis raises an obvious question.

“Well, if this is nuts, why not go to cash and wait out the correction and then buy back in.”

The best answer to that question came from Albert Edwards this week.

“I cast my mind back to 2000 where the narrative around the then IT bubble was incredibly persuasive, just as it is now. But the problem that skeptical investors have now, as they did in 1999, is that selling, or underweighting US IT, can destroy performance if one exits too early.”

Regarding speculative bull markets, as noted above, the “this is nuts” part can remain “nuts” for much longer than you think. Therefore, given that we have to generate returns for our clients or suffer career risk, we must be careful not to exit the markets too early…or too late.

Therefore, regardless of your personal views, the bull market that started in October remains intact. The speculative frenzy is still present. As such, we are reducing equity exposure modestly and rebalancing risk by following our basic procedures.

  1. Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)
  2. Sell Those Positions That Aren’t Working. If they don’t rally with the market during a bounce, they will decline when it sells off again.
  3. Move Trailing Stop Losses Up to new levels.
  4. Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you have an aggressive allocation to equities at this point of the market cycle, you may want to try to recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

Could I be wrong? Absolutely.

But a host of indicators are sending us an early warning.

What’s worse:

  1. Missing out temporarily on some additional short-term gains or
  2. Spending time getting back to even which is not the same as making money.

Opportunities are made up far easier than lost capital.” – Todd Harrison

Housing Is Unaffordable. Dems Want To Make It Worse.

The cost of housing remains a hot-button topic with both Millennials and Gen-Z. Plenty of articles and commentaries address the concern of supply and affordability, with the younger generations getting hit the hardest. Such was the subject of this recent CNET article:

“The housing affordability crisis means it’s taking longer for people to become homeowners — and that’s especially impacting millennials and Gen Zers, economically disadvantaged families, and minority groups. There’s not one single driver of the crisis, but several colliding elements that put homeownership out of reach: rising home prices, high mortgage interest rates and limited housing supply. That’s on top of myriad financial challenges, including sluggish wage growth and increasing student loan and credit card debt among middle-income and low-income Americans.”

The chart below of the housing affordability index certainly supports those claims.

NAR Housing Affordability Index

As noted by CNET, there are many apparent reasons causing housing to be unaffordable, from a lack of supply to increased mortgage rates and rising prices. Over the last couple of years, as the Fed aggressively hiked interest rates, the supply of homes on the market has grown. Such is because higher interest rates lead to higher mortgage rates and higher monthly payments for homes. It is also worth noting that previously, when the supply of homes exceeded eight months, the economy was in a recession.

Fed rates and housing supply

At the same time, higher interest rates and increased supply should equate to lower home prices and, therefore, create more affordability.” As shown, such was the case in prior periods, but post-pandemic housing prices skyrocketed as “stimulus checks” fueled a rash of buyers.

Home prices vs Fed funds.

As is always the case with everything in economics, price is ALWAYS a function of supply versus demand.

A Host Of Bad Decisions Created This Problem

The following economic illustration is taught in every “Econ 101” class. Unsurprisingly, inflation is the consequence if supply is restricted and demand increases.

Supply vs Demand chart

While such was the case following the economic shutdown in 2020, the current housing affordability problem is a function of bad decisions made at the turn of the century. Before 2000, the average home buyer needed good credit and a 20% down payment. Those constraints kept demand and supply in balance to some degree. While housing increased with inflation, median household incomes could keep pace.

However, in the late 90s, banks and realtors lobbied Congress heavily to change the laws to allow more people to buy homes. Alan Greenspan, then Fed Chairman, pushed adjustable-rate mortgages, mortgage companies began using split mortgages to bypass the need for mortgage insurance, and credit requirements were eased for borrowers. By 2007, mortgages were being given to subprime borrowers with no credit and no verifiable sources of income. These actions inevitably led to increased demand that outpaced available supply, pushing home prices well above what incomes could afford.

Median and average home prices vs wage growth

This episode in the housing market resulted from zero-interest policies by the Federal Reserve. That policy and massive liquidity injections into the financial markets brought hoards of speculators, from individuals to institutions. Institutional players like Blackstone, Blackrock, and many others purchased 44% of all single-family homes in 2023 to turn them into rentals. As prices rose, advances like AirBnB brought more demand from individuals for rentals, further reducing the available housing pool. Those influences lead to even higher prices for available inventory.

Notably, it isn’t a lack of housing construction. The Total Housing Activity Index is not far from its all-time highs following the 2020 pandemic “housing rush.” The issue is the removal of too many homes by “non-home buyers” from the available inventory.

Total housing activity index

Furthermore, existing home sales are absent. Current homeowners are unwilling to sell homes with a 4% mortgage rate to buy a home with a 7% mortgage. As shown, existing home sales remain remarkably absent.

Existing home sales

All of these actions have exacerbated the problem. At the root of it all is the Federal Reserve, keeping interest rates too low for too long. Oversupplying liquidity and creating repeated surges in home prices. It is not a far stretch to realize the bulk of the housing problem directly results from Governmental forces.

Housing process and the Fed.

So, what does this have to do with the Democrats?

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Dems Want To Make The Housing Problem Worse

Sen. Elizabeth Warren, D-Mass., and three other Democratic lawmakers are pushing Jerome Powell to lower interest rates at the upcoming Fed meeting to make housing more affordable.

“As the Fed weighs its next steps in the new year, we urge you to consider the effects of your interest rate decisions on the housing market. The direct effect of these astronomical rates has been a significant increase in the overall home purchasing cost to the average consumer.” – Letter To Jerome Powell

As discussed above, lowering interest rates is not the solution to lowering housing prices. Lower interest rates would bring more buyers into a market already short inventory, thereby increasing home prices. We can already see the impact of lower mortgage rates on home prices just since October. Prices rose as yields fell on hopes the Federal Reserve would cut rates in 2024. If mortgage rates revert to 4%, where they were during most of the last decade, home prices will significantly increase.

Housing prices vs 30-year  mortgage

The Terrible Terrible Solution

There is only one solution to return home prices to affordability for most of the population. That is to reduce the existing demand. If Elizabeth Warren is serious about doing that, passing laws today would go a long way to solving that problem.

  1. Restrict corporate and institutional interests from buying individual homes.
  2. Increase the lending standards to require a minimum 15% down payment and a good credit score. (such would also increase the stability of banks against another housing crisis.)
  3. Increase the debt-to-income ratios for home buyers.
  4. Return the mortgage market to straight fixed-rate mortgages. (No adjustable rate, split, etc.)
  5. Require all banks that extend mortgages to hold 25% of the mortgage on their books.

Yes, those are very tough standards to meet and initially would exclude many from home ownership. But, home ownership should be a demanding standard to meet, as the cost of home ownership is high. For the individual, such standards would ensure that home ownership is feasible and that such ownership, along with the subsequent fees, taxes, maintenance costs, etc., would still allow for financial stability. For the lenders, it would reduce the liability of another financial crisis to almost zero, as the housing market’s stability would be inevitable.

But most importantly, such strict standards would immediately cause an evaporation of housing demand. With a complete lack of demand, housing prices would fall and reverse the vast appreciation caused by a decade of fiscal and monetary largesse. Yes, it would be a very tough market until those excesses reverse, but such is the consequence of allowing banks and institutions to run amok in the housing market.

Naturally, none of this will ever happen or considered, as there is too much money in the housing market for corporations, institutions, and banks to feed on. But one thing is for sure: if the Democrats get their wish and the Fed cuts rates again, housing prices will become even more unaffordable.

S&P Index Set To Hit 5000 As Bull Run Continues

In September 2021, I discussed how the markets had set its sights on the S&P 500 index hitting 5000. To wit.

“Yes, the rally off the COVID-19 bottom in March 2020 has been extraordinary, but we think there are further gains ahead. Solid economic and corporate profit growth, in conjunction with a still-accommodative Fed, means that the environment for stocks remains favorable. As a result of our higher EPS estimates, we raise our targets for the S&P 500 for December 2021 by 100 points to 4,600 and June 2022 by 150 points to 4,800. We initiate our December 2022 target of 5,000, representing about 13% price appreciation from current levels.’” – David Lefkowitz, UBS.

Of course, the market peaked in January 2022, just four months later, at 4796.56. Fast forward 2-full years of returning investors to breakeven, and the market is again approaching that magical round number of 5000.

The quest to 5000 for the S&P Index

Nonetheless, with the market surging higher since the beginning of the year, bullish investors are drooling over the next significant milestone for the market – S&P Index 5000. These milestones have a gravitational pull as investors become fixated on them. Interestingly, the time to reach these milestones continues to shrink, particularly after the Federal Reserve became hyperactive with monetary policy changes.

S&P Index 1000 Point Milestones

These milestones have very little meaning other than being psychological markers or having the ability to put on an “S&P 5000” hat if you’re in the media. Nonetheless, the bullish backdrop suggests the market will likely hit that psychological level soon, if not already.

But the question we should be asking ourselves is what most likely will happen next.

Things Are Always The Same

Just a few months ago, in October, with the market down 10% from its peak, investors were very negative about the S&P Index.

More than once, I received emails asking me if “the selling is ever going to stop.”

Then I wrote an article explaining why “October Weakness Would Lead To A Year-End Run.” To wit:

“A reasonable backdrop between the summer selloff, sentiment, positioning, and buybacks suggests a push higher by year-end. Add to that the performance chase by portfolio managers as they buy stocks for year-end reporting purposes.”

Since then, there has been a stunning reversal of bearish sentiment. Investors once again believe that “nothing can stop this bull rally.”

Funny enough, that was the same sentiment discussed in the July 2022 report “Trading An Unstoppable Bull Market.”

“The S&P Index is set to close out its fifth straight month of gains. In addition to being up six out of the seven months this year, returns are unusually high, with the S&P advancing 18% year-to-date. There is little doubting the incredibly bullish tailwind for the US equities despite the Fed hiking interest rates and reducing its balance sheet.”

That was just before the 10% decline into October.

The history lesson is that investors again believe we are in an unstoppable bull market. With the S&P index set to set a historical record by hitting 5000, it seems nothing can derail the bulls. But such is always the sentiment just before it changes. The only question is, what causes the change in sentiment? Unfortunately, we will never know with certainty until after the fact.

We do know that the market currently has all the ingredients needed for a period of price correction. For example, retail and professional investor sentiment is at levels usually associated with short- to intermediate-term market peaks. The chart below marks when the investor sentiment ratio is above 2.5. Those levels have previously marked short-term market peaks. Ratios below 0.75 have correlated with market bottoms.

Composite investor sentiment vs the market.

Another measure of bullish sentiment is comparing investor sentiment to the volatility index. Low levels of volatility exist when there is little concern about a market correction. Low volatility and bullish sentiment are often cozy roommates. The chart below compares the VIX/Sentiment ratio to the S&P Index. Once again, this measure suggests that markets are at risk of a short-term price correction.

Sentiment / Vix ratio versus the market.

Furthermore, our composite gauge of weekly technical indicators has already reached more extreme levels. Historically, we are close to a peak when this gauge exceeds 90 (scale is 0 to 100).

Technical Gauge vs the market

As is always the case, the resolution of more extreme bullish sentiment and technical price extensions is through a short-term reversal. However, such does not mean that the market won’t hit 5000 first, as we suspect it will.

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S&P Index At 5000, Most Stocks Aren’t

Another interesting facet about the current market is that as the S&P Index approaches a psychological 5000 level, that advance continues to be a function of a relatively small number of stocks doing most of the lifting. As we discussed previously, given the weight of the top-10 “Market-Capitalization” companies in the S&P index, which currently comprises 35% of the index, as shown.

Weighting of top 10 stocks

Those stocks disproportionately impact the performance of the index. That impact is represented by the comparison to the S&P 500 “Equal-Weight” index, which removes that effect.

Market cap vs equal weight returns

This narrowness of winners and losers is better represented by comparing the major market’s relative performance since 2014. Other than the Nasdaq, which is heavily weighted in Technology, all other major markets have lagged the S&P Index.

Major market performance

Even within the S&P index itself, except for Technology, all other sectors have underperformed the index since 2020.

market vs sector performance

Critically, while the S&P index is hitting “all-time” highs and hitting the psychological level of 5000, it remains a story of the “haves” and the “have nots.” While Mega-capitalization companies have earnings, and investors are bidding up the market in anticipation of future earnings growth, earnings are declining for everyone else.

