Tag Archives: leverage

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.

Stocks Vs. Bonds: Why We Own Them & You Should Too

Flip on CNBC, pick up a financial paper, or scroll a financial website and you will find a great range of materials discussing the stock market, hot stocks, bad stocks, stock trading tips, and stock investment strategies.

Why? Because stocks are sexy, and the Wall Street casino — with all its flickering lights, screaming patrons, and carnival barkers — makes money for the purveyors of products ranging from IPOs to mutual funds and investment research.

On the other hand, you don’t hear much about bonds. Why? Because bonds are boring? Maybe so. Historically, however, discounting bonds has constituted an investment mistake, and the inevitable cooling down and possible volatility of the stock market in the next decade will make bonds a crucial part of your portfolio.

A recent BNY Mellon Investment Management survey underscored the lack of understanding about bonds and the bond market.

“A BNY Mellon Investment Management national survey on fixed-income investing was stunning: A measly 8% of Americans were able to accurately define fixed-income investments.

The 29-question online survey of just more than 2,000 adults, conducted in July, clearly shows that many Americans admit to having little knowledge about various fixed-income markets and how to invest in them. Here’s a rundown of those who answered “I do not understand it at all” with regard to the following types of bonds: Treasuries, 39%; municipal bonds, 45%; high-yield bonds, 46%; corporate bonds, 51%; structured products, 53%; Treasury Inflation Protected Securities, 63%. Of the 849 respondents who don’t own fixed income or don’t have any investment portfolio, 44% said they don’t buy bonds because they don’t understand the different types of securities.”

This is fascinating but not surprising. Since the financial media focuses only on headline-grabbing corporate news, the minute-by-minute price change of the markets, or what some investment guy with a product to sell you has to say, bonds don’t get much attention.

But, as BNY states, if you don’t understand what bonds are — and more importantly, what they can do for your portfolio — you may be missing out on something really big: And not just if you’re a retiree either.

Bonds can play a vital role for investors of any age because they reduce overall portfolio volatility. The less volatility a portfolio has, the less likely an investor will be to act emotionally during market declines and panic-sell investments to reduce losses.

Bonds also provide the third leg to the total return of a portfolio. Equities offer the first two legs, capital appreciation and dividends. Bonds offers stability by providing investors with both a safety-of-principal function (by returning the initial principal at maturity) and interest income.

Adding bonds to portfolios create better diversification and asset allocation for investors, which can lead to better returns over time, particularly during periods of increased volatility.

Is It The Right Time To Invest In Bonds?

Because interest rates are currently low, concerns about a recession in the U.S. economy have risen. This has led many media commentators to suggest the bonds are now wildly overvalued. For example:

“When evaluating the desirability of government bonds as a long-term investment, it’s imperative to compare the prevailing yields of bonds with the earnings yields for stocks.”

While this is a common comparison, it is also wrong.

Let’s compare the two:

Earnings Yield

  • “Earnings yield” is the inverse of P/E ratios and tells you only what the yield is currently, not what it will be in the future.
  • Investors do not “receive” an “earnings yield” from owning stocks. There is no “yield payment” paid out to shareholders; it is merely a mathematical calculation.
  • There is no protection of principal.

Treasury Yield

  • Investors receive a specific yield, calculable to the penny, which is paid to the holder.
  • Holders also have a government-guaranteed return of principal at maturity.

As we have written previously, it is essential to align expectations and investing requirements. Stocks have liquidity, and potential return (or loss), but no safety of principal. Treasuries have a stated return and a high degree of safety. However, to guarantee the stated return, Treasuries must be held to maturity and may not be liquid, if liquidity is part of your goal.

For most investors, completely discounting the advantage of owning bonds over the last 20 years has been a mistake. By reducing volatility and drawdowns, investors were better able to withstand the eventual storms that wiped out large chunks of capital.

Some may look at the graph below and see that bonds and stocks are at the same level. While this is true, bonds gave you the same amount of return as stocks with much less risk (and, needless to say, stress) during two major bear markets.

It is also worth pointing out that stocks are once again grossly overvalued, and a significant drawdown is probable in the coming years.

Over the next decade, the prospect of low stock market returns, possibly approaching zero, seems much less appealing than the positive return offered by risk-free asset.

Given that we are in the most extended bull market cycle in history, combined with high valuations and weakening fundamentals, it might be time to pay more attention to what bonds can offer you.

They could turn out to be one of the best-performing assets in your portfolio during the next cycle.

Margin Debt Is Declining. Are The Bulls In The Clear?

In a recent weekly newsletter (Subscribe for free e-delivery), I discussed the rather dramatic decline of short-interest in the S&P 500 which suggests a high degree of complacency by investors.

As Wolf Richter recently noted:

“Of the total shares outstanding of the SPDR S&P 500 ETF, only 2.6% were out on loan to short-sellers this week, the lowest since early October 2018, and down from 7% during the summer, according to IHS Markit data cited by Bloomberg. Meaning that short-sellers who want to short the entire market, and not specific companies, are worried that the market will break out, powered by a Brexit deal or a miraculous US-China trade deal as per presidential tweet, or whatever, and rip their faces off if they’re short the market.”

In other words, optimism about the “bull market” continuing is actually rather high, despite seemingly negative sentiment from headlines.

As Wolf goes on to note, short-sellers are “speculators” in the purest form. They are also leveraged investors who have been deleveraging as of late. The chart below shows margin debt as reported by FINRA, as compared to the “free cash balance” of investors.

You can see that since May 2018, the level of “negative cash balances” has improved as margin debt has declined. However, we need to keep this in perspective as even with the recent improvement, negative cash balances are still twice as high as any other point in history.

More importantly, note the events related to increases in margin debt. Clearly, a decade of ultra-low interest rates, ongoing liquidity infusions by Central Banks, and surging levels of stock buybacks have emboldened speculators to take on ever-increasing levels of “risk” through leverage.

This deleveraging process over the last year, combined with the sharp drop in “short interest,” suggests the speculative investors have become much more cautious on the market.

However, is this more negative positioning, a contrarian signal for the markets?

Are The Bulls In The Clear?

Maybe not.

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

Currently, margin debt has crossed below the 12- month average. If we take a longer-term look at the data we find that breaks of the 12-month moving average have indeed provided a decent signal to reduce equity risk in portfolios (blue highlights). Yes, as with any indicator, there are times that it doesn’t work, but more often than not, it has provided a reasonable assessment of elevated risk. 

Importantly, margin debt is not a technical indicator which can be used to trade markets. Margin debt is just additional “gasoline” to lift asset prices higher as the leverage provides for additional purchasing power. However, “leverage” also works in reverse as it provides an accelerant for larger declines as lenders “force” the liquidation of assets to cover credit lines without regard to the borrower’s position.

That last sentence is the most important. The issue with margin debt, in particular, is that the unwinding of leverage is NOT at the investor’s discretion. It is at the discretion of the broker-dealers that extended the leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) When lenders fear they may not be able to recoup their credit-lines, they force the borrower to either put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen all at once as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

It is when an “event” causes lenders to “panic” that margin becomes problematic. As I discussed previously:

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

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

The last time we saw such an event was here:”

Note in the chart above the market had two declines early in 2008, which ‘reduced’ margin debt but did NOT trigger “margin calls.” The event which caused lenders to panic was when Lehman Brothers was forced into bankruptcy and concerns over counter-party risk caused banks to dramatically reduce their “risk exposure.”

We never know what the catalyst will be which forces lenders to become concerned about “default” risk, but there is more than sufficient leverage in the market, with deteriorating credit quality, to supply an “event.”

Growth Rate Vs. Market

History, going back to 1959, also suggests the “bulls” should not be overly complacent with the modest pullback in “margin debt.” 

While not always immediately coincident, there is a significant correlation between the growth rate in margin debt relative to the growth rate of the S&P 500 (both adjusted for inflation). Over the last year, the S&P 500 has struggled to make advances as margin debt growth has weakened.

Furthermore, if we look at real, inflation-adjusted margin debt as a percent of GDP, the declines have also been coincident with both weaker economic and market outcomes.