S&P 500 EPS with and with Mag 7 stocks.

Here is the data numerically to better visualize the problem.

Maginficent 7 stocks earnings versus the rest of the market.

With markets technically stretched, sentiment bullish, and still weak fundamental underpinnings, the index hitting 5000 as a measure of market health is a bit of a mirage.

At some point, earnings for the broad market will need to accelerate, requiring more substantial economic growth rates, or a more meaningful correction will occur to realign valuations. Historically, it has been the latter.

Notably, such reversions in price have often occurred just after the market hits a psychological milestone.

Retirement Savers Are Piling Into Stocks. Is That A Good Idea?

As the financial markets grind higher, retirement savers have consciously decided to add more to equity risk. Such was the result of a recent Bloomberg survey.

“Retirement savers want more stocks in their portfolios as a hedge against inflation, potentially offering a long-term tailwind for equities as societies age, according to the latest Bloomberg Markets Live Pulse survey.

Almost half of the 252 respondents said they were putting more funds into stocks as a response to rising prices – far eclipsing the 6% who said they’d be adding the traditional inflation hedge, gold.” – Simon White

Stock are popular with future retirees.

While the respondents said they were buying stocks as a hedge against inflation, which may be part of the answer, the reality is that a surging bull market over the last 14 years is more likely the real reason. The same psychology permeated into the next question, which asked which asset classes would do the best as society ages. Given the real-world experience of most individuals of skyrocketing home prices and stocks, it was not surprising to see both ranking as top answers.

Stocks and House prices expected to go up.

Given the recency bias of most individuals, the responses were unsurprising given the outsized proportion of market gains relative to the long-term averages. Such was the recent topic of “Portfolio Return Expectations Are Too High.” To wit:

The chart shows the average annual inflation-adjusted total returns (dividends included) since 1928. I used the total return data from Aswath Damodaran, a Stern School of Business professor at New York University. The chart shows that from 1928 to 2023, the market returned 8.45% after inflation. However, after the financial crisis in 2008, returns jumped by nearly four percentage points for the various periods. After over a decade, many investors have become complacent in expecting elevated portfolio returns from the financial markets. However, can those expectations continue to be met in the future?”

Bar Chart of "Arithmetic Average S&P 500 Annual Total Real Return Over Different Periods" with data from 1928 to 2023.

That last sentence is critical.

A Staggering Shortfall

There are a couple of apparent reasons individuals are willing to take on increased risk in portfolios, the most obvious being the rather significant savings shortfall. For example, a previous survey by CNBC found that most Americans will need $1.3 million to retire comfortably.

“When it comes to how much they will need to retire comfortably, Americans have a “magic number” in mind — $1.27 million, according to new research from Northwestern Mutual.

The survey found that respondents in their 50s expected to need the most when they retire — more than $1.5 million. For those in their 60s and 70s, who are close to or in retirement, those expectations dropped to less than $1 million.”

How much do US adults have saved for retirement.

The problem with that data is that most individuals are nowhere close to those levels of savings.

“A recent survey conducted by Clever Real Estate polled 1,000 Gen Xers born between 1965 and 1980 to find out how they fare regarding personal finances and the road to retirement. A staggering 56% of Gen Xers said they have less than $100,000 saved for retirement, and 22% said they have yet to save a single cent.

While the desire to retire may be there, the money just isn’t. A whopping 64% of respondents said they stopped saving for retirement not because they don’t want to but because they simply can’t afford to.

Approximately, how much do income brackets have saved for retirement.

Furthermore, a LendingClub survey shows that 61% of U.S. consumers live paycheck to paycheck.

It’s a dire situation for most Americans, particularly those retirement savers. As such, it is unsurprising that more individuals are looking to the stock market as a solution to make up the shortfall.

However, therein lies the risk.

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The Risk Of Risk

One of the incredible genetic traits of humans is the ability to forget pain. The trait is essential to the survival of the species. If cavemen clearly remembered the agonizing pain of being attacked by a predator, they would have likely never left their caves to hunt. If women vividly remembered the excruciating pain of childbirth, they would probably never have more than one. In the financial markets, investors all too soon forget the painful memories of bear markets, particularly when the bull is stampeding.

Currently, the bull market that began in 2009 remains firmly intact. Despite a mild stumble in 2022, the long-term trend remains higher, and investors feel confident that the trend will remain indefinitely. However, a risk has been overlooked amid above-average returns over the last decade. That risk is liquidity, which we discussed in more depth in “The Markets Are Frontrunning The Fed.” 

“The psychological change is a function of more than a decade of fiscal and monetary interventions that have separated the financial markets from economic fundamentals. Since 2007, the Federal Reserve and the Government have continuously injected roughly $43 Trillion in liquidity into the financial system and the economy to support growth. That support entered the financial system, lifting asset prices and boosting consumer confidence to support economic growth.”

Government interventions and the stock market.

The risk of reduced monetary liquidity may become problematic for stocks to sustain current returns. As shown below, nearly 100% of the index returns from 1900 to the present came during the 4-periods of multiple expansion. With valuations currently very elevated, the reduction of monetary liquidity may lead to the next secular period of “multiple contraction,” which would yield much lower rates of returns.

Bull and Bear Market Cycles

In other words, retirement savers currently allocating more savings to equity risk could well be setting themselves up for an extended period of higher volatility and lower expected rates of return.

Real returns and valuations.

Conclusion

As Jeremy Grantham previously noted:

“All 2-sigma equity bubbles in developed countries have broken back to trend. But before they did, a handful went on to become superbubbles of 3-sigma or greater: in the U.S. in 1929 and 2000 and in Japan in 1989. There were also superbubbles in housing in the U.S. in 2006 and Japan in 1989. All five of these superbubbles corrected all the way back to trend with much greater and longer pain than average.

Today in the U.S. we are in the fourth superbubble of the last hundred years.”

Therefore, unless the Federal Reverse is committed to a never-ending program of zero interest rates and quantitative easing, the eventual reversion of returns to their long-term means is inevitable.

It is hard to fathom how forward return rates will not be disappointing compared to the last decade. However, those excess returns were the result of a monetary illusion. The consequence of dispelling that illusion will be challenging for retirement savers.

However, throughout history, investors have repeatedly invested the most into equity risk and the worst possible times. For retirement savers, this time will likely be no different.

“Theory Of Reflexivity” And Does It Matter?

I received an email this past week concerning George Soros’ “Theory Of Reflexivity.”

“I am not a fan of Soros, but this market has the look and feel of the dot com bust of 2000. In a few short words, the AI investment phenomenon is feeding on itself just as the internet and fiber did in 1999.”

It’s an interesting question, and I have previously written about the “Theory of Reflexivity.” Notably, this theory begins to resurface whenever markets become exuberant. However, concerning the email, there seems to be a similarity between the current “A.I.” driven speculation and what was seen in the late 90s.

Nasdaq Dot.com vs Today

There is, of course, a significant difference between the companies surging higher today versus those in the late 90s. That difference is that those companies involved in the “A.I.” race have revenues and earnings versus many Dot.com darlings that didn’t. Nonetheless, the valuations paid for many companies today, in terms of price-to-sales, are certainly not justifiable. The table below shows all the companies in the S&P 500 index with a price-to-sales ratio above 10x. Do you recognize any you own?

Stocks trading above 10x sales

I picked 10x price-to-sales because of what Scott McNeely, then CEO of Sun Microsystems, said in a circa 1999 interview.

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. Iassumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are?”

This is an important point. At a Price-to-Sales ratio of TWO (2), a company needs to grow sales by roughly 20% annually. That growth rate will only maintain a normalized price appreciation required to maintain that ratio. At 10x sales, the sales growth rate needed to maintain that valuation is astronomical.

While 41 companies in the S&P 500 are trading above 10x price-to-sales, 131 companies (26% of the S&P) trade above 5x sales and must grow sales by more than 100% yearly to maintain that valuation. The problem is that some companies, like Apple (AAPL), have declining revenue growth rates.

Apple annual revenue growth

While it is believed that “A.I.” is a game changer, this is not the first time we have seen such a “revolution” in the markets.

Stock market vs valuations

As shown, there is an end to these cycles, as valuations ultimately matter.

So, what does this have to do with the “Theory of Reflexivity.”

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The “Theory Of Reflexivity” – A Rudimentary Theory Of Bubbles

For investors, in the “heat of the moment,” silly notions like “valuations,” “equity risk premiums,” and “revenue growth” matter very little. Such is because, in the very short term, all that matters is momentum. However, over extended periods, valuations are a direct determinant of returns.

Despite one selloff after another leading to increased volatility, the markets are currently hitting all-time highs as the speculative chase for return heats up. However, the current market mentality reminds me much of what Alan Greenspan said about this behavior.

Thus, this vast increase in the market value of asset claims is, in part, the indirect result of investors accepting lower compensation for risk. Market participants too often view such an increase in market value as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low-risk premiums.

Alan Greenspan, August 25th, 2005.

A decline in perceived risk is often self-reinforcing in that it encourages presumptions of prolonged stability and thus a willingness to reach over an ever-more extended time period. But, because people are inherently risk averse, risk premiums cannot decline indefinitely. Whatever the reason ‎ for narrowing credit spreads, and they differ from episode to episode, history caution’s that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender.

Alan Greenspan, September 27th, 2005.

Once again, investors accept a low equity risk premium for market exposure. (Data courtesy of Aswath Damodaran, Stern University)

Equity Risk Premium

Such brings us to George Soros’ “Theory Of Reflexivity.”

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

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

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

The chart below is an example of asymmetric bubbles.

Asymmetric-bubbles

Soros’ view on the pattern of bubbles is interesting because it changes the argument from a fundamental to a technical view. Let me explain.

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Bubbles And Exuberance

Prices reflect the psychology of the market, which can create a feedback loop between the markets and fundamentals. As Soros stated:

“Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”

The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis. I then looked at the markets before each significant market correction and overlaid the asymmetrical bubble shape, as discussed by George Soros.

Previous market periods of asymmetric market bubbles.

Of course, what each of those previous periods had in common were three things:

  1. High valuation levels (chart 1)
  2. Large deviations from the long-term exponential growth trend of the market. (chart 2)
  3. High levels of investor exuberance which drive chart 1 and 2.

The S&P 500 trades in the upper 90% of its historical valuation levels.

CAPE valuations deviations from growth trend.

However, since stock market “bubbles” reflect speculation, greed, and emotional biases, valuations only reflect those emotions. As such, price becomes more reflective of psychology. From a “price perspective,” the level of “greed” is on full display as the S&P 500 trades at one of the most significant deviations on record from its long-term exponential trend. (Such is hard to reconcile, given a 35% correction in March 2020 and a 20% decline in 2022.)

S&P 500 deviation from growth trend

Historically, all market crashes have resulted from things unrelated to valuation levels. Issues such as liquidity, government actions, monetary policy mistakes, recessions, or inflationary spikes are the culprits that trigger the “reversion in sentiment.”

Notably, the “bubbles” and “busts” are never the same.

Comparing the current market to any previous period is rather pointless. Is the current market like 1995, 1999, or 2007? No. Valuations, economics, drivers, etc., all differ from one cycle to the next.

Critically, the financial markets adapt to the cause of the previous “fatal crashes.” However, that adaptation won’t prevent the next one.

Conclusion

There is currently much debate about the health of financial markets. Can prices remain detached from the fundamentals long enough for the economic/earnings recession to catch up with prices?

Maybe. It has just never happened.

The speculative appetite for “yield,” fostered by the Fed’s ongoing interventions and suppressed interest rates, remains a powerful force in the short term. Furthermore, investors have now been successfully “trained” by the markets to “stay invested” for “fear of missing out.”

The speculative risks and excess leverage increase leave the markets vulnerable to a sizable correction. The only missing ingredient for such a correction is the catalyst that starts the “panic for the exit.” 

It is all reminiscent of the 1929 market peak when Dr. Irving Fisher uttered his famous words: “Stocks have now reached a permanently high plateau.” The clamoring of voices proclaiming the bull market still has plenty of room to run tells the same story. History is replete with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.

When will Soros’ “Theory of Reflexivity” affect the market? No one knows with any certainty. But what we do know with certainty is that markets are affected by gravity. Eventually, for whatever reason, what goes up will come down.

Make sure to manage your portfolio risk accordingly.

Money Market “Cash On The Sidelines” – A Myth That Won’t Die

As money market account balances soar, the mainstream media again proclaims, “There is $6 trillion of cash on the sidelines just waiting to come into the market.”

No? Well, here it is directly from YahooFinance:

“The growing pile of cash in money market funds should serve as a strong backstop for the stock market in 2024, according to a recent note from Fundstrat’s technical strategist Mark Newton. The allure of 5% interest rates has led to a surge in money market fund assets this year, with total cash on the sidelines recently reaching a record $5.88 trillion. That’s up 24% from last year, when money market funds held $4.73 trillion in cash.

‘While several prominent sentiment polls have turned more optimistic in the last few weeks, this gauge should be a source of comfort to market bulls, meaning that minor pullbacks in the weeks/months to come likely should be buyable given the global liquidity backdrop coupled with ample cash on the sidelines,” Newton said.

The surge in money markets since the “pandemic” has revived the age-old narrative that “money on the sidelines” is set to come into the markets. However, they don’t tell you those funds have accumulated since 1974. Correctly, in the aftermath of crisis events, some of these assets rotate from “safety” to “risk,” but not the degree commentators suggest.

Money market funds vs the market

Here is the problem with the “cash on the sidelines” reasoning: it is a complete myth.

The Myth Of Cash On The Sidelines

We have repeatedly discussed this myth, but it is worth repeating, particularly when the financial media begins to push the narrative to garner headlines.

There is a superficial, glib appeal to the idea. After all, lots of people hold money on deposit at the bank, and they could use that money to buy stocks, right? After all, the latest financial data from the Office of Financial Research shows more than $6.3 Trillion sitting in money market accounts.

Money market fund balances

So what’s to prevent some of that money “coming into the market?”

Simple. The fallacy of composition. This was the point we made previously:

Every transaction in the market requires both a buyer and a seller, with the only differentiating factor being the transaction’s price. Since this is required for there to be equilibrium in the markets, there can be no “sidelines.” 

Think of this dynamic like a football game. Each team must field 11 players despite having over 50 players. If a player comes off the sidelines to replace a player on the field, the player being replaced will join the ranks of the 40 or so other players on the sidelines. At all times, there will only be 11 players per team on the field. This is true if teams expand to 100 or even 1000 players.”

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Less Cash Than You Think

Furthermore, despite this very salient point, looking at the stock-to-cash ratios (cash as a percentage of investment portfolios) also suggests very little buying power for investors. As shown in the chart from Sentimentrader.com, as asset prices have escalated, so have individuals’ appetite to chase risk. The current equity to money market asset ratio, although down from its record, is still above all pre-financial crisis peaks.

Equity to Money Market funds balances vs the market

If we look specifically at retail investors, their cash levels have been at the lowest level since 2014 and are not far from record lows. At the same time, equity allocations are not far from the levels in 2007.

AAII cash, equity and bond allocations

The same is valid with money market levels relative to the market capitalization of the S&P 500 index. The ratio is currently near its lowest since 1980, which suggests that even if the cash did come into the market, it would not move the needle much.

money market vs market capitalization ratios vs the market

With net exposure to equity risk by individuals at very high levels it suggests two things:

  1. There is little buying left from individuals to push markets marginally higher, and
  2. The stock/cash ratio, shown below, is near levels that generally coincide with market peaks.

But it isn’t just individual investors that are “all in,” but professionals as well.

Mutual fund cash levels vs the market

So, if retail and professional investors are already primarily allocated to equity exposure, with very little “cash on the sidelines,” who has all this cash?

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So, Where Is All This Cash, Then?

To understand who is holding all the cash currently in money market funds, we can break the Office Of Financial Research data down by category.

Money market funds breakdown

There are a few things we need to consider about money market funds.

  1. Just because I have money in a money market account doesn’t mean I am saving it for investing purposes. It could be an emergency savings account, a down payment for a house, or a vacation fund on which I want to earn a higher interest rate. 
  2. Also, corporations use money markets to store cash for payroll, capital expenditures, operations, and other uses unrelated to investing in the stock market. 
  3. Foreign entities also store cash in the U.S. for transactions processed in the United States, which they may not want to repatriate back into their country of origin immediately.

The list goes on, but you get the idea.

Furthermore, you will notice the bulk of the money is in Government Money Market funds. These particular types of money market funds often have much higher account minimums (from $100,000 to $1 million), suggesting these funds are not retail investors. (Those would be the smaller balances of prime retail funds.)

Of course, since the “Great Financial Crisis,” one of the primary uses of corporate “cash on the sidelines” has been for share repurchases to boost earnings. As noted previously, as much as 40% of the bull market since 2012 can be attributed to share buybacks alone.

Share buybacks vs SP500

What Changes The Game

As noted above, the stock market is always a function of buyers and sellers, each negotiating to make a transaction. While there is a buyer for every seller, the question is always at “what price?” 

In the current bull market, few people are willing to sell, so buyers must keep bidding up prices to attract a seller to make a transaction. As long as this remains the case and exuberance exceeds logic, buyers will continue to pay higher prices to get into the positions they want to own.

Such is the very definition of the “greater fool” theory.

However, at some point, for whatever reason, this dynamic will change. Buyers will become more scarce as they refuse to pay a higher price. When sellers realize the change, there will be a rush to sell to a diminishing pool of buyers. Eventually, sellers begin to “panic sell” as buyers evaporate and prices plunge.

Sellers live higher. Buyers live lower.

What causes that change? No one knows.

But for now, we need to put the myth of “cash on the sidelines” to rest.

All-Time Highs For Stocks As Bitter Economic Headlines Persist

As the stock market hit all-time highs this past week, there remains an interesting disconnect from the more dour economic concerns of the average American. A recent survey by Axios, a left-leaning website that supports the current Administration, addressed this issue.

Poll after poll shows that the country is bummed out by the economy. Voters blame Biden. Nearly four in 10 Americans rate their financial situation as poor, according to a new Axios Vibes survey by The Harris Poll. In the language of our new Vibes series — which taps into the depth of Americans’ feelings — those surveyed feel sad about jobs and the economy.”

We compile a consumer sentiment composite index using the University of Michigan and Conference Board measures to confirm that assessment. Interestingly, while the stock market is hitting all-time highs, the gap between economic expectations and current conditions remains profoundly negative.

Consumer Confidence Composite vs S&P 500

That gap should be unsurprising given the increases in borrowing costs directly impacting the average American. As shown, both the headline composite sentiment index and expectations are far off their highs as the Federal Reserve aggressively hiked borrowing costs.

Consumer confidence vs Fed rates

However, the upside is that if the market can continue to register further all-time highs, which we will discuss why in a moment, such should translate into increased consumer confidence. Such is because even though the average household has very little money invested in the financial markets, the drumbeat of all-time highs from the media reduces economic concerns. Improvements in consumer confidence lead to increases in consumer spending, which translates into economic growth.

Confidence vs PCE

However, given that higher rates remain and consumers have drained most of their savings, there is likely only a limited impact on further improvements in confidence. While stocks are currently registering all-time highs, much of that gain is based on the assumption that the Federal Reserve will cut rates and reintroduce monetary liquidity.

Front-Running The Fed

The last paragraph is critical. We previously discussed how the Federal Reserve used “Pavlov’s experiment” to train investors over the last decade. To wit:

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). Pavlov discovered 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.”

In 2010, then Fed Chairman Ben Bernanke introduced the “neutral stimulus” to the financial markets by adding a “third mandate” to the Fed’s responsibilities – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose, and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” – Ben Bernanke, Washington Post Op-Ed, November, 2010.

Importantly, for conditioning to work, the “neutral stimulus,” when introduced, must be followed by the “potent stimulus” for the “pairing” to be completed. For investors, as each round of “Quantitative Easing” was introduced, the “neutral stimulus,” the stock market rose, the “potent stimulus.” 

That analysis also corresponds to the Fed cutting rates as well. The chart below compares the Fed rate hiking cycle and its balance sheet contraction and expansion to the S&P 500 index. Since 2008, the Federal Reserve, through its messaging, has trained investors to respond to increased liquidity actions. Previously, markets tended to correct during periods of monetary tightening, as should be expected. However, this time, investors are front-running the Fed to get ahead of the reversal in monetary tightening.

Fed funds vs balance sheet vs the stock market

While there has been previous debate on the impact of the Fed’s balance sheet changes on the markets, there is a very high correlation between the two, suggesting it is more than a coincidence. The correlation explains the Federal Reserve’s control over the financial markets.

Cumulative growth of balance sheet vs the stock market correlation

The influence of the Federal Reserve on the markets is evident in a recent BofA survey of professional managers on the “biggest driver of equity prices in 2024.” While fundamentals and corporate earnings should have been the top answer, 52 percent said “The Fed.” However, since “Liquidity” is controlled by the Fed, it was 59%.

BofA Survey of Investment Professionals on the driver of equity prices in 2024.

Such makes it clear how the markets can obtain all-time highs despite the underlying view of the average American who has very little or no participation in it.

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It’s A Narrow Market

Another issue worth delving into with the market breaking out to all-time highs is the narrow participation in that rally. The chart below shows each market sector of the S&P 500 rebased to 100 as of January 2021. I have compared each to the S&P 500 itself. While the overall market is indeed reaching new all-time highs, it is the function of just one sector – Technology.

Sector performance of the market.

While the Technology sector can grow earnings in a slower economic environment, market liquidity has chased just a handful of stocks over the last year. Through the end of 2023, the S&P 500 market-capitalization weighted index doubled the return of the equal-weighted index. The reason is that the top-10 stocks in the index absorb more than 30% of all flows into passive indexes.

SP500 Market Cap vs Equal Weighted Returns.

In 2024, that deviation continues as the chase for “artificial intelligence” dominates media headlines.

Market Capitalization vs Equal Weight index performance

Given that Mega-capitalization stocks are a place of safety where major asset managers can place large amounts of capital, and the bulk of expected earnings growth will come from those companies, it is not surprising we are seeing the divergence again. However, while such a deviation is unsustainable long-term, the recent breakout to all-time highs may continue as “F.O.M.O” outpaces fundamentals and valuations. Given that the 24% advance in 2023 was primarily a function of valuation expansion, current valuation multiples are at risk of disappointment if earnings fail to achieve rather lofty expectations.

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Earnings Are Key

Economic activity generates the revenues, and ultimately earnings, for corporations. Therefore, the consumer’s return of confidence in the economy is the key to sustaining the all-time highs in the market. The overriding problem for the average American is the decline in savings and wages and increases in the cost of debt.

S&P 500 market vs wages vs savings

What most economists and mainstream analysts miss is that while the economy remains robust, it remains a function of massive increases in deficit spending. The problem, and why Americans are so sour on the economy, is that while deficit spending keeps the economy from recession, it is temporary and does not increase the wealth or prosperity of the average American.

Federal Receipts & Expenditures

The problem for the market is that as the monetary impulse from the 2020 stimulus campaign to the Inflation Reduction and CHIPs Act continues to support economic activity, the rest of the economy is slowing. Ultimately, such will show up in the reduction of rather lofty earnings expectations, which are already declining.

2024 earnings estimates

Lastly, given that most sectors are experiencing stagnating earnings growth because of slower economic activity, any risk arising that impacts the earnings of the handful of stocks driving the market could be significant. With valuations elevated, any disappointment, or worse, a potential recession, could lead to a considerable market repricing.

Valuations deviation from long-term trend

For now, the market’s breakout to all-time highs is bullish and will likely lead to further gains. However, the critical message is not to forget there is still substantial risk underlying the current economy and the market.

Narrow markets are fine until they aren’t.

The problem with that statement is that it is difficult to realize when something has changed. As is always the case with investing, market risks always occur “slowly, then all at once.”

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.

Shedlock: Recession Will Be Deeper Than The Great Financial Crisis

Economists at IHS Markit downgraded their economic forecast to a deep recession.