It is hard to see what was happening prior to 1980. The next chart shows margin debt growth from 1959-1987.

(Most people have forgotten there were three back-to-back bear markets in 1960’s-1970’s as interest rates were spiking higher. The 1974 bear market was the one that simply wiped everyone out!)

Again, what we find is a correlation between asset prices and margin debt. When margin growth occurs extremely quickly, which coincides with more extreme investor exuberance, corresponding unwinds of the debt have been brutal.

This time is not likely any different. 

As shown, it is not uncommon for margin debt to start to unwind (margin debt inverted for clarity) before the bear market begins.

It’s All Coincident

When it comes to “margin debt,” it is a “coincident” indicator. Such should not be surprising since rising levels of margin debt are considered to be a measure of investor confidence. Investors are more willing to take out debt against investments when shares are rising, and they have more value in their portfolios to borrow against. However, the opposite is also true when falling asset prices reduce the amount of credit available and assets must be sold to bring the account back into balance.

I both agree and disagree with the idea that margin debt levels are simply a function of market activity and have no bearing on the outcome of the market.

By itself, margin debt is inert.

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

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

As I noted above, it will likely take a correction of more than 20%, or a “credit related” event, which sparks broker-dealer concerns about repayment of their credit lines. The risk to the market is “when” those “margin calls” are made.

It is not the rising level of debt that is the problem; it is the decline which marks peaks in both market and economic expansions.

Currently, the “bullish bias” remains intact, and the recent volatility in the market has not shaken investors loose as of yet. Therefore, it is certainly understandable why so many are suggesting you should ignore the recent drop in margin debt.

But history suggests you probably shouldn’t.

The Fed & The Stability/Instability Paradox

“Only those that risk going too far can possibly find out how far one can go.” – T.S. Eliot

Well, this certainly seems to be the path that the Federal Reserve, and global Central Banks, have decided take.

Yesterday, the Fed lowered interest rates by a quarter-point and maintained their “dovish” stance but suggested they are open to “allowing the balance sheet to grow.” While this isn’t anything more than just stopping Q.T. entirely, the markets took this as a sign that Q.E. is just around the corner.

That expectation is likely misguided as the Fed seems completely unconcerned of any recessionary impact in the near-term. However, such has always been the case, historically speaking, just before the onset of a recession. This is because the Fed, and economists in general, make predictions based on lagging data which is subject to large future revisions. Regardless, the outcome of the Fed’s monetary policies has always been, without exception, either poor, or disastrous.

“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. As shown in the chart below, when the Fed has lifted the short-term lending rates to a level higher than the 2-year rate, bad ‘stuff’ has historically followed.”

The idea of pushing limits to extremes also applies to stock market investors. As we pointed out on Tuesday, the risks of a liquidity-driven event have increased markedly in recent months. Yet, despite the apparent risk, investors have virtually “no fear.” (Bullish advances are supported by extremely low levels of volatility below the long-term average of 19.)

First, “record levels” of anything are records for a reason. It is where the point where previous limits were reached. Therefore, when a ‘record level’ is reached, it is NOT THE BEGINNING, but rather an indication of the MATURITY of a cycle. While the media has focused on employment, record stock market levels, etc. as a sign of an ongoing economic recovery, history suggests caution.”

In the “rush to be bullish” this a point often missed. When markets are hitting “record levels,” it is when investors get “the most bullish.” That is the case currently with retail investors “all in.”

Conversely, they are the most “bearish” at the lows.

It is just human nature.

“What we call the beginning is often the end. And to make an end is to make a beginning. The end is where we start from.” – T.S. Eliot

The point here is that “all things do come to an end.” The further from the “mean” something has gotten, the greater the reversion is going to be. The two charts below illustrate this point clearly.

Bull markets, with regularity, are almost entirely wiped out by the subsequent bear market.

Despite the best of intentions, market participants never act rationally.

Neither do consumers.

The Instability Of Stability

This is the problem facing the Fed.

Currently, investors have been led to believe that no matter what happens, the Fed can bail out the markets and keep the bull market going for a while longer. Or rather, as Dr. Irving Fisher once uttered:

“Stocks have reached a permanently high plateau.”

Interestingly, the Fed is dependent on both market participants, and consumers, believing in this idea. As we have noted previously, with the entirety of the financial ecosystem now 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” is now the most significant risk.

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

The Fed is highly dependent on this assumption as it provides 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 have built up in the system.

Simply, the Fed is dependent on “everyone acting rationally.”

Unfortunately, that has never been the case.

The behavioral biases of individuals is one of the most serious risks facing the Fed. Throughout history, as noted above, the Fed’s actions have repeatedly led to negative outcomes despite the best of intentions.

  • In the early 70’s it was the “Nifty Fifty” stocks,
  • Then Mexican and Argentine bonds a few years after that
  • “Portfolio Insurance” was the “thing” in the mid -80’s
  • Dot.com anything was a great investment in 1999
  • Real estate has been a boom/bust cycle roughly every other decade, but 2006 was a doozy
  • Today, it’s ETF’s and “Passive Investing,” and levered credit.

As noted Tuesday, the risk to this entire house of cards is a credit-related event.

Anyone wonder what might happen should passive funds become large net sellers of credit risk? In that event, these indiscriminate sellers will have to find highly discriminating buyers who–you guessed it–will be asking lots of questions. Liquidity for the passive universe–and thus the credit markets generally–may become very problematic indeed.

The recent actions by Central Banks certainly suggest risk has risen. Whether this was just an anomalous event, or an early warning, it is too soon to know for sure. However, if there is a liquidity issue, the risk to ‘uniformed investors’ is substantially higher than most realize. 

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing. That is, until suddenly, and often without warning, it all goes “pear\-shaped.”

In November and December of last year, it was the uniformity of the price moves which revealed the fallacy “passive investing” as investors headed for the door all at the same time. While, that rout was quickly forgotten as markets stormed back to all-time highs, on “hopes” of Central Bank liquidity and “trade deals.”

The difference today, versus then, are the warning signs of deterioration in areas which pose a direct threat to everyone “acting rationally.” 

“While yields going to zero] certainly sounds implausible at the moment, just remember that all yields globally are relative. If global sovereign rates are zero or less, it is only a function of time until the U.S. follows suit. This is particularly the case if there is a liquidity crisis at some point.

It is worth noting that whenever Eurodollar positioning has become this extended previously, the equity markets have declined along with yields. Given the exceedingly rapid rise in the Eurodollar positioning, it certainly suggests that ‘something has broken in the system.’” 

Risk is clearly elevated as the Fed is cutting rates despite the “economic data” not supporting it. This is clearly meant to keep everyone acting rationally for now.

The problem comes when they don’t.

The Single Biggest Risk To Your Money

All of this underscores the single biggest risk to your investment portfolio.

In extremely long bull market cycles, investors become “willfully blind,” to the underlying inherent risks. Or rather, it is the “hubris” of investors they are now “smarter than the market.”

Yet, the list of concerns remains despite being completely ignored by investors and the mainstream media.

  • Growing economic ambiguities in the U.S. and abroad: peak autos, peak housing, peak GDP.
  • Political instability and a crucial election.
  • The failure of fiscal policy to ‘trickle down.’
  • An important pivot towards easing in global monetary policy.
  • Geopolitical risks from Trade Wars to Iran 
  • Inversions of yield curves
  • Deteriorating earnings and corporate profit margins.
  • Record levels of private and public debt.
  •  More than $3 trillion of covenant light and/or sub-prime corporate debt. (now larger and more pervasive than the size of the subprime mortgages outstanding in 2007)

For now, none of that matters as the Fed seems to have everything under control.

The more the market rises, the more reinforced the belief “this time is different” becomes.

Yes, our investment portfolios remain invested on the long-side for now. (Although we continue to carry slightly higher levels of cash and hedges.)

However, that will change, and rapidly so, at the first sign of the “instability of stability.” 

Unfortunately, by the time the Fed realizes what they have done, it has always been too late.