Please consider COVID-19 Recession to be Deeper Than That of 2008-2009

Our interim global forecast is the second prepared in March and is much more pessimistic than our 17 March regularly scheduled outlook. It is based on major downgrades to forecasts of the US economy and oil prices. The risks remain overwhelmingly on the downside and further downgrades are almost assured.

IHS Markit now believes the COVID-19 recession will be deeper than the one following the global financial crisis in 2008-09. Real world GDP should plunge 2.8% in 2020 compared with a drop of 1.7% in 2009. Many key economies will see double-digit declines (at annualized rates) in the second quarter, with the contraction continuing into the third quarter.

It will likely take two to three years for most economies to return to their pre-pandemic levels of output. More troubling is the likelihood that, because of the negative effects of the uncertainty associated with the virus on capital spending, the path of potential GDP will be lower than before. This happened in the wake of the global financial crisis.

Six Key Points

  1. Based on recent data and developments, IHS Markit has slashed the US 2020 forecast to a contraction of 5.4%.
  2. Because of the deep US recession and collapsing oil prices, IHS Markit expects Canada’s economy to contract 3.3% this year, before seeing a modest recovery in 2021.
  3. Europe, where the number of cases continues to grow rapidly and lockdowns are pervasive, will see some of the worst recessions in the developed world, with 2020 real GDP drops of approximately 4.5% in the eurozone and UK economies. Italy faces a decline of 6% or more. The peak GDP contractions expected in the second quarter of 2020 will far exceed those at the height of the global financial crisis.
  4. Japan was already in recession, before the pandemic. The postponement of the summer Tokyo Olympics will make the downturn even deeper. IHS Markit expects a real GDP contraction of 2.5% this year and a very weak recovery next year.
  5. China’s economic activity is expected to have plummeted at a near-double-digit rate in the first quarter. It will then recover sooner than other countries, where the spread of the virus has occurred later. IHS Markit predicts growth of just 2.0% in 2020, followed by a stronger-than-average rebound in 2021, because of its earlier recovery from the pandemic.
  6. Emerging markets growth will also be hammered. Not only are infection rates rising rapidly in key economies, such as India, but the combination of the deepest global recession since the 1930s, plunging commodity prices, and depreciating currencies (compounding already dangerous debt burdens) will push many of these economies to the breaking point.

No V-Shaped Recovery

With that, Markit came around to my point of view all along. Those expecting a V-shaped recovery are sadly mistaken.

I have been amused by Goldman Sachs and Morgan Stanley predictions of a strong rebound in the third quarter.

For example Goldman Projects a Catastrophic GDP Decline Worse than Great Depression followed by a fantasyland recovery.

  • Other GDP Estimates
  • Delusional Forecast
  • Advice Ignored by Trump
  • Fast Rebound Fantasies

I do not get these fast rebound fantasies, and neither does Jim Bianco. He retweeted a Goldman Sachs estimate which is not the same as endorsing it.

I do not know how deep this gets, but the rebound will not be quick, no matter what.

Fictional Reserve Lending

Please note that Fictional Reserve Lending Is the New Official Policy

The Fed officially cut reserve requirements of banks to zero in a desperate attempt to spur lending.

It won’t help. As I explain, bank reserves were effectively zero long ago.

US Output Drops at Fastest Rate in a Decade

Meanwhile US Output Drops at Fastest Rate in a Decade

In Europe, we see Largest Collapse in Eurozone Business Activity Ever.

Lies From China

If you believe the lies (I don’t), China is allegedly recovered.

OK, precisely who will China be delivering the goods to? Demand in the US, Eurozone, and rest of the world has collapse.

We have gone from praying China will soon start delivering goods to not wanting them even if China can produce them.

Nothing is Working Now: What’s Next for America?

On March 23, I wrote Nothing is Working Now: What’s Next for America?

I noted 20 “What’s Next?” things.

It’s a list of projections from an excellent must see video presentation by Jim Bianco. I added my own thoughts on the key points.

The bottom line is don’t expect a v-shaped recovery. We will not return to the old way of doing business.

Globalization is not over, but the rush to globalize everything is. This will impact earnings for years to come.

Finally, stimulus checks are on the way, but there will be no quick return to buying cars, eating out, or traveling as much.

Boomers who felt they finally had enough retirement money just had a quarter of it or more wiped out.

It will take a long time, if ever, for the same sentiment to return. Spending will not recover. Boomers will die first, and they are the ones with the most money.

The COVID19 Tripwire

“You better tuck that in. You’re gonna’ get that caught on a tripwire.Lieutenant Dan, Forrest Gump

There is a popular game called Jenga in which a tower of rectangular blocks is arranged to form a sturdy tower. The objective of the game is to take turns removing blocks without causing the tower to fall. At first, the task is as easy as the structure is stable. However, as more blocks are removed, the structure weakens. At some point, a key block is pulled, and the tower collapses. Yes, the collapse is a direct cause of the last block being removed, but piece by piece the structure became increasingly unstable. The last block was the catalyst, but the turns played leading up to that point had just as much to do with the collapse. It was bound to happen; the only question was, which block would cause the tower to give way?

A Coronavirus

Pneumonia of unknown cause first detected in Wuhan, China, was reported to the World Health Organization (WHO) on December 31, 2019. The risks of it becoming a global pandemic (formally labeled COVID-19) was apparent by late January. Unfortunately, it went mostly unnoticed in the United States as China was slow to disclose the matter and many Americans were distracted by impeachment proceedings, bullish equity markets, and other geopolitical disruptions.

The S&P 500 peaked on February 19, 2020, at 3393, up over 5% in the first two months of the year. Over the following four weeks, the stock market dropped 30% in one of the most vicious corrections of broad asset prices ever seen. The collapse erased all of the gains achieved during the prior 3+ years of the Trump administration. The economy likely entered a recession in March.

There will be much discussion and debate in the coming months and years about the dynamics of this stunning period. There is one point that must be made clear so that history can properly record it; the COVID-19 virus did not cause the stock and bond market carnage we have seen so far and are likely to see in the coming months. The virus was the passive triggering mechanism, the tripwire, for an economy full of a decade of monetary policy-induced misallocations and excesses leaving assets priced well beyond perfection.

Never-Ending Gains

It is safe to say that the record-long economic expansion, to which no one saw an end, ended in February 2020 at 128 months. To suggest otherwise is preposterous given what we know about national economic shutdowns and the early look at record Initial Jobless Claims that surpassed three million. Between the trough in the S&P 500 from the financial crisis in March 2009 and the recent February peak, 3,999 days passed. The 10-year rally scored a total holding-period return of 528% and annualized returns of 18.3%. Although the longest expansion on record, those may be the most remarkable risk-adjusted performance numbers considering it was also the weakest U.S. economic expansion on record, as shown below.

They say “being early is wrong,” but the 30-day destruction of valuations erasing over three years of gains, argues that you could have been conservative for the past three years, kept a large allocation in cash, and are now sitting on small losses and a pile of opportunity with the market down 30%.

As we have documented time and again, the market for financial assets was a walking dead man, especially heading into 2020. Total corporate profits were stagnant for the last six years, and the optics of magnified earnings-per-share growth, thanks to trillions in share buybacks, provided the lipstick on the pig.

Passive investors indiscriminately and in most cases, unknowingly, bought $1.5 trillion in over-valued stocks and bonds, helping further push the market to irrational levels. Even Goldman Sachs’ assessment of equity market valuations at the end of 2019, showed all of their valuation measures resting in the 90-99th percentile of historical levels.

Blind Bond Markets

The fixed income markets were also swarming with indiscriminate buyers. The corporate bond market was remarkably overvalued with tight spreads and low yields that in no way offered an appropriate return for the risk being incurred. Investment-grade bonds held the highest concentration of BBB credit in history, most of which did not qualify for that rating by the rating agencies’ own guidelines. The junk bond sector was full of companies that did not produce profits, many of whom were zombies by definition, meaning the company did not generate enough operating income to cover their debt servicing costs. The same held for leveraged loans and collateralized loan obligations with low to no covenants imposed. And yet, investors showed up to feed at the trough. After all, one must reach for extra yield even if it means forgoing all discipline and prudence.

To say that no lessons were learned from 2008 is an understatement.

Black Swan

Meanwhile, as the markets priced to ridiculous valuations, corporate executives and financial advisors got paid handsomely, encouraging shareholders and clients to throw caution to the wind and chase the market ever higher. Thanks also to imprudent monetary policies aimed explicitly at propping up indefensible valuations, the market was at risk due to any disruption.

What happened, however, was not a slow leaking of the market as occurred leading into the 2008 crisis, but a doozy of a gut punch in the form of a pandemic. Markets do not correct by 30% in 30 days unless they are extremely overvalued, no matter the cause. We admire the optimism of formerly super-intelligent bulls who bought every dip on the way down. Ask your advisor not just to tell you how he is personally invested at this time, ask him to show you. You may find them to be far more conservative in their investment posture than what they recommend for clients. Why? Because they get paid on your imprudently aggressive posture, and they do not typically “eat their own cooking”. The advisor gets paid more to have you chasing returns as opposed to avoiding large losses.

Summary

We are facing a new world order of DE-globalization. Supply chains will be fractured and re-oriented. Products will cost more as a result. Inflation will rise. Interest rates, therefore, also will increase contingent upon Fed intervention. We have become accustomed to accessing many cheap foreign-made goods, the price for which will now be altered higher or altogether beyond our reach. For most people, these events and outcomes remain inconceivable. The widespread expectation is that at some point in the not too distant future, we will return to the relative stability and tranquility of 2019. That assuredly will not be the case.

Society as a whole does not yet grasp what this will mean, but as we are fond of saying, “you cannot predict, but you can prepare.” That said, we need to be good neighbors and good stewards and alert one another to the rapid changes taking place in our communities, states, and nation. Neither investors nor Americans, in general, can afford to be intellectually lazy.

The COVID-19 virus triggered these changes, and they will have an enormous and lasting impact on our lives much as 9-11 did. Over time, as we experience these changes, our brains will think differently, and our decision-making will change. Given a world where resources are scarce and our proclivity to – since it is made in China and “cheap” – be wasteful, this will probably be a good change. Instead of scoffing at the frugality of our grandparents, we just might begin to see their wisdom. As a nation, we may start to understand what it means to “save for a rainy day.”

Save, remember that forgotten word.

As those things transpire – maybe slowly, maybe rapidly – people will also begin to see the folly in the expedience of monetary and fiscal policy of the past 40 years. Expedience such as the Greenspan Put, quantitative easing, and expanding deficits with an economy at full employment. Doing “what works” in the short term often times conflicts with doing what is best for the most people over the long term.

Anatomy of The Bear. Lessons from Russell Napier.

One of my annual re-reads is Russell Napier’s classic tome “Anatomy of the Bear.”

A mandatory study for every financial professional and investor who seeks to understand not only how damaging bear markets can be but also the traits which mark their bottoms. Every bear is shaken from hibernation for different reasons. However, when studying the four great bottoms of bears in 1921, 1932, 1949 and 1982, there are several common traits to these horrendous cycles.  I thought it would be interesting to share them with you.

First, keep in mind, bear markets characteristically purge weakness – weak companies, weak advisors, weak investors. I want you to consider them less a bloodletting and more a cleansing of a system. There will be unsuitable investors who will never return to the market and justifiably so. Businesses that were patronized pre-Covid, will either be gone or completely reinvent. Bear markets slash equity valuations. Unfortunately, this doesn’t mean that stocks return to healthy valuations quickly after a bear departure. Some believe the global economy can turn on and off like a light switch without major repercussions. In other words,  the belief is once the worst of this horrid virus ceases,  business activity invariably will return to normal. I believe it’ll be quite the contrary.

I mentioned on the radio show in December that I expected wage growth to top out in 2019. Keep in mind, through this yet another outlier economic upheaval, there will be employers who will realize they don’t require as many employees and will let them go or cap their wages for years to rebuild profit margins. Without the tailwind of stock buybacks to equity prices, corporate employees will bear the brunt of the pain. In addition, organizations will realize many of their remaining employees are equipped to work from home and perhaps gather in-person perhaps once a month or every couple of weeks. Thus, large commercial space will no longer be required which is going to require massive reinvention by the commercial real estate industry.
The cry of nationalism will rise. Products manufactured overseas especially China, will take a hit which means Americans will face greater inflationary challenges while also dealing with muted or non-existent wage growth. We will experience ‘ more money chasing too-few goods.’ Many, especially younger generations will continue to strip themselves down to basics (I especially envision this in Generation Z;  those born in the mid-late 1990s such as my daughter Haley).  This sea-change will require most of the U.S. population to finally live below their means, dramatically downsize, reinvent, expand, the definition of wealth to include more holistic, ethereal methods that go way beyond household balance sheets and dollars.
I hope I’m wrong. So very wrong about most of what I envision for the future.
Here are several traits that every major market bottom share – courtesy of Russell Napier:

  1. Bears tend to die on low volume, at least the big bears do. 

Low volume represents a complete disinterest in stocks. Keep in mind this clearly contradicts the tenet which states that bears end with one act of massive capitulation – a  downward cascade on great volume. Those actions tend to mark the beginning of a bear cycle, not the end. A rise in volume on rebounds, falling volumes on weakness would better mark a bottoming process in a bear market.

2. Bears are tricky.

There will appear to be a recovery; an ‘all-clear’ for stock prices. It’ll suck in investors who believe the market recovery is upon us just to be financially ravaged again. Anecdotally, I know this cycle isn’t over as I still receive calls from people who are anxious to get into the market and perceive the current market a buying opportunity. At the bottom of a bear, I should be hearing great despair and clear disdain for stock investing.

3. Bears can be tenacious.

They refuse to die or at the least, quickly return to hibernation. The 1921 move from overvaluation to undervaluation took over ten years. Bear markets, where three-year price declines make overvalued equities cheap, are the exception, not the rule. As of this writing,  the Shiller P/E is at 24x – hardly a bargain.  At the bottom market cycle of the Great Recession, the Shiller CAPE was at 15x. There is still valuation adjustment ahead.

4. Bears can depart before earnings actually recover.

Investors who wait for a complete recovery in corporate earnings will arrive late to the stock-investment party.  Most likely it’s going to take a while (especially with their debt burden), for the majority of U.S. companies to reflect healthy earnings growth. CEOs who employ stock buybacks to boost EPS will be considered pariahs and gain unwanted attention from Congress and even the Executive Branch. My thought is a savvy investor should look to minimize indexing and select individual stocks with strong balance sheets which include low debt and plenty of free cash flow within sectors and industries that are nimble to adjust to the global economy post-crisis.

5. Bear market damage can be inconceivable, especially to a generation of investors who never experienced one.

The bear market of 1929-32 was characterized by an 89% decline. The average is 38% for bears;  however, averages are misleading. I have no idea how much damage this bear ultimately unleashes. The closest comparison I have is the 1929-1932 cycle. However, with the massive fiscal and monetary stimulus (and I don’t believe we’ve seen the full extent of it yet),  my best guess is a bear market contraction somewhere between the Great Depression and Great Recession. At the least, I believe we re-test lows and this bear is a 40-45% retracement from the highs.

6. Bear markets end on the return of general price stability and strong demand for durables such as autos.

In 1949, as in 1921 and 1932, a return of general price stability coincided with the end of the equity bear market. Demand and price stability of selected commodities augured well for general price stabilization.  Watch how industrial metals recover such as copper, now at the lowest levels since the fall of 2017. The Baltic Dry Index is off close to 20% so far this year. Low valuations (not there yet), when combined with a return to normalcy in the general price level, may provide the best opportunity for future above-average equity returns. We are not there.

7. Bear markets that no longer decline on bad news are a positive.

The combination of large short positions in conjunction with a market that fails to decline on bad news was overall a positive indicator of a rebound in 1921, 1932 and 1949. Also, limited stock purchases by retail investors may be considered an important building block for a bottom.  Since the worst of economic numbers haven’t been witnessed yet, there remains too much hope of a vicious recovery in stock prices as well as the overall global economies.

8. Not all bear markets lead the economy by six-to-nine months.

Generally, markets lead the economy. However, this tenet failed to hold true for the four great bears. At extreme times, the bottoms for the economy and the equity market were aligned and in several cases, the economy LED stocks higher!  It’s unclear whether this bear behaves in a similar fashion only because of massive fiscal and monetary stimulus. We’re not done with stimulus methods either. If anything, they’ve just begun! I know. Tough to fathom.

For me and the RIA Team, every bear provides an important lesson. The beast comes in all sizes; their claws differ in sharpness. However, they are all dangerous to financial wealth.

I believe the market will eventually witness a “V” shaped recovery due to unprecedented stimulus. Unfortunately, I believe the economy will remain sub-par for a long period. Here’s a vision I shared on Facebook recently:

Let me give you one example how an economy cannot turn off, then on, like a light switch.

Joe’s Donuts is closed. Joe lets his 2 employees go, at least temporarily. Joe employs his wife Emily to assist as she’s just been laid off from her job. Joe is a quick thinker. He creates pre-packaged dough-to-go bags and sells them outside the store. His sales are off 75% as most businesses around him are shuttered. Joe was able to negotiate postponement of his rent for one month but will have to pay two months in May.

Joe has a profitable business but he’s already eaten through a quarter of his cash reserves to pay for supplies, maintain expenses to keep going. He can’t afford another month of quarantine.

The quarantine is lifted May 1 (best case scenario). Joe’s establishment is open! He’s hesitant to have employees return because he wants to gauge business for a month. He discovers that business is still off 40% from last year at the same time. Why? Because his patrons have either been let go or in repair of ravaged household balance sheets. In addition, he notices that purchasing boxes of donuts for office meetings is way off.

Joe contacts his former 2 employees. He tells them he still doesn’t require them. He’s handling the traffic sufficiently alone at this time. Joe now owes 2 months of rent. He takes one month from the business’ reserve account; distributes another from his retirement account.

Joe’s wife Ellen has been called back to work by her former employer, a local car dealership. She’s been asked to work the same job, same responsibilities. However, the pay is 10% less. Out of desperation, she takes the job. Meanwhile, Joe tells Ellen that they need to find a way to continue to cut household expenses…. Well, you get the picture.

I think this is reality for at least a year after the ‘all clear.’

There’s never been a better time to catch up on reading. Russell’s book is available through Amazon. For those interested in market history,  the pages hold invaluable insights.

For me, markets are always battlefields, but I’ve survived several conflicts.

Consider “Anatomy of The Bear,” part of your financial literary war chest.

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.

Fed Trying To Inflate A 4th Bubble To Fix The Third

Over the last couple of years, we have often discussed the impact of the Federal Reserve’s ongoing liquidity injections, which was causing distortions in financial markets, mal-investment, and the expansion of the “wealth gap.” 

Our concerns were readily dismissed as bearish as asset prices were rising. The excuse:

“Don’t fight the Fed”

However, after years of zero interest rates, never-ending support of accommodative monetary policy, and a lack of regulatory oversight, the consequences of excess have come home to roost. 

This is not an “I Told You So,” but rather the realization of the inevitable outcome to which investors turned a blind-eye too in the quest for “easy money” in the stock market. 

It’s a reminder of the consequences of “greed.” 

The Liquidity Trap

We previously discussed the “liquidity trap” the Fed has gotten themselves into, along with Japan, which will plague economic growth in the future. To wit:

“The signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

Our “economic composite” indicator is comprised of 10-year rates, inflation (CPI), wages, and the dollar index. Importantly, downturns in the composite index leads GDP. (I have estimated the impact to GDP for the first quarter at -2% growth, but my numbers may be optimistic)

The Fed’s problem is not only are they caught in an “economic liquidity trap,” where monetary policy has become ineffective in stimulating economic growth, but are also captive to a “market liquidity trap.”

Whenever the Fed, or other Global Central Banks, have engaged in “accommodative monetary policy,” such as QE and rate cuts, asset prices have risen. However, general economic activity has not, which has led to a widening of the “wealth gap” between the top 10% and the bottom 90%. At the same time, corporations levered up their balance sheets, and used cheap debt to aggressively buy back shares providing the illusion of increased profitability while revenue growth remained weak. 

As I have shown previously, while earnings have risen sharply since 2009, it was from the constant reduction in shares outstanding rather than a marked increase in revenue from a strongly growing economy. 

Now, the Fed is engaged in the fight of its life trying to counteract a “credit-event” which is larger, and more insidious, than what was seen during the 2008 “financial crisis.”  

Over the course of the next several months, the Federal Reserve will increase its balance sheet towards $10 Trillion in an attempt to stop the implosion of the credit markets. The liquidity being provided may, or may not be enough, to offset the risk of a global economy which is levered roughly 3-to-1 according to CFO.com:

“The global debt-to-GDP ratio hit a new all-time high in the third quarter of 2019, raising concerns about the financing of infrastructure projects.

The Institute of International Finance reported Monday that debt-to-GDP rose to 322%, with total debt reaching close to $253 trillion and total debt across the household, government, financial and non-financial corporate sectors surging by some $9 trillion in the first three quarters of 2019.”

Read that last part again.

In 2019, debt surged by some $9 Trillion while the Fed is injecting roughly $6 Trillion to offset the collapse. In other words, it is likely going to require all of the Fed’s liquidity just to stabilize the debt and credit markets. 

Bubbles, Bubbles, Bubbles

Jerome Powell clearly understands that after a decade of monetary infusions and low interest rates, he has created an asset bubble larger than any other in history. However, they were trapped by their own policies, and any reversal led to almost immediate catastrophe as seen in 2018.

As I wrote previously:

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s.”

For quite some time now, we have warned investors against the belief that no matter what happens, the Fed can bail out the markets, and keep the bull market. Nevertheless, it was widely believed by the financial media that, to quote Dr. Irving Fisher:

“Stocks have reached a permanently high plateau.”

What is important to understand is that it was imperative for the Fed that market participants, and consumers, believed in this idea. With the entirety of the financial ecosystem more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the “instability of stability” was the most significant risk. 

“The ‘stability/instability paradox’ assumes that all players are rational, and such rationality implies avoidance of complete destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’”

The Fed had hoped they would have time, and the “room” needed, after more than 10-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that had built up in the system. 

Unfortunately, they ran out of time, and the markets stopped “acting rationally.”

This is the predicament the Federal Reserve currently finds itself in. 

Following each market crisis, the Fed has lowered interest rates, and instituted policies to “support markets.” However, these actions led to unintended consequences which have led to repeated “booms and busts” in the financial markets.  

While the market has currently corrected nearly 25% year-to-date, it is hard to suggest that such a small correction will reset markets from the liquidity-fueled advance over the last decade.

To understand why the Fed is trapped, we have to go back to what Ben Bernanke said in 2010 as he launched the second round of QE:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

I highlight the last sentence because it is the most important. Consumer spending makes up roughly 70% of GDP; therefore increased consumer confidence is critical to keeping consumers in action. The problem is the economy is no longer a “productive” economy, but rather a “financial” one. A point made by Ellen Brown previously:

“The financialized economy – including stocks, corporate bonds and real estate – is now booming. Meanwhile, the bulk of the population struggles to meet daily expenses. The world’s 500 richest people got $12 trillion richer in 2019, while 45% of Americans have no savings, and nearly 70% could not come up with $1,000 in an emergency without borrowing.

Central bank policies intended to boost the real economy have had the effect only of boosting the financial economy. The policies’ stated purpose is to increase spending by increasing lending by banks, which are supposed to be the vehicles for liquidity to flow from the financial to the real economy. But this transmission mechanism isn’t working, because consumers are tapped out.”

This was shown in a recent set of studies:

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.”

As I stated previously:

“If consumption retrenches, so does the economy.

When this happens debt defaults rise, the financial system reverts, and bad things happen economically.”

That is where we are today. 

The Federal Reserve is desperate to “bail out” the financial and credit markets, which it may  be successful in doing, however, the real economy may not recover for a very long-time. 

With 70% of employment driven by small to mid-size businesses, the shutdown of the economy for an extended period of time may eliminate a substantial number of businesses entirely. Corporations are going to retrench on employment, cut back on capital expenditures, and close ranks. 

While the Government is working on a fiscal relief package, it will fall well short of what is needed by the overall economy and a couple of months of “helicopter money,” will do little to revive an already over leveraged, undersaved, consumer. 