The August Jobs Report Confirms The Economy Is Slowing

After the monthly jobs report was released last week, I saw numerous people jumping on the unemployment rate as a measure of success, and in this particular case, Trump’s success as President.

  • Unemployment November 2016: 4.7%
  • Unemployment August 2019: 3.7%

Argument solved.

President Trump has been “Yuugely” successful at putting people to work as represented by a 1% decline in the unemployment rate since his election.

But what about President Obama?

  • Unemployment November 2008: 12.6%
  • Unemployment November 2016: 4.7%

Surely, a 7.9% drop in unemployment should be considered at least as successful as Trump’s 1%.

Right?

Here’s a secret, neither one is important.

First, Presidents don’t put people to work. Corporations do. The reality is that President Obama and Trump had very little to do with the actual economic recovery.

Secondly, as shown below, the recovery in employment began before either President took office as the economic recovery would have happened regardless of monetary interventions. Importantly, note the drop in employment has occurred with the lowest level of annual economic growth on record. (I wouldn’t necessarily be touting this as #winning.)

Lastly, both measures of “employment success” are erroneous due to the multitude of problems with how the entire series is “guessed at.” As noted previously by Morningside Hill:

  • The Bureau of Labor Statistics (BLS) has been systemically overstating the number of jobs created, especially in the current economic cycle.
  • The BLS has failed to account for the rise in part-time and contractual work arrangements, while all evidence points to a significant and rapid increase in the so-called contingent workforce.
  • Full-time jobs are being replaced by part-time positions, resulting in double and triple counting of jobs via the Establishment Survey.  (Examples: Uber, Lyft, GrubHub, FedEx, Amazon)
  • A full 93% of the new jobs reported since 2008 were added through the business birth and death model – a highly controversial model which is not supported by the data. On the contrary, all data on establishment births and deaths point to an ongoing decrease in entrepreneurship.
  • Jobless claims have recently reached their lowest level on record which purportedly signals job market strength. Since hiring patterns have changed significantly and increasingly more people are joining the contingent workforce, jobless claims are no longer a good leading economic indicator. Part-time and contract-based workers are most often ineligible for unemployment insurance. In the next downturn, corporations will be able to cut through their contingent workforce before jobless claims show any meaningful uptick.

Nonetheless, despite a very weak payroll number, the general “view” by the mainstream media, and the Federal Reserve, is the economy is still going strong.

In reality, one-month of employment numbers tell us very little about what is happening in the actual economy. While most economists obsess over the data from one month to the next, it is the “trend” of the data which is far more important to understand.

The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current annual rate of employment growth is 1.4% which is lower than any previous employment level in history prior to the onset of a recession.

But while this is a long-term view of the trend of employment in the U.S., what about right now? The chart below shows the civilian employment level from 1999 to present.

While the recent employment report was slightly below expectations, the annual rate of growth is slowing at a faster pace. Moreover, there are many who do not like the household survey due to the monthly volatility in the data. Therefore, by applying a 3-month average of the seasonally-adjusted employment report, we see the slowdown more clearly.

But here is something else to consider.

While the BLS continually 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. A simpler method to use for smoothing volatile monthly data is using a 12-month moving average of the raw data as shown below.

Near peaks of employment cycles, the employment data deviates from the 12-month average, but then reconnects 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. 

But there is more to this story.

A Function Of Population

One thing which is not discussed when reporting on employment is the “growth” of the working-age population. Each month, new entrants into the population create “demand” through their additional consumption. Employment should increase to accommodate for the increased demand from more participants in the economy. Either that or companies resort to automation, off-shoring, etc. to increase rates of production without increases in labor costs. The chart below shows the total increase in employment versus the growth of the working-age population.

The missing “millions” shown in the chart above is one of the “great mysteries” about the longest economic booms in U.S. history. This is particularly a conundrum when the Federal Reserve talks about the economy nearing “full employment.” The disparity shows up in both the Labor Force Participation Rate and those “Not In Labor Force.”

Note that since 2009, the number of those “no longer counted” has dominated the employment trends of the economy. In other words, those “not in labor force” as a percent of the working-age population has skyrocketed.

Of course, as we are all very aware, there are many who work part-time, are going to school, etc. But even when we consider just those working “full-time” jobs, particularly when compared to jobless claims, the percentage of full-time employees is still well below levels of the last 35 years.

It’s All The Baby Boomers Retiring

One of the arguments often given for the low labor force participation rate is that millions of “baby boomers” are leaving the workforce for retirement.

This argument doesn’t carry much weight given that the “Millennial” generation, which is significantly larger, is simultaneously entering the workforce. The other problem is shown below, there are more individuals over the age of 55, as a percentage of that age group, in the workforce today than in the last 50-years.

Of course, the reason they aren’t retiring is that they can’t. After two massive bear markets, weak economic growth, questionable spending habits,and poor financial planning, more individuals over the age of 55 are still working because they simply can’t “afford” to retire.

However, for argument sake, let’s assume that every worker over the age of 55 retires. If the “retiring” argument is valid, then employment participation rates should soar once that group is removed. The chart below is full-time employment relative to the working-age population of 16-54.

Nope.

The other argument is that Millennials are going to school longer than before so they aren’t working either. (We have an excuse for everything these days.)

The chart below strips out those of college-age (16-24) and those over the age of 55.

With the prime working-age group of labor force participants still at levels seen previously in 1988, it does raise the question o2f just how robust the labor market actually is?

Michael Lebowitz touched on this issue previously:

“Why are so many people struggling to find a job and terminating their search if, as we are repeatedly told, the labor market is so healthy? To explain the juxtaposition of the low jobless claims number and unemployment rate with the low participation rate and weak wage growth, a calculation of the participation rate adjusted unemployment rate is revealing.”

‘When people stop looking for a job, they are still unemployed, but they are not included in the U-3 unemployment calculation. If we include those who quit looking for work in the data, the employment situation is quite different. The graph below compares the U-3 unemployment rate to one that assumes a constant participation rate from 2008 to today. Contrary to the U-3 unemployment rate of 3.90%, this metric implies an adjusted unemployment rate of 8.69%.

Importantly, this number is much more consistent with the data we have laid out above, supports the reasoning behind lower wage growth, and is further confirmed by the Hornstein-Kudlyak-Lange Employment Index.”

(The Hornstein-Kudlyak-Lange Non-Employment Index including People Working Part-Time for Economic Reasons (NEI+PTER) is a weighted average of all non-employed people and people working part-time for economic reasons expressed as the share of the civilian non-institutionalized population 16 years and older. The weights take into account persistent differences in each group’s likelihood of transitioning back into employment. Because the NEI is more comprehensive and includes tailored weights of non-employed individuals, it arguably provides a more accurate reading of labor market conditions than the standard unemployment rate.)

One of the main factors which was driving the Federal Reserve to raise interest rates, and reduce its balance sheet, was the perceived low level of unemployment. However, now, they are trying to lower rates despite an even lower level of unemployment than previous.

The problem for the Federal Reserve is they are caught between a “stagflationary economy” and a “recession.” 

“With record low jobless claims, there is no recession on the horizon.” -says mainstream media.

Be careful with that assumption.

In November of 1969 jobless claims stood at 211,000, having risen slightly from the lows recorded earlier that year. Despite the low number of claims, a recession started a month later, and jobless claims would nearly double within six months.

This episode serves as a reminder that every recession followed interim lows in jobless claims and the unemployment rate. We are confident that the dynamics leading to the next recession will not be any different.

But then again, maybe the yield-curve is already giving us the answer.

Strongest Economy Ever? I Warned You About Negative Revisions

Over the last 18-months, there has been a continual drone of political punditry touting the success of “Trumponomics” as measured by various economic data points. Even the President himself has several times taken the opportunity to tweet about the “strongest economy ever.”

But if it is the “strongest economy ever,” then why the need for aggressive rate cuts which are “emergency measures” to be utilized to offset recessionary conditions?

First, it is hard to have an “aggressive rate-cutting cycle” when you only have 2.4% to work with.

Secondly, I am not sure we want to be like China or Europe economically speaking, and running a $1.5 Trillion deficit during an expansion, suspending the debt ceiling, and expanding spending isn’t that much different.

Nonetheless, I have repeatedly cautioned about the risk of taking credit for the economic bump, or the stock market, as a measure of fiscal policy success. Such is particularly the case when you are a decade into the current economic cycle.

Economic growth is more than just a reported number. The economy has been “in motion” following the last recession due to massive liquidity injections, zero interest rates, and a contraction in the labor force. Much like a “snowball rolling downhill,” the continuation of economic momentum should have been of little surprise.

As an example, we can look at full-time employment (as a percentage of 16-54  which removes the “retiring baby boomer” argument) by President. The rise in full-time employment has been on a steady trend higher following the financial crisis as the economic and financial systems repaired themselves.

As discussed previously, economic data is little more than a “wild @$$ guess” when it is initially reported. However, one-year and three-years later, the data is revised to reveal a more accurate measure of the “real” economy.

Unfortunately, we pay little attention to the revisions.

While there are many in the media touting “the strongest economy ever” since Trump took office, a quick look at a chart should quickly put that claim to rest.

Yes, there was a spurt in economic growth during 2018, which did seem to support the claims that Trump’s policies were working. As I warned then, there were factors at play which were obfuscating the data.

“Lastly, government spending has been very supportive to the markets in particular over the last few quarters as economic growth has picked up. However, that “sugar-high” was created by 3-massive Hurricanes in 2017 which has required billions in monetary stimulus which created jobs in manufacturing and construction and led to a temporary economic lift. We saw the same following the Hurricanes in 2012 as well.”

“These “sugar highs” are temporary in nature. The problem is the massive surge in unbridled deficit spending only provides a temporary illusion of economic growth.”

The importance is that economic “estimates” become skewed by these exogenous factors, and I have warned these over-estimations would be reversed when annual revisions are made.

Last week, the annual revisions to the economic data were indeed negative. The chart below shows “real GDP” pre- and post-revisions.

This outcome was something I discussed previously:

With the Fed Funds rate running at near 2%, if the Fed now believes such is close to a ‘neutral rate,’ it would suggest that expectations of economic growth will slow in the quarters ahead from nearly 6.0% in Q2 of 2018 to roughly 2.5% in 2019.”

However, there is further evidence that actual, organic, economic growth is weaker than the current negative revisions suggest. More importantly, the revisions to the 2019 data, in 2020, will very likely be as negative as well.

This is also the case with the employment data which I discussed previously:

“Months from now, the Establishment Survey will undergo its annual retrospective benchmark revision, based almost entirely on the Quarterly Census of Employment and Wages conducted by the Labor Department. That’s because the QCEW is not just a sample-based survey, but a census that counts jobs at every establishment, meaning that the data are definitive but take time to collect.”

“The Establishment Survey’s nonfarm jobs figures will clearly be revised down as the QCEW data show job growth averaging only 177,000 a month in 2018. That means the Establishment Survey may be overstating the real numbers by more than 25%.”

There is nothing nefarious going on here.

It is the problem with collecting data from limited samples, applying various seasonal adjustment factors to it, and “guesstimating” what isn’t known. During expansions, the data is always overstated and during recessions it is understated. This is why using lagging economic data as a measure of certainty is always erroneous.

Debt-Driven Growth

I recently discussed the “death of fiscal conservatism” as Washington passed another spending bill.

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

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

The “good news” is, if you want to call it that, is that Government spending does show up in economic growth. The “bad news” is that government spending has a negative “multiplier” effect since the bulk of all spending goes to non-productive investments. (Read this)

Nonetheless, the President suggests we are “winning.”

The problem is that economic growth less government spending is actually “recessionary.” 

As shown in the chart below, since 2010 it has taken continually increases in Federal expenditures just to maintain economic growth at the same level it was nearly a decade ago. Such a “fiscal feat” is hardly indicative of “winning.”

As Mike Shedlock noted, part of the issue with current economic estimates is simply in how it is calculated.

In GDP accounting, consumption is the largest component. Naturally, it is not possible to consume oneself to prosperity. The ability to consume more is the result of growing prosperity, not its cause. But this is the kind of deranged economic reasoning that is par for the course for today.

In addition to what Tenebrarum states, please note that government transfer payments including Medicaid, Medicare, disability payments, and SNAP (previously called food stamps), all contribute to GDP.

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

This is critically important to understand.

While government spending, a function of continually increasing debt, does appear to have an economic benefit, corporate profits tell a very different story.

The Real Economy

I have been noting for a while the divergence between “operating earnings” (or rather “earnings fantasy”) versus corporate profits which are what companies actually report for tax purposes. From “Earnings Growth Much Weaker Than Advertised:”

“The benefit of a reduction in tax rates is extremely short-lived since we compare earnings and profit growth on a year-over-year basis.

In the U.S., the story remains much the same as near-term economic growth has been driven by artificial stimulus, government spending, and fiscal policy which provides an illusion of prosperity.”

Since consumption makes up roughly 70% of the economy, then corporate profits pre-tax profits should be growing if the economy was indeed growing substantially above 2%.”

We now know the economy wasn’t growing well above 2% and, as a consequence, corporate profits have been revised sharply lower on a pre-tax basis.

The reason we are looking at PRE-tax, rather than post-tax, profits is because we can see more clearly what is actually happening at the corporate level.

Since corporate revenues come for the sale of goods and services, if the economy was growing strongly then corporate profits should be reflective of that. However, since 2014, profits have actually been declining. If we take the first chart above and adjust it for the 2019-revisions we find that corporate profits (both pre- and post-tax) are the same level as in 2012 and have been declining for the last three-years in particular.

Again, this hardly indicates the “strongest economy in history.”

These negative revisions to corporate profits also highlight the over-valuation investors are currently paying for asset prices.  Historically, such premiums have had rather horrific “paybacks” as markets eventually “reprice” for reality.

Trump’s Political Risk

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

Most fiscal, and monetary, policy changes can take up to a year before the impact shows in the economic data. While changes to “tax rates” can have a more immediate impact, “interest rate” changes take longer to filter through.

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

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

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

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

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

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

It will likely be something he eventually regrets.

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

Questions About The “Stellar” June Jobs Report (Which Also Confirm The Fed’s Concerns)

On Wednesday, Jerome Powell testified before Congress the U.S. economy is “suffering” from a bout of uncertainty caused by trade tensions and slow global growth. To wit:

“Since [the Fed meeting in mid-June], based on incoming data and other developments, it appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook.”

That outlook, however, would seem to be askew of the recent employment report for June from the Bureau of Labor Statistics last week. That report showed an increase in employment of 224,000 jobs. It was also the 105th consecutive positive jobs report, which is one of the longest in U.S. history.

However, if employment is as “strong” as is currently believed, which should be a reflection of the underlying economy, then precisely what is the Fed seeing?

Well, I have a few questions for you to ponder concerning to the latest employment report which may actually support the Fed’s case for rate cuts. These questions are also important to your investment outlook as there is a high correlation between employment, economic growth, and not surprisingly, corporate profitability.

Let’s get started.

Prelude: The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current annual rate of employment growth is 1.5%, which is lower than any previous employment level prior to a recession in history.

More importantly, as noted by Lakshman Achuthan and Anirvan Banerji via Bloomberg:

“A key part of the answer lies with jobs ‘growth,’ which has been slowing much more than most probably realize. Despite the better-than-forecast jobs report for June, the fact is the labor force has contracted by more than 600,000 workers this year. And we’re not just talking about the disappointing non-farm payroll jobs numbers for April and May.

Certainly, that caused year-over-year payroll growth, based on the Labor Department’s Establishment Survey – a broad survey of businesses and government agencies – to decline to a 13-month low. But year-over-year job growth, as measured by the separate Household Survey – based on a Labor Department survey of actual households – that is used to calculate the unemployment rate is only a hair’s breadth from a five-and-a-half-year low.”


Question: Given the issues noted above, does it seem as if the entirety of the economy is as robust as stated by the mainstream media? More importantly, how does 1.5% annualized growth in employment create sustained rates of higher economic growth going forward?