The 4th-Bubble

As I stated previously:

“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.”

The implosion of the credit markets made rate reductions completely ineffective and has pushed the Fed into the most extreme monetary policy bailout in the history of the world. 

The Fed is hopeful they can inflate another asset bubble to restore consumer confidence and stabilize the functioning of the credit markets. The problem is that since the Fed never unwound their previous policies, current policies are having a much more muted effect. 

However, even if the Fed is able to inflate another bubble to offset the damage from the deflation of the last bubble, there is little evidence it is doing much to support economic growth, a broader increase in consumer wealth, or create a more stable financial environment. 

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade, and there is little evidence that growth will recover following this crisis to the degree many anticipate.

There are numerous problems which the Fed’s current policies can not fix:

  • 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 in the U.S., remains demographics, and interest rates. As the aging population grows, they are becoming a net drag on “savings,” the dependency on the “social welfare net” will explode as employment and economic stability plummets, and the “pension problem” has yet to be realized.

While the current surge in QE may indeed be successful in inflating another bubble, 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 already been reached.

One thing is for certain, the Federal Reserve will never be able to raise rates, or reduce monetary policy ever again. 

Welcome to United States of Japan.

Why QE Is Not Working

The process by which money is created is so simple that the mind is repelled.” – JK Galbraith

By formally announcing quantitative easing (QE) infinity on March 23, 2020, the Federal Reserve (Fed) is using its entire arsenal of monetary stimulus. Unlimited purchases of Treasury securities and mortgage-backed securities for an indefinite period is far more dramatic than anything they did in 2008. The Fed also revived other financial crisis programs like the Term Asset-Backed Securities Loan Facility (TALF) and created a new special purpose vehicle (SPV), allowing them to buy investment-grade corporate bonds and related ETF’s. The purpose of these unprecedented actions is to unfreeze the credit markets, stem financial market losses, and provide some ballast to the economy.

Most investors seem unable to grasp why the Fed’s actions have been, thus far, ineffective. In this article, we explain why today is different from the past. The Fed’s current predicament is unique as they have never been totally up against the wall of zero-bound interest rates heading into a crisis. Their remaining tools become more controversial and more limited with the Fed Funds rate at zero. Our objective is to assess when the monetary medicine might begin to work and share our thoughts about what is currently impeding it.

All Money is Lent in Existence.

That sentence may be the most crucial concept to understand if you are to make sense of the Fed’s actions and assess their effectiveness.

Under the traditional fractional reserve banking system run by the U.S. and most other countries, money is “created” via loans. Here is a simple example:

  • John deposits a thousand dollars into his bank
  • The bank is allowed to lend 90% of their deposits (keeping 10% in “reserves”)
  • Anne borrows $900 from the same bank and buys a widget from Tommy
  • Tommy then deposits $900 into his checking account at the same bank
  • The bank then lends to someone who needs $810 and they spend that money, etc…

After Tommy’s deposit, there is still only $1,000 of reserves in the banking system, but the two depositors believe they have a total of $1,900 in their bank accounts.  The bank’s accountants would confirm that. To make the bank’s accounting balance, Anne owes the bank $900. The money supply, in this case, is $1,900 despite the amount of real money only being $1,000.

That process continually feeds off the original $1,000 deposit with more loans and more deposits. Taken to its logical conclusion, it eventually creates $9,000 in “new” money through the process from the original $1,000 deposit.

To summarize, we have $1,000 in deposited funds, $10,000 in various bank accounts and $9,000 in new debt. While it may seem “repulsive” and risky, this system is the standard operating procedure for banks and a very effective and powerful tool for generating profits and supporting economic growth. However, if everyone wanted to take their money out at the same time, the bank would not have it to give. They only have the original $1,000 of reserves.

How The Fed Operates

Manipulating the money supply through QE and Fed Funds targeting are the primary tools the Fed uses to conduct monetary policy. As an aside, QE is arguably a controversial blend of monetary and fiscal policy.

When the Fed provides banks with reserves, their intent is to increase the amount of debt and therefore the money supply. As such, more money should result in lower interest rates. Conversely, when they take away reserves, the money supply should decline and interest rates rise. It is important to understand, the Fed does not set the Fed Funds rate by decree, but rather by the aforementioned monetary actions to incentivize banks to increase or reduce the money supply.

The following graph compares the amount of domestic debt outstanding versus the monetary base.

Data Courtesy: St. Louis Federal Reserve

Why is QE not working?

So with an understanding of how money is created through fractional reserve banking and the role the Fed plays in manipulating the money supply, let’s explore why QE helped boost asset prices in the past but is not yet potent this time around.

In our simple banking example, if Anne defaults on her loan, the money supply would decline from $1,900 to $1,000. With a reduced money supply, interest rates would rise as the supply of money is more limited today than yesterday. In this isolated example, the Fed might purchase bonds and, in doing so, conjure reserves onto bank balance sheets through the magic of the digital printing press. Typically the banks would then create money and offset the amount of Anne’s default.  The problem the Fed has today is that Anne is defaulting on some of her debt and, at the same time, John and Tommy need and want to withdraw some of their money.

The money supply is declining due to defaults and falling asset prices, and at the same time, there is a greater demand for cash. This is not just a domestic issue, but a global one, as the U.S. dollar is the world’s reserve currency.

For the Fed to effectively stimulate financial markets and the economy, they first have to replace the money which has been destroyed due to defaults and lower asset prices. Think of this as a hole the Fed is trying to fill. Until the hole is filled, the new money will not be effective in stimulating the broad economy, but instead will only help limit the erosion of the financial system and yes, it is a stealth form of bailout. Again, from our example, if the banks created new money, it would only replace Anne’s default and would not be stimulative.

During the latter part of QE 1, when mortgage defaults slowed, and for all of the QE 2 and QE 3 periods, the Fed was not “filling a hole.” You can think of their actions as piling dirt on top of a filled hole.

These monetary operations enabled banks to create more money, of which a good amount went mainly towards speculative means and resulted in inflated financial asset prices. It certainly could have been lent toward productive endeavors, but banks have been conservative and much more heavily regulated since the crisis and prefer the liquid collateral supplied with market-oriented loans.

QE 4 (Treasury bills) and the new repo facilities introduced in the fall of 2019 also stimulated speculative investing as the Fed once again piled up dirt on top of a filled hold.  The situation changed drastically on February 19, 2020, as the virus started impacting perspectives around supply chains, economic growth, and unemployment in the global economy. Now QE 4, Fed-sponsored Repo, QE infinity, and a smorgasbord of other Fed programs are required measures to fill the hole.

However, there is one critical caveat to the situation.

As stated earlier, the Fed conducts policy by incentivizing the banking system to alter the supply of money. If the banks are concerned with their financial situation or that of others, they will be reluctant to lend and therefore impede the Fed’s efforts. This is clearly occurring, making the hole progressively more challenging to fill. The same thing happened in 2008 as banks became increasingly suspect in terms of potential losses due to their exorbitant leverage. That problem was solved by changing the rules around how banks were required to report mark-to-market losses by the Federal Accounting Standards Board (FASB). Despite the multitude of monetary and fiscal policy stimulus failures over the previous 18 months, that simple re-writing of an accounting rule caused the market to turn on a dime in March 2009. The hole was suddenly over-filled by what amounted to an accounting gimmick.

Summary

Are Fed actions making headway on filling the hole, or is the hole growing faster than the Fed can shovel as a result of a tsunami of liquidity problems? A declining dollar and stability in the short-term credit markets are essential gauges to assess the Fed’s progress.

The Fed will eventually fill the hole, and if the past is repeated, they will heap a lot of extra dirt on top of the hole and leave it there for a long time. The problem with that excess dirt is the consequences of excessive monetary policy. Those same excesses created after the financial crisis led to an unstable financial situation with which we are now dealing.

While we must stay heavily focused on the here and now, we must also consider the future consequences of their actions. We will undoubtedly share more on this in upcoming articles.

America: WILL WE FINALLY LEARN A LESSON?

Much of what passes for orthodoxy in economics and finance proves, on closer examination, to be shaky business.” The Misbehavior of Markets – by Benoit Mandelbrot & Richard L. Hudson.

If as households we do crumble financially yet another time, will this ‘outlier’ event finally teach us a valuable lesson? One we’ll never forget (again)? I mean, how many Black Swans or events that create wholesale economic and financial devastation must we endure to work diligently, effortlessly, to shore up our family’s finances?

Unfortunately, as humans, we focus on risk and financial stability too late. Always. Too. Late. We are creatures of complacency and mainstream financial advice does nothing but fuel our overconfidence bias. Only when a storm is upon us, wreaking havoc, do we seek to board the windows and secure what’s important to us. 

We’re cajoled by ‘experts’ during good times. We’re taught how outlier events occur every 1,000 years. Strange how rare occurrences aren’t so rare. They seem to happen every decade. So, let me ask you – How many times do these so-called ‘rare’ events need to occur before fiscal discipline becomes a priority for all of us?

Over the last three years, at RIA we have created several financial tenets to guard against financial vulnerability. I don’t mean to preach; I mean to teach.

I hope over the next few years, once this pandemic is past and we rummage through the economic rubble, we’ll take it upon ourselves to remain vigilant through the complacency and take the following rules to heart.

1. A painful reminder about the ‘buy and hold’ investment philosophy or whatever horrid expletive you’re probably calling it right now.

Never forget that convincing words, piles of academic studies and mined data from big-box financial retailers in pretty packages make it easy to share convincing stories to push stocks. Hopefully, investors who spent most of their time and money getting back to even remain comforted by the narratives. They’ll now do it again.

I’ll admit – I’m nonplussed by the appeal of buy-and-hold to the purists. I truly envy them.

It seems to be a “What Me Worry?” kind of existence. There seems to be an eerie comfort to throwing money into a black hole of overvalued investments and hoping that it transforms into a white light of wealth 20 years down the road (even if it’s a very dim bulb). I truly wish I could be convinced that a blind buy-and-hold fable is truth.

I so passionately want investors to achieve returns and exceed their financial life benchmarks or goals; it’s good for me too. I also would like to minimize the damage from bears. Is that too much to ask?

At Real Investment Advice we think it’s one of a money manager’s primary responsibilities.

Buy-and-hold at the core wrapped in rules of risk management is a healthy, long-term strategy to build and protect wealth. That’s what we’re doing at this juncture.

If you’re completely out of the market for an extended period, I mean zilch, zero, then stock investing may not be appropriate for you. Hey, it isn’t for everyone, especially today when the flood of central bank liquidity (I’ve never witnessed anything like it), algos (the robots), probably $4 trillion in fiscal stimulus coming, tries to stem the devastation. The bull market is dead, a bear is tricky to navigate. I am grateful to be a partner at a firm where all members understand the devastation of bear markets and are not ‘deer in headlights’ as this crisis is upon us. Take heart – the bear will die; the bull will run again. As investors we will bleed. The key is not to hemorrhage. There is a difference.

It’s not too late to undertake a quick gut check – Realize that an allocation of 10-20% to domestic and international stocks can drop 40% on average in bear markets. Investors fail to realize that diversifying between foreign and U.S. stocks doesn’t manage the risk they care about most – risk of principal loss. We are witnessing this now – one more time on the disaster hit parade. The world has become increasingly an Irwin Allen (The Poseidon Adventure; The Towering Inferno), film and we are the actors.

Let’s say your retirement plan balance is $90,000. In a conservative allocation, $18,000 (20%), may be allocated to stocks. If a bear cycle takes the stock balance down to $10,800 and makes you a bit queasy, then certainly the market doesn’t fit into your overall investment philosophy.

If you do have the intestinal fortitude to maintain an allocation to stocks, your financial partner is a buy-and-hold zealot (highly likely), and you haven’t taken profits (a tenet of risk management) or rebalanced this year, then there’s still an opportunity to do so on rallies. It’s acceptable to maintain additional cash as much as buy-and-hold purists abhor cash.   

You’re not the ‘idiot’ who sells at the bottom just because you adhere to rules of risk management.

Granted, investors can be their worst emotional enemies. If risk management rules are employed as an integration to an overall investment process, then selling at the very bottom may be avoided. From my experience, the dumbest actions of those who did sell at the bottom in March 2009, rest almost solely on their brokers.

You see, if financial professionals would have empathized with their clients and took enough (any) action to preserve capital as clients were calling with concern in late 2007, maybe, just maybe, those distressed investors wouldn’t have sold out of everything pretty much at the bottom.

The advice “not to worry, markets always come back,” regurgitated repeatedly did nothing to allay concerns; frankly hollow words made brokers appear as if they employed market blinders or were in a state of denial. They appeared ignorant, not aware of the severity of the crisis.

I listened enough to begin surgically trimming positions (I explained to clients we sought to take a scalpel, not a machete to reducing stock exposure in portfolios), and was proactive to sell clients out of a Charles Schwab bond fund described as “stable in price,” an “alternative to cash,” in November 2007 when the mutual fund share price was doing nothing but faltering.

Although Schwab portfolio management assured us in the field repeatedly that there was “nothing wrong with the fund,” and it wasn’t suffering mass redemptions, it did eventually go bust and Schwab was held accountable for lack of oversight.

Unfortunately, the company got off easy as the settlement with the SEC was nothing but a financial slap on the wrist when the fund held $13.5 billion at its peak.

You tell me this stuff isn’t rigged against retail investors? I believe differently. I always will.

Proactive behavior allowed me to maintain a semblance of stock ownership and then begin to increase exposure through the summer of 2009.  I deemed it buy-and-hold with a “protective twist.”

If your broker isn’t actively listening and is discounting concerns, it’s time to replace him or her. Answers received should be thorough and backed by analysis.

If you must invest today, consider dollar-cost averaging.

Usually, dollar-cost averaging where you add a fixed dollar amount to variable investments on a regular schedule, underperforms value or lump-sum investing. Unless the cyclically adjusted price-to-earnings ratio or CAPE exceeds 18.6 (today, it exceeds 25).

An impressive analysis and paper by Jon M. Luskin, CFP® for the Journal of Financial Planning titled “Dollar-Cost Averaging Using the CAPE Ratio: An Identifiable Trend Influencing Outperformance,” outlines how investment periods with a CAPE greater than 18.6 is beneficial to dollar-cost averaging with investment returns .45% greater than lump-sum investing.

The other side of the coin of buy-and-hold isn’t active trading.

Cop out. Lame excuse. I can’t be clearer. Not only are you branded a ‘bear’ if you employ a sell discipline, it appears that the buy-and-hold purists can’t think outside of extremes. They tend to associate selling with active trading. It’s a clever ploy designed to avoid the conversation or even the thought of a sell process. It’s just impossible.

Not it isn’t. And it isn’t active trading either. Active trading isn’t going to generate returns, just activity. Plus, if you consider that trades cost ZERO at most big-box financial retailers, transaction costs aren’t a concern anymore.

For years, the investment industry has tried to scare clients into staying fully invested in the stock market, no matter how high stocks go or what’s going on in the economy. Investors are repeatedly warned that doing anything otherwise is simply foolish because “you can’t time the market.” 

Here’s why per Lance Roberts:

“Wall Street firms, despite what the media advertising tells you, are businesses. As a business, their job is to develop and deliver products to investors in whatever form investor appetites demand…Wall Street is always happy to provide ‘products’ to the consumers they serve.

As Wall Street quickly figured out that it was far more lucrative to collect ongoing fees rather than a one-time trading commission…The mutual fund business was booming, and business was ‘brisk’ on Wall Street as profits surged.”

I’ll add:

Frankly, it’s too much work. Financial experts are primarily peddlers of managed products. They’re hired to regurgitate sell-side biased data mined from their employer’s research department. What they’re implying is they’re too busy meeting sales goals to consider risk management (the way you define it as an investor), important.

With that being said, consider other rules to protect your household for when the next ‘outlier’ event occurs (I mean, after this one).

 2. The FVC – The Financial Vulnerability Cushion.

The main purpose of the Financial Vulnerability Cushion is to fortify the foundation of a financial house. You’ve heard about maintaining three to six months of living expenses in cash for emergencies. Well, define an emergency. The car breaks down, sure. The A/C goes out? Right. Expenses such as these fit well into a three to six-month cash cushion. However, Black Swan events remind us this cushion isn’t enough.  We must finally learn to separate emergency from crisis.

Over the last six months we’ve been discussing on the radio how important it is to build a cash war chest of one to two years’ worth of living expenses and maintain it above everything else. These reserves are for crisis. A sudden job loss; major illness. Unfortunately, millions will be out of work here. Some, long term. I’m increasingly concerned about those who work in the energy sector. Never forget. Don’t listen to mainstream financial media again. Remember this time and work diligently to build a FVC.

3. Create financial rules around debt control and savings. Then stick to them. No matter what. Good times or bad.

Consider strict debt management and savings habits as the blend of robust soil which allows opportunities to be realized. Excessive debt and limited ability to buffer against financial emergencies and crisis can limit a person’s ability to take on riskier but rewarding ventures like career change, entrepreneurial endeavors and risks that may lead to significant, long-term wealth.

Mortgage debt: Primary residence mortgage = 2X gross salary.

Student loan debt:  Limited to one year’s worth of total expense, tuition, room & board, expenses.

Personal, unsecured debt (credit card, auto): No more than 25% of gross monthly household income.

4. Be smarter with credit.

Today, credit cards are used for various reasons – convenience, cash back, travel reward points and the most unfortunate, to meet ongoing living expenses in the face of structural wage stagnation. So, consider the following.

Credit Card Debt = No greater than 4% of monthly gross income.

If your household gross income is $50,000 then credit card debt shouldn’t exceed $2,000. Per WalletHub, Texas ranks 46 with $2,848 in average credit card debt.

Survival tip: Take control of your money. Contact your credit card provider today and request a lower interest rate, perhaps the favorable balance transfer rate along with delayed payments. We are in this catastrophe together and it’s the least they can do for at least the rest of the year.

Car Loan Debt-to-Income Ratio:

Cars are required like breathing here in Houston and Texas, overall. However, they are not investments. Their values do not appreciate. If anything, auto values decrease as soon as you drive away from the dealership.

Car Loan Obligation = No greater than 25% of monthly gross income.

For example, a household bringing in $60,000 a year shouldn’t have more than $15,000 in outstanding auto loan debt. In my household, the ratio is less than 10%. I drive a Toyota RAV4. Put your ego aside; consider reliability first.

As I complete interviews with media and news outlets in Houston and across the country, my heart is overwhelmed with sorrow for those who are suffering through this, yet another ‘rare’ historical episode.

Please reach out to our team with questions and for guidance.

Every question is a good question.

Never be afraid to ask.

Shedlock: Fed Trying To Save The Bond Market As Unemployment Explodes

Bond market volatility remains a sight to behold, even at the low end of the curve.

Bond Market Dislocations Remain

The yield on a 3-month T-Bill fell to 1.3 basis points then surged to 16.8 basis points in a matter of hours. The yield then quickly crashed to 3 basis points and now sits at 5.1 basis points.

The Fed is struggling even with the low end of the Treasury curve.

$IRX 3-Month Yield

Stockcharts shows the 3-month yield ($IRX) dipping below zero but Investing.Com does not show the yield went below zero.

Regardless, these swings are not normal.

Cash Crunch

Bloomberg reports All the Signs a Cash Crunch Is Gripping Markets and the Economy

In a crisis, it is said, all correlations go to one. Threats get so overwhelming that everything reacts in unison. And the common thread running through all facets of financial markets and the real economy right now is simple: a global cash crunch of epic proportions.

Investors piled $137 billion into cash-like assets in the five days ending March 11, according to a Bank of America report citing EPFR Global data. Its monthly fund manager survey showed the fourth-largest monthly jump in allocations to cash ever, from 4% to 5.1%.

“Cash has become the king as the short-term government funds have had massive deposits, with ~$13 billion inflows last week (a 10-standard deviation move),” adds Maneesh Dehspande, head of equity derivatives strategy at Barclays.

4th Largest Jump in History

It’s quite telling that a jump of a mere 1.1 percentage point to 5.1% cash is the 4th largest cash jump in history.

Margin and Short Covering

“In aggregate, the market saw a large outflow, with $9 billion of long liquidation and $6 billion of short covering,” said Michael Haigh, global head of commodity research at Societe Generale. “This general and non-directional closure of money manager positions could be explained by a need for cash to pay margin calls on other derivatives contracts.

The comment is somewhat inaccurate. Sideline cash did not change “in aggregate” although cash balances t various fund managers did.

This is what happens when leveraged longs get a trillion dollar derivatives margin call or whatever the heck it was.

Need a Better Hedge

With the S&P 500 down more than 12% in the five sessions ending March 17, the Japanese yen is weaker against the greenback, the 10-year Treasury future is down, and gold is too.

That’s another sign dollars are top of mind, and investors are selling not only what they want to, but also what they have to.

Dash to Cash

It’s one thing to see exchange-traded products stuffed full of relatively illiquid corporate bonds trade below the purported sum of the value of their holdings. It’s quite another to see such a massive discount develop in a more plain-vanilla product like the Vanguard Total Bond Market ETF (BND) as investors ditched the product to raise cash despite not quite getting their money’s worth.

The fund closed Tuesday at a discount of nearly 2% to its net asset value, which blew out to above 6% last week amid accelerating, record outflows. That exceeded its prior record discount from 2008.

It is impossible for everyone to go to cash at the same time.

Someone must hold every stock, every bond and every dollar.

Fed Opens More Dollar Swap Lines

Moments ago Reuters reported Fed Opens Dollar Swap Lines for Nine Additional Foreign Central Banks.

The Fed said the swaps, in which the Fed accepts other currencies in exchange for dollars, will for at least the next six months allow the central banks of Australia, Brazil, South Korea, Mexico, Singapore, Sweden, Denmark, Norway and New Zealand to tap up to a combined total of $450 billion, money to ensure the world’s dollar-dependent financial system continues to function.

The new swap lines “like those already established between the Federal Reserve and other central banks, are designed to help lessen strains in global U.S. dollar funding markets, thereby mitigating the effects of these strains on the supply of credit to households and businesses, both domestically and abroad,” the Fed said in a statement.

The central banks of South Korea, Singapore, Mexico and Sweden all said in separate statements they intended to use them.

Fed Does Another Emergency Repo and Relaunches Commercial Paper Facility

Yesterday I commented Fed Does Another Emergency Repo and Relaunches Commercial Paper Facility

Very Deflationary Outcome Has Begun: Blame the Fed

The Fed is struggling mightily to alleviate the mess it is largely responsible for.

I previously commented a Very Deflationary Outcome Has Begun: Blame the Fed

The Fed blew three economic bubbles in succession. A deflationary bust has started. They blew bubbles trying to prevent “deflation” defined as falling consumer prices.


BIS Deflation Study

The BIS did a historical study and found routine price deflation was not any problem at all.

“Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the BIS study.

For a discussion of the study, please see Historical Perspective on CPI Deflations: How Damaging are They?

Deflation is not really about prices. It’s about the value of debt on the books of banks that cannot be paid back by zombie corporations and individuals.

Blowing bubbles in absurd attempts to arrest “price deflation” is crazy. The bigger the bubbles the bigger the resultant “asset bubble deflation”. Falling consumer prices do not have severe negative repercussions. Asset bubble deflations are another matter.

Assessing the Blame

Central banks are not responsible for the coronavirus. But they are responsible for blowing economic bubbles prone to crash.

The equities bubbles before the coronavirus hit were the largest on record.

Dollar Irony

The irony in this madness is the US will be printing the most currency and have the biggest budget deficits as a result. Yet central banks can’t seem to get enough dollars. In that aspect, the dollar ought to be sinking.

But given the US 10-year Treasury yield at 1.126% is among the highest in the world, why not exchange everything one can for dollars earning positive yield.

This is all such circular madness, it’s hard to say when or how it ends.

Unemployment Set To Explode

A SurveyUSA poll reveals 9% of the US is out of a job due to the coronavirus.

Please consider the Results of SurveyUSA Coronavirus News Poll.