Prelude: One thing which is never discussed when reporting on employment is the “growth” of the working age population. Each month, new entrants into the population create “demand” through their additional consumption. Employment should increase to accommodate for the increased demand from more participants in the economy. Either that or companies resort to automation, off-shoring, etc. to increase rates of production without increases in labor costs. The next chart shows the total increase in employment versus the growth of the working age population.


Question: Just how “strong” is employment growth? Does it seem that 96%+ of the working-age population is gainfully employed?


Prelude: The missing “millions” shown in the chart above is one of the “great mysteries” about one of the longest economic booms in U.S. history. This is particularly a conundrum when the Federal Reserve talks about the economy nearing “full employment.”

The next several charts focus on the idea of “full employment” in the U.S. While Jobless Claims are reaching record lows, the percentage of full time versus part-time employees is still well below levels of the last 35 years. It is also possible that people with multiple part-time jobs are being double counted in the employment data.


Question: With jobless claims at historic lows, and the unemployment rate below 4%, then why is full-time employment relative to the working-age population at just 50.10% (Only slightly above the 1980 peak)?


Prelude: One of the arguments often given for the low labor force participation rates is that millions of “baby boomers” are leaving the workforce for retirement. This argument doesn’t carry much weight given the significantly larger “Millennial” generation that is simultaneously entering the workforce.

However, for argument sake, let’s assume that every worker over the age of 55 retires. If the “retiring” argument is valid, then employment participation rates should soar once that group is removed. The chart below is full-time employment relative to the working-age population of 16-54.


Question: At 50.38%, and the lowest rate since 1981, just how big of an impact are “retiring baby boomers” having on the employment numbers?


Prelude: One of the reasons the retiring “baby boomer” theory is flawed is, well, they aren’t actually retiring. Following two massive bear markets, weak economic growth, questionable spending habits, and poor financial planning, more individuals over the age of 55 are still working than at any other time since 1960.

The other argument is that Millennials are going to school longer than before so they aren’t working either. The chart below strips out those of college age (16-24) and those over the age of 55. Those between the ages of 25-54 should be working.


Question: With the prime working age group of labor force participants still at levels seen previously in 1988, just how robust is the labor market actually?


Prelude: Of course, there are some serious considerations which need to be taken into account about the way the Bureau of Labor Statistics measures employment. The first is the calculation of those no longer counted as part of the labor force. Beginning in 2000, those no longer counted as part of the labor force detached from its longer-term trend. The immediate assumption is all these individuals retired, but as shown above, we know this is not exactly the case.


Question: Where are the roughly 95-million Americans missing from the labor force? This is an important question as it relates to the labor force participation rate. Secondly, these people presumably are alive and participating in the economy so exactly how valid is the employment calculation when 1/3rd of the working-age population is simply not counted?


Prelude: The second questionable calculation is the birth/death adjustment. I addressed this in more detail previously, but here is the general premise.

Following the financial crisis, the number of “Births & Deaths” of businesses unsurprisingly declined. Yet, each month, while the market is glued to the headline number, they additions from the “birth/death” adjustment go both overlooked and unquestioned.

Every month, the BLS adds numerous jobs to the non-seasonally adjusted payroll count to “adjust” for the number of “small businesses” being created each month, which in turns “creates a job.”  (The total number is then seasonally adjusted.)

Here is my problem with the adjustment.

The BLS counts ALL business formations as creating employment. However, in reality, only about 1/5th of businesses created each year actually have an employee. The rest are created for legal purposes like trusts, holding companies, etc. which have no employees whatsoever. This is shown in the chart below which compares the number of businesses started WITH employees from those reported by the BLS. (Notice that beginning in 2014, there is a perfect slope in the advance which is consistent with results from a mathematical projection rather than use of actual data.)

These rather “fictitious” additions to the employee ranks reported each year are not small, but the BLS tends even to overestimate the total number of businesses created each year (employer AND non-employer) by a large amount.

How big of a difference are we talking about?

Well, in the decade between 2006 and 2016 (the latest update from the Census Bureau) the BLS added roughly 7.6 million more employees than were created in new business formations.

This data goes a long way in explaining why, despite record low unemployment, there is a record number of workers outside the labor force, 25% of households are on some form of government benefit, wages remain suppressedand the explosion of the “wealth gap.” 


Question: If 1/3rd of the working-age population simply isn’t counted, and the birth-death adjustment inflates the employment roles, just how accurate is the employment data?


Prelude: If the job market was as “tight” as is suggested by an extremely low unemployment rate, the wage growth should be sharply rising across all income spectrums. The chart below is the annual change in real national compensation (less rental income) as compared to the annual change in real GDP. Since the economy is 70% driven by personal consumption, it should be of no surprise the two measures are highly correlated.

Side Question: Has “renter nation” gone too far?


Question: Again, if employment was as strong as stated by the mainstream media, would not compensation, and subsequently economic growth, be running at substantially stronger levels rather than at rates which have been more normally associated with past recessions?


I have my own assumptions and ideas relating to each of these questions. However, the point of this missive is simply to provide you the data for your own analysis. The conclusion you come to has wide-ranging considerations for investment portfolios and allocation models.

Does the data above support the notion of a strongly growing economy that still has “years left to run?”  

Or, does the fact the Fed is considering cutting interest rates to stimulate economic growth suggests the economy may already be weaker than headlines suggest?

One important note to all of this is the conclusion from Achuthan and Banerji:

“But there’s even more cause for concern. Months from now, the Establishment Survey will undergo its annual retrospective benchmark revision, based almost entirely on the Quarterly Census of Employment and Wages conducted by the Labor Department. That’s because the QCEW is not just a sample-based survey, but a census that counts jobs at every establishment, meaning that the data are definitive but take time to collect. 

The Establishment Survey’s nonfarm jobs figures will clearly be revised down as the QCEW data show job growth averaging only 177,000 a month in 2018. That means the Establishment Survey may be overstating the real numbers by more than 25%.”

These facts are in sharp contrast to strong job growth narrative.

But then again, maybe the yield-curve is already telling the answer to these questions.

The Message From The Jobs Report – The Economy Is Slowing

Last week, the Bureau of Labor Statistics (BLS) published the March monthly “employment report” which showed an increase in employment of 196,000 jobs. As Mike Shedlock noted on Friday:

“The change in total non-farm payroll employment for January was revised up from +311,000 to +312,000, and the change for February was revised up from +20,000 to +33,000. With these revisions, employment gains in January and February combined were 14,000 more than previously reported. After revisions, job gains have averaged 180,000 per month over the last 3 months.

BLS Jobs Statistics at a Glance

  • Nonfarm Payroll: +196,000 – Establishment Survey
  • Employment: -201,000 – Household Survey
  • Unemployment: -24,000 – Household Survey
  • Involuntary Part-Time Work: +189,000 – Household Survey
  • Voluntary Part-Time Work: +144,000 – Household Survey
  • Baseline Unemployment Rate: Unchanged at 3.8% – Household Survey
  • U-6 unemployment: Unchanged at 7.3% – Household Survey
  • Civilian Non-institutional Population: +145,000
  • Civilian Labor Force: -224,000 – Household Survey
  • Not in Labor Force: +369,000 – Household Survey
  • Participation Rate: -0.2 to 63.0– Household Survey”

There is little argument the streak of employment growth is quite phenomenal and comes amid hopes the economy will continue to avoid a recessionary contraction. When looking at the average rate of employment growth over the last 3-months, as Mike noted at 180,000, there is a clear slowing in the trend of employment. It is this “trend” we will examine more closely today.

While a tremendous amount of attention is focused on the monthly employment numbers, the series is one of the most highly manipulated, guesstimated, and annually revised series produced by any agency. The whole issue of seasonal adjustments, which try to account for temporary changes to employment due to a variety of impacts, is entirely too systematic to be taken at face value. The chart below shows the swings between the non-seasonally adjusted and seasonally adjusted data – anything this rhythmic should be questioned rather than taken at face value as “fact.”

As stated, 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.

The chart below shows the peak annual rate of change for employment before the onset of a recession. The current annual rate of employment growth is 1.4% which is lower than any previous employment level prior to a recession in history.

But while this is a long-term view of the trend of employment in the U.S., what about right now? The chart below shows employment from 1999 to present.

While the recent employment report was slightly above expectations, the annual rate of growth is slowing. The chart above shows two things. The first is the trend of the household employment survey on an annualized basis. Secondly, while the seasonally-adjusted reported showed 196,000 jobs created, the actual household survey showed a loss of 200,000 jobs. 

Many do not like the household survey for a variety of reasons but even if we use the 3-month average of seasonally-adjusted employment we see the same picture. (The 3-month average simply smooths out some of the volatility.)

But here is something else to consider.

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. A simpler method to use for smoothing volatile monthly data is using a 12-month moving average of the raw data as shown below.

Notice that near peaks of employment cycles the employment data deviates from the 12-month average but tends to reconnect as reality emerges. (Also, note the pickup in employment due to the slate of “natural disasters” in late 2017 which are now fading as reconstruction completes)

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. 

However, there is more to this story.

A Function Of Population

One thing which is never discussed when reporting on employment is the “growth” of the working age population. Each month, new entrants into the population create “demand” through their additional consumption. Employment should increase to accommodate the increased demand from more participants in the economy. Either that or companies resort to automation, off-shoring, etc. to increase rates of production without increases in labor costs. The chart below shows the total increase in employment versus the growth of the working age population.

The missing “millions” shown in the chart above is one of the “great mysteries” about one of the longest economic booms in U.S. history. This is particularly a conundrum when the Federal Reserve talks about the economy nearing “full employment.” The Labor Force Participation Rate below shows this great mystery.

Since many conservatives continue to credit President Trump with a booming economy and employment gains, we can look at changes to the labor force participation rate by President as a measure of success. Currently, Trump’s gains are either less than Clinton, the same as Reagan, or tracking Bush Sr.; “spin it” as you will.

Of course, as we are all very aware, there are many people who are working part-time, going to school, etc. But even when we consider just those working “full-time” jobs, particularly when jobless claims are reaching record lows, the percentage of full-time employees is still well below levels of the last 35 years.

“With jobless claims at historic lows, and the unemployment rate at 4%, then why is full-time employment relative to the working-age population at just 50.27% which is down from 50.5% last month?”

It’s All The Baby Boomers Retiring

One of the arguments often given for the low labor force participation rate is that millions of “baby boomers” are leaving the workforce for retirement. This argument doesn’t carry much weight given that the “Millennial” generation, which is significantly larger, is simultaneously entering the workforce. The other problem is shown below, there are more individuals over the age of 55, as a percentage of that age group, in the workforce today than in the last 50-years.

Of course, the reason they aren’t retiring is that they can’t. After two massive bear markets, weak economic growth, questionable spending habits,and poor financial planning, more individuals over the age of 55 are still working because they simply can’t “afford” to retire.

However, for argument sake, let’s assume that every worker over the age of 55 retires. If the “retiring” argument is valid, then employment participation rates should soar once that group is removed. The chart below is full-time employment relative to the working-age population of 16-54.

Importantly, note in the first chart above the number of workers over the age of 55 increased last month. However, employment of 16-54 year olds declined from 50.78% to 50.55%. It is also, the lowest rate since 1985, which was the last time employment was increasing from such low levels.

The other argument is that Millennials are going to school longer than before so they aren’t working either. (We have an excuse for everything these days.) The chart below strips out those of college age (16-24) and those over the age of 55. Uhm…

Here is the same chart of employed 25-54 year olds as a percentage of just that group.

When refined down to this level, talk about data mining, we do actually see recovery, however, after the longest economic expansion on record, a record stock market, and record levels of corporate debt to fund expansions and buybacks; employment ratios for this group are at the same level as seen in 1988. Such should raise the question of just how robust the labor market actually is?

Low initial jobless claims coupled with the historically low unemployment rate are leading many economists to warn of tight labor markets and impending wage inflation. If there is no one to hire, employees have more negotiating leverage according to prevalent theory. While this seems reasonable on its face, further analysis into the employment data suggests these conclusions are not so straightforward.

Strong Labor Statistics

Michael Lebowitz recently pointed out some important considerations in this regard.

“The data certainly suggests that the job market is on fire. While we would like nothing more than to agree, there is other employment data which contradicts that premise.”

For example, if there are indeed very few workers in need of a job, then current workers should have pricing leverage over their employers.  This does not seem to be the case as shown in the graph of personal income below.

Furthermore, a closer inspection of the BLS data reveals that, since 2008, 16 million people were reclassified as “leaving the workforce”. To put those 16 million people into context, from 1985 to 2008, a period almost three times longer than the post-crisis recovery, a similar number of people left the workforce.

Why are so many people struggling to find a job and terminating their search if, as we are repeatedly told, the labor market is so healthy? To explain the juxtaposition of the low jobless claims number and unemployment rate with the low participation rate and weak wage growth, a calculation of the participation rate adjusted unemployment rate is revealing.

When people stop looking for a job, they are still unemployed, but they are not included in the U-3 unemployment calculation. If we include those who quit looking for work in the data, the employment situation is quite different. The graph below compares the U-3 unemployment rate to one that assumes a constant participation rate from 2008 to today. Contrary to the U-3 unemployment rate of 3.90%, this metric implies an adjusted unemployment rate of 8.69%.

Importantly, this number is much more consistent with the data we have laid out above, supports the reasoning behind lower wage growth, and is further confirmed by the Hornstein-Kudlyak-Lange Employment Index.

(The Hornstein-Kudlyak-Lange Non-Employment Index including People Working Part-Time for Economic Reasons (NEI+PTER) is a weighted average of all non-employed people and people working part-time for economic reasons expressed as the share of the civilian non-institutionalized population 16 years and older. The weights take into account persistent differences in each group’s likelihood of transitioning back into employment. Because the NEI is more comprehensive and includes tailored weights of non-employed individuals, it arguably provides a more accurate reading of labor market conditions than the standard unemployment rate.)

One of the main factors driving the Federal Reserve to raise interest rates and reduce its balance sheet is the perceived low level of unemployment. Simultaneously, multiple comments from Fed officials suggest they are justifiably confused by some of the signals emanating from the jobs data. As we have argued in the past, the current monetary policy experiment has short-circuited the economy’s traditional traffic signals. None of these signals is more important than employment.

As Michael noted:

“Logic and evidence argue that, despite the self-congratulations of central bankers, good wage-paying jobs are not as plentiful as advertised and the embedded risks in the economy are higher. We must consider the effects that these sequences of policy error might have on the economy – one where growth remains anemic and jobs deceptively elusive.

Given that wages translate directly to personal consumption, a reliable interpretation of employment data has never been more important. Oddly enough, it appears as though that interpretation has never been more misleading. If we are correct that employment is weak, then future rate hikes and the planned reduction in the Fed’s balance sheet will begin to reveal this weakness soon.”

As an aside, it is worth noting that in November of 1969 jobless claims stood at 211,000, having risen slightly from the lows recorded earlier that year. Despite the low number of claims, a recession started a month later, and jobless claims would nearly double within six months. This episode serves as a reminder that every recession followed interim lows in jobless claims and the unemployment rate. We are confident that the dynamics leading to the next recession will not be any different.

But then again, maybe the yield-curve is already giving us the answer.

You Have A “Trading” Problem – 10 Steps To Fix It

In April of 2018, I wrote an article entitled “10-Reasons The Bull Market Ended In 2018” in which I concluded:

“There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a ‘panic selling’ situation.)

If I am wrong, and the bull market resumes, we simply remove hedges and reallocate equity exposure.

‘There is little risk, in managing risk.’

The end of bull markets can only be verified well after the fact, but therein lies the biggest problem. Waiting for verification requires a greater destruction of capital than we are willing to endure.”

It is important to remember, that “Risk” is simply the function of how much you will lose when you are wrong in your assumptions.