Key Findings

  1. 9% of Working Americans (14 Million) So Far Have Been Laid Off As Result of Coronavirus; 1 in 4 Workers Have Had Their Hours Reduced;
  2. 2% Have Been Fired; 20% Have Postponed a Business Trip; Shock Waves Just Now Beginning to Ripple Through Once-Roaring US Economy:
  3. Early markers on the road from recession to depression as the Coronavirus threatens to stop the world from spinning on its axis show that 1 in 4 working Americans have had their hours reduced as a result of COVID-19, according to SurveyUSA’s latest time-series tracking poll conducted 03/18/20 and 03/19/20.
  4. Approximately 160 million Americans were employed in the robust Trump economy 2 months ago. If 26% have had their hours reduced, that translates to 41 million Americans who this week will take home less money than last, twice as many as SurveyUSA found in an identical poll 1 week ago. Time-series tracking graphs available here.
  5. 9% of working Americans, or 14 million of your friends and neighbors, will take home no paycheck this week, because they were laid off, up from 1% in an identical SurveyUSA poll 1 week ago. Time-series tracking graphs available here.
  6. Unlike those laid-off workers who have some hope of being recalled once the worst of the virus has past, 2% of Americans say they have lost their jobs altogether as a result of the virus, up from 1% last week.
  7. Of working Americans, 26% are working from home either some days or every day, up from 17% last week. A majority, 56%, no longer go to their place of employment, which means they are not spending money on gasoline or transit tokens.

About: SurveyUSA interviewed 1,000 USA adults nationwide 03/18/20 through 03/19/20. Of the adults, approximately 60% were, before the virus, employed full-time or part-time outside of the home and were asked the layoff and reduced-hours questions. Approximately half of the interviews for this survey were completed before the Big 3 Detroit automakers announced they were shutting down their Michigan assembly lines. For most Americans, events continue to unfold faster than a human mind is able to process the consequences.

Grim Survey of Reduced Hours

Current Unemployment Stats

Data from latest BLS Jobs Report.

If we assume the SurveyUSA numbers are accurate and will not get worse, we can arrive at some U3 and U6 unemployment estimates.

Baseline Unemployment Estimate (U3)

  • Unemployed: 5.787 million + 14 million = 19.787 million unemployed
  • Civilian Labor Force: 164.546 million (unchanged)
  • Unemployment Rate: 19.787 / 164.546 = 12.0%

That puts my off the top of the head 15.0% estimate a few days in the ballpark.

Underemployment Estimate (U6)

  • Employed: 158.759 million.
  • 26% have hours reduced = 41.277 million
  • Part Time for Economic Reasons: 4.318 million + 41.277 million = 45.595 million underemployed
  • 45.595 million underemployed + 19.787 million unemployed = 65.382 million
  • Civilian Labor Force: 164.546 million (unchanged)
  • U6 Unemployment Rate: 65.382 / 164.546 = 39.7%

Whoa Nellie

Wow, that’s not a recession. A depression is the only word.

Note that economists coined a new word “recession” after the 1929 crash and stopped using the word depression assuming it would never happen again.

Prior to 1929 every economic slowdown was called a depression. So if you give credit to the Fed for halting depressions, they haven’t. Ity’s just a matter of semantics.

Depression is a very fitting word if those numbers are even close to what’s going to happen.

Meanwhile, It’s no wonder the Fed Still Struggles to Get a Grip on the Bond Market and there is a struggled “Dash to Cash”.

Very Deflationary Outcome Has Begun: Blame the Fed

The Fed is struggling mightily to alleviate the mess it is largely responsible for.

I previously commented a Very Deflationary Outcome Has Begun: Blame the Fed

The Fed blew three economic bubbles in succession. A deflationary bust has started. They blew bubbles trying to prevent “deflation” defined as falling consumer prices.

BIS Deflation Study

The BIS did a historical study and found routine price deflation was not any problem at all.

“Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the BIS study.

For a discussion of the study, please see Historical Perspective on CPI Deflations: How Damaging are They?

Deflation is not really about prices. It’s about the value of debt on the books of banks that cannot be paid back by zombie corporations and individuals.

Blowing bubbles in absurd attempts to arrest “price deflation” is crazy. The bigger the bubbles the bigger the resultant “asset bubble deflation”. Falling consumer prices do not have severe negative repercussions. Asset bubble deflations are another matter.

Assessing the Blame

Central banks are not responsible for the coronavirus. But they are responsible for blowing economic bubbles prone to crash.

The equities bubbles before the coronavirus hit were the largest on record.

Dollar Irony

The irony in this madness is the US will be printing the most currency and have the biggest budget deficits as a result. Yet central banks can’t seem to get enough dollars. In that aspect, the dollar ought to be sinking.

But given the US 10-year Treasury yield at 1.126% is among the highest in the world, why not exchange everything one can for dollars earning positive yield.

This is all such circular madness, it’s hard to say when or how it ends.

The Problem With Pragmatism… and Inflation

Pragmatism is seeking immediate solutions with little to no consideration for the longer-term benefits and consequences. An excellent example of this is the Social Security system in the United States. In the Depression-era, a government-sponsored savings plan was established to “solve” for lack of retirement savings by requiring contributions to a government-sponsored savings plan.  At the time, the idea made sense as the population was greatly skewed towards younger people.  No one seriously considered whether there would always be enough workers to support benefits for retired people in the future. Now, long after those policies were enacted and those that pushed the legislation are long gone, the time is fast approaching when Social Security will be unable to pay out what the government has promised.

Pragmatism is the common path of governments, led by politicians seeking re-election and the retention of power. Instead of considering the long-term implications of their policies, they focus on satisfying an immediate desire of their constituents.

In his book Economics in One Lesson, Henry Hazlitt made this point very clear by elaborating on the problems that eventually transpire from imprudent monetary and fiscal policy.

“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Nine-tenths of the economic fallacies that are working such dreadful harm in the world today are the result of ignoring this lesson.”

Inflation

One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. When asked to define inflation, most people 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 is a disequilibrium between the amounts of currency entering an economic system relative to the productive output of that same system.

In today’s world, there is only fiat (“by decree”) currencies. In other words, the value of currencies are not backed by some physical commodity such as gold, silver, or oil. Currencies are only backed by the perceived productive capacity of the nation and the stability of the issuing government. If a government takes unreasonable measures in managing its fiscal and monetary affairs, then the standard of living in that society will deteriorate, and confidence in it erodes.

Put another way, when the people of a nation or its global counterparts lose confidence in the fiscal and monetary policy-makers, the result is a loss of confidence in the medium of exchange, and a devaluation of the currency ensues. The influence of those in power will ultimately prove to be unsustainable.

Inflation is an indicator of confidence in the currency as a surrogate of confidence in the policies of a government. It is a mirror. This is why James Grant is often quoted as saying, “The gold price is the reciprocal of the world’s faith in central banking.”

Confidence in a currency may be lost in a variety of ways. The one most apparent today is creating too many dollars as a means of subsidizing the spending habits of politicians and the borrowing demands of corporations and citizens.

Precedent

There is plenty of modern-day historical precedent for a loss of confidence from excessive debt creation and the inevitable excessive currency creation. Weimar Germany in the 1920s remains the modern era poster child, but Zimbabwe, Argentina, and Venezuela also offer recent examples.

Following the 2008 financial crisis, many believed that the actions of the Federal Reserve were “heroic.” Despite failing to see the warning signs of a housing bubble in the months and even years leading up to the crisis, the Fed’s perspective was that it exists to provide liquidity. As the chart below illustrates, that is precisely what they did.

Data Courtesy Bloomberg

That pragmatic response failed to heed Hazlitt’s warning. What are the longer-term effects for the economy, the bailed-out banking system, and all of us? How would these policies affect the economy, markets, society, and the wealth of the nation’s citizens in five, ten, or twenty years?

Keeping interest rates at a low level for many years following the financial crisis while the economy generally appears to have recovered raises other questions. The Fed continues to argue that inflation remains subdued. That argument goes largely undisputed despite credible evidence to the contrary. Further, it provides the Fed a rationalization for keeping rates well below normal.

Politicians who oversee the Fed and want to retain power, consent to low-rate policies believing it will foster economic growth. While that may make sense to some, it is short-sighted and, therefore, pragmatic. The assessment does not account for a variety of other complicating factors, namely, what may transpire in the future as a result? Are seeds of excess being sown as was the case in the dot-com bubble and the housing bubble? If so, can we gauge the magnitude?

Policy Imposition

In the mid-1960s, President Lyndon Johnson sought to escalate U.S. involvement in the Vietnam War. In doing so, he knew he would need the help of the Fed to hold interest rates down to run the budget deficits required to fund that war. Although then-Fed Chairman William McChesney Martin was reluctant to ease monetary policy, he endured various forms of abuse from the Oval Office and finally acquiesced.

The bullying these days comes from President Trump. Although his arguments for easier policy contradict what he said on the campaign trail in 2016, Jerome Powell is compliant. Until recently, the economy appeared to be running at full employment and all primary fundamental metrics were well above the prior peaks set in 2007.

Additionally, Congress, at Trump’s behest and as the chart below illustrates, has deployed massive fiscal stimulus that created a yawning gap (highlighted) between fiscal deficits and the unemployment picture. This is a divergence not seen since the Johnson administration in the 1960s (also highlighted) and one of magnitude never seen. As is very quickly becoming clear, those actions both monetary and fiscal, were irresponsible to the point of negligence. Now, when we need it most as the economy shuts down, there is little or no “dry powder”.

Data Courtesy Bloomberg

President Johnson got his way and was able to fund the war with abnormally low interest rates. However, what ensued over the next 15 years was a wave of inflation that destroyed the productive capacity of the economy well into the early 1980s. Interest rates eventually rose to 18%, and economic dynamism withered as did the spirits of the average American.

The springboard for that scenario was a pragmatic policy designed to solve an immediate problem with no regard for the future. Monetary policy that suppressed interest rates and fiscal policy that took advantage of artificially low interest rates to accumulate debt at a relatively low cost went against the American public best interests. The public could not conceive that government “of, by and for the people” would act in such a short-sighted and self-serving manner.

Data Courtesy Bloomberg

The Sequel

Before the COVID-19 pandemic, the Congressional Budget Office (CBO) projections for U.S. budget deficits exceeded $1 trillion per year for the next 10-years. According to the CBO, the U.S. Treasury’s $22.5 trillion cumulative debt outstanding was set to reach $34.5 trillion by 2029, and that scenario assumed a very optimistic GDP growth of 3% per year. Further, it laughably assumed no recession will occur in the next decade, even though we are already in the longest economic expansion since the Civil War. In the event of a recession, a $1.8 trillion-dollar annual deficit would align with average historical experience. Given the severity of what is evident from the early stages of the pandemic, that forecast may be very much on the low end of reality.

The 1960s taught us that monetary and fiscal policy is always better erring on the side of conservatism to avoid losing confidence in the currency. Members of the Fed repeatedly tell the public they know this. Yet, if that is the case, why would they be so influenced by a President focused on marketing for re-election purposes? Alternatively, maybe the policy table has been set over the past ten years in a way that prevents them from taking proper measures? Do they assume they would be rejected despite the principled nature of their actions?

Summary

Inflation currently seems to be the very least of our worries. Impeachment, Iran, North Korea and climate change were all crisis head fakes.

The Fed was also distracted by what amounted to financial dumpster fires in the fall of 2019. After a brief respite, the Fed’s balance sheet began surging higher again and they cut the Fed Funds rate well before there was any known threat of a global pandemic. What is unclear is whether imprudent fiscal policies were forcing the Fed into imprudent monetary policy or whether the Fed’s policies, historical and current, are the enabler of fiscal imprudence. Now that the world has changed, as it has a habit of doing sometimes even radically, policymakers and the collective public are in something of a fine mess to understate the situation.

Now we are contending with a real global financial, economic, and humanitarian threat and one that demands principled action as opposed to short-sighted pragmatism.

The COVID-19 pandemic is clearly not a head fake nor is it a random dumpster fire. Neither is it going away any time soon. Unlike heads of state or corporate CEOs, biological threats do not have a political agenda and they do not care about the value of their stock options. There is nothing to negotiate other than the effectiveness of efforts required to protect society.

Given the potential harm caused by the divergence between stimulus and economic fundamentals, it would be short-sighted and irresponsibly pragmatic to count out the prospect of inflation. Given the actions of the central bankers, it could also be the understatement of this new and very unusual decade.