2018 has been a year of predictions gone horribly wrong.

Not surprisingly, after a decade-long bull market, individuals who were betting on a more positive outcome this year are now clinging to “hope.”

Do you remember all of the analysis about how:

  • Rate hikes won’t matter
  • Surging earnings due to tax cuts will power the market higher
  • Valuations are reasonable

These were all issues which we have heavily questioned over the last couple of years.

And the majority of our warnings “fell on deaf ears” as just being simply “bearish.” 

Of course, you really can’t blame the average investor for ignoring fundamental realities considering they have been repeatedly told the stock market is a “sure thing.” Just “buy and hold” and the market will return 10% a year just as it has over the last 100 years.

This fallacy has been so repeatedly espoused by pundits, brokers, financial advisors, and the media that it has become accepted as “truth.”

But, if it were true, then explain why roughly 80% of Americans, according to numerous surveys, have less than one years salary saved up on average? Furthermore, no one who simply bought and held the S&P 500 has ever lost money over a 10- or 20-year time span. Right? 

Not exactly.

Here is the problem.

No matter how resolute people think they are about buying and holding, they usually fall into the same old emotional pattern of “buying high” and “selling low.”

Investors are human beings. As such, we gravitate towards what feels good and we seek to avoid pain. When things are euphoric in the market, typically at the top of a long bull market, we buy when we should be selling. When things are painful, at the end of a bear market, we sell when we should be buying.

In fact, it’s usually the final capitulation of the last remaining “holders” that sets up the end of the bear market and the start of a new bull market. As Sy Harding says in his excellent book “Riding The Bear:” 

“No such creature as a ‘buy and hold’ investor ever emerged from the other side of the subsequent bear market.”

Statistics compiled by Ned Davis Research back up Harding’s assertion. Every time the market declines more than 10%, (and “real” bear markets don’t even officially begin until the decline is 20%), mutual funds experience net outflows of investor money. To wit:

“Lipper also found the largest outflows on record from stocks ($46BN)the largest outflows since December 2015 from taxable bond ($13.4BN) and Investment Grade bond ($3.7BN) funds, and the 4th consecutive week of outflows from high yield bonds ($2.1BN), offset by a panic rush into cash as money market funds attracted over $81BN in inflows, the largest inflow on record.”

“Fear is a stronger emotion than greed.”

Most bear markets last for months (the norm), or even years (both the 1929 and 1966 bear markets), and one can see how the torture of losing money week after week, month after month, would wear down even the most determined “buy and hold” investor.

But the average investor’s pain threshold is a lot lower than that. The research shows that it doesn’t matter if the bear market lasts less than 3 months (like the 1990 bear) or less than 3 days (like the 1987 bear). People will still sell out, usually at the very bottom, and almost always at a loss.

So THAT is how it happens.

And the only way to avoid it – is to avoid owning stocks during bear markets. If you try to ride them out, odds are you’ll fail. And if you believe that we are in a “New Era,” and that bear markets are a thing of the past, your next of kin will have our sympathies.

But you can do something about it.

Just like any “detox” program, these are the steps to follow to becoming a better long-term investor.

10-Step Process To Curing The Addiction

STEP 1: Admitting there is a problem 

The first step in solving any problem is to realize that you have a “trading” problem. Be willing to take the steps necessary to remedy the situation

STEP 2: You are where you are

It doesn’t matter what your portfolio was in March of 2000, March of 2009, or last Friday.  Your portfolio value is exactly what it is, rather it is realized or unrealized. The loss is already lost, and understanding that will help you come to grips with needing to make a change. Open those statements and look at them – shock therapy is usually effective in bringing about awareness.

STEP 3:  You are not a loser

Most people have a tendency to believe that if they “sell a loser,” then they are a “loser” by extension. They try to ignore the situation, or hide the fact they lost money, which in turn causes more mistakes. This only exacerbates the entire problem until they then try to assign blame to anyone and anything else.

You are not a loser. You made an investment mistake. You lost money. 

It has happened to every person that has ever invested in the stock market, and there are many others who lost more than you.

STEP 4:  Accept responsibility

In order to begin the repair process, you must accept responsibility for your situation. It is not the market’s fault. It is not your advisor’s or money manager’s fault, nor is it the fault of Wall Street. 

It is your fault.

Once you accept that it is your fault and begin fixing the problem, rather than postponing the inevitable and suffering further consequences of inaction, only then can you begin to move forward.

STEP 5:  Understand that markets change

Markets change due to a huge variety of factors from interest rates to currency risks, political events, to geo-economic challenges.

If this is a true statement, then how does it make sense to buy and hold?

If markets are in a constant state of flux, and your portfolio remains in a constant state, then the law of change must apply: 

The law of change:  Change will occur and the elements in the environment will adapt or become extinct and that extinction in and of itself is a consequence of change. 

Therefore, if you are a buy and hold investor then you have to modify and adapt to an ever-changing environment or you will become extinct.

STEP 6:  Ask for help

This market has baffled, and confused, even the best of investors and will likely continue to do so for a while. So, what chance do you have doing it on your own?

Don’t be afraid to ask, or get help, if you need it. This is no longer a market which will forgive mistakes easily and while you may pay a little for getting help, a helping hand may keep you from making more costly investment mistakes in the future.

STEP 7:  Make change gradually

No one said that change was going to easy or painless. Going against every age-old philosophy and piece of advice you have ever been given about investing is tough, confusing and froth with doubt.

However, make changes gradually at first – test the waters and measure the results. For example, sell the positions that are smallest in size with the greatest loss. You will make no noticeable change in the portfolio right away, but it will make you realize that you can actually execute a sell order without suffering a negative consequence.

Gradually work your way through the portfolio on rallies and cleanse the portfolio of the evil seeds of greed that now populate it, and replace them with a garden of investments that will flourish over time.

STEP 8:  Develop a strategy 

Now that you have cleaned everything up you should be feeling a lot more in control of your portfolio and your investments. Now you are ready to start moving forward in the development of a goal-based investment strategy.

If your portfolio is a hodge-podge of investments, then how do you know whether or not your portfolio will generate the return you need to meet your goals. A goal-based investment strategy builds the portfolio to match investments, and investment vehicles, in an orderly structure to deliver the returns necessary with the least amount of risk possible. Ditch the benchmark index and measure your progress against your investment destination instead.

STEP 9:  Learn it. Live it. Love it.

Once you have designed the strategy, including monthly contributions to the plan, it is time to implement it. This is where the work truly begins.

  • You must learn the plan inside and out so every move you make has a reason and a purpose. 
  • You must live the plan so that adjustments are made to the plan, and the investments, to match performance, time and value horizons.
  • Finally, you must love the plan so that you believe in it and will not deviate from it. 

It must become a part of your daily life, otherwise, it will be sacrificed for whims and moments of weakness.

STEP 10:  Live your life 

That’s it.

You are in control of your situation rather than the situation controlling you.

The markets will continue to remain volatile as a more important “bear market” takes hold in the next year or so.

The good news is that there will be lots of opportunities to make money along the way.

But that is just how it works. As long as you work your plan, the plan will work for you, and you will reach your goals…eventually.

There is no “get rich quick” plan.

So, live your life, enjoy your family, and do whatever it is that you do best. Most importantly, make your portfolio work as hard for you as you did for the money you put into it.

Did The Market Miss Powell’s Real Message?

Last week, I discussed the recent message from Fed Chairman Jerome Powell which sent the markets surging higher.

“During his speech, Powell took to a different tone than seen previously and specifically when he stated that current rates are ‘just below’ the range of estimates for a ‘neutral rate.’ This is a sharply different tone than seen previously when he suggested that a “neutral rate” was still a long way off.

Importantly, while the market surged higher after the comments on the suggestion the Fed was close to ‘being done’ hiking rates, it also suggests the outlook for inflation and economic growth has fallen. With the Fed Funds rate running at near 2%, if the Fed now believes such is close to a ‘neutral rate,’ it would suggest that expectations of economic growth will slow in the quarters ahead from nearly 6.0% in Q2 of 2018 to roughly 2.5% in 2019.”

Since then, the bond market has picked up on that realization as the yield has flattened considerably over the last few days as the 10-year interest rate broke back below the 3% mark. The chart below shows the difference between the 2-year and the 10-year interest rate.

Now, there are many who continue to suggest “this time is different” and an inverted yield curve is not signaling a recession, and Jerome Powell’s recent comments are “in line” with a “Goldilocks economy.”

Maybe.

But historically speaking, while an inversion of the yield curve may not “immediately” coincide with a recessionary onset, given its relationship to economic activity it is likely a “foolish bet” to suggest it won’t. A quick trip though the Fed’s rate hiking history and “soft landing” scenarios give you some clue as to their success.

While the Fed has been acting on previously strong inflationary data due to surging oil prices, the real long-term drivers of inflation pressures weren’t present. I have commented on this previously, but Kevin Giddis from Raymond James had a good note on this:

“We have always known that the bond market wasn’t as worried about inflation as the Fed, but it really needed the Fed to come out and indicate a ‘shift’ in that way of thought to seal the deal.”

This is exactly correct, and despite the many arguments to the contrary we have repeatedly stated the rise in interest rates was a temporary phenomenon as “rates impact real economic activity.” The “real economy,” due to a surge in debt-financed activity, was not nearly strong enough to withstand substantially higher rates. Of course, such has become readily apparent in the recent housing and auto sales data.

Flat As A Pancake

All of sudden, the bond market has woken up to reality after a year-long slumber. The current spread between the 2-year note and the 10-year note is as tight as it has been in many years and has rarely occurred when the economic fundamentals were as strong as many believe.

The reality, of course, is much of the current strength in economic activity is not from organic inputs in a consumer-driven economy, but rather from one-off impacts of several natural disasters, a surge in consumer debt, and a massive surge in deficit spending. To wit:

“The problem is the massive surge in unbridled deficit spending only provides a temporary illusion of economic growth. Over the long-term, debt leads to economic suppression. Currently, the deficit is rapidly approaching $1 Trillion, and will exceed that level in 2019, which will require further increases in the national debt.”

“There is a limited ability to issue debt to pay for excess spending. The problem with running a $1 Trillion deficit during an economic expansion is that it reduces the effectiveness of that tool during the next recession.”

Our assessment of Powell’s change in tone comes from the message the bond market is sending about the risk to the economy. Since economic data is revised in arrears, the onset of a recession will likely surprise most economists when they learn about it “after the fact.”  Let’s go back to Kevin:

“Here is what we know right now:

1) The U.S. economy seems to be slowing, falling under the weight of higher borrowing costs. What’s hard to predict is whether this is a trend change or a temporary pause.

2) The Fed appeared to blink last week, but we won’t know for sure until December 19th when they release their Rate Decision and ‘tell’ the market what the forward-looking path looks like to them.

3) Inflation is well-contained. For all of you who left town riding on the ‘inflation train,’ welcome back.

4) Global economies are weakening and could get weaker.

5) Friday’s release of the Employment Report should give the market guidance on wages, but not much else.

Kevin is correct, take a look at inflation breakeven rates.

It is quite likely these are not temporary stumbles, but rather a more important change in the previous trends. More importantly, the “global weakness” has continued to accelerate and given that roughly 40% of corporate profits are driven by exports, this does not bode well for extremely lofty earnings forecasts going into 2019.

What Powell Really Said

Caroline Baum had an interesting comment on MarketWatch on Tuesday morning:

“I read with interest the articles last week about the Federal Reserve’s new “unpredictable” and “flexible” approach to monetary policy. No longer can financial markets rely on the gradual, premeditated and practically pre-announced adjustments to the benchmark overnight interest rate, according to these analyses. From now on, the Fed will be ‘data dependent.’”

The whole article is worth a read, but the point being made is that the Fed has always been “data dependent” even if their ability to read and interpret the data has been somewhat flawed. The table below is the average range of their predictions for GDP they publish each quarter versus what really happened.

As Caroline noted, the September projections pegged the “neutral rate” range at 2.5-3.5% with a median estimate of 3%. If Powell is indeed suggesting that the neutral rate has fallen to the low-end of that range, he is likely only confirming what the “yield curve” has been telling us for months. As I quoted previously:

“The yield curve itself does not present a threat to the U.S. economy, but it does reflect a change in bond investor expectations about Federal Reserve actions and about the durability of our current economic expansion.”

Importantly, yield curves, like valuations, are “terrible” with respect to the “timing” of the economic slowdown and/or the impact to the financial markets. So, the longer the economy and markets continue to grow without an event, or sign of weakness, investors begin to dismiss the indicator under the premise “this time is different.” 

The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting that Powell may have “woken up to smell the coffee.” While the curve is not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker much of the mainstream economists suggests. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q4.)

Mr. Powell most likely also realizes that continuing to tighten monetary policy will simply accelerate the time frame to the onset of the next recession. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

The only question is the timing.

There are currently too many indicators already suggesting higher rates are impacting interest rate sensitive, and economically important, areas of the economy. The only issue is when investors recognize the obvious and sell in the anticipation of a market decline.

As I discussed previously, the stock market is a strong leading indicator of economic turns and the turmoil this year may be signaling just that.

Believing that professional investors will simply ignore the weight of evidence to contrary in the “hopes” this “might” be different this time is not a good bet as “risk-based” investors will likely act sooner, rather than later. Of course, the contraction in liquidity causes the decline in asset prices which will contribute to the economic contraction as consumer confidence is shattered. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become “obvious” the yield curve was sending the correct message until far too late to be useful.

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

Closed-End Fund Discounts

It’s debatable whether the recent stock market slide created some bargains, but there’s another corner of financial markets where inefficiencies prevail more regularly – the closed-end fund universe.

What’s a Closed-End Fund?

Unlike mutual funds, which continually issue and redeem shares according to investor demand, closed-end funds take in money and issue a finite number of shares once, in an initial public offering. After the IPO, the fund closes to new money; there are no outflows and no inflows, making the arrangement convenient for holding illiquid assets. Investors must then trade shares on an open exchange like stocks to each other rather than purchasing and redeeming with the fund itself.

For that reason, the share price of a closed-end fund can rise above or fall below the net asset value of the fund’s holdings. When a fund’s share price drops below, or trades at a discount to, its net asset value (NAV), it can be a bargain as long as investors understand there’s no guarantee that the price will match its NAV soon or ever. Sometimes activist investors accumulate closed-end fund shares to pressure fund management to liquidate the assets and use the proceeds to buy back shares in order to close the gap between price and NAV. But there’s no guarantee an activist will accumulate shares of any fund or apply pressure successfully after accumulation.

The other important feature of closed-end funds is that they often borrow money against their investments. Regulations demand that a fund have $3 in assets for every $1 of debt issued and $2 of assets for every $1 of preferred stock issued. But those rules still allow for a significant amount of borrowed money that can boost returns when the assets in the funds are doing well and interest rates remain stable or hurt returns when underlying assets are slumping and interest rates are increasing. As of the end of 2017, around 64% of closed-end funds used leverage or borrowed money, according to the Investment Company Institute.

Currently, 250 out of 638 funds in Morningstar’s database are trading at discounts to NAV of 10% or more. Municipal bond funds have significant representation among the funds trading at the largest discounts, though other classes of funds, including energy and MLP funds are among the most heavily discounted.

Any Bargains?

I compiled a list of funds trading at the biggest discounts and with a z-score of -2.5 or lower. A z-score is the difference between the fund’s current and average discounts relative to its standard deviation. Many analysts consider a z-score of -2.5 or less as an indication of cheapness.

Four of the top-10 on our list of biggest current discounts and Z-Scores of -2 or lower are muni bond funds. All of them have leverage ratios above 35%. That means if interest rates continue to move higher, bond funds using borrowed money could suffer. But if rates stabilize or decline, that could be a boon for these funds.

Also, a word of caution about the Boulder fund – I’ve seen it among funds with the cheapest discounts for many years. The discount could narrow from here, but I wouldn’t count on it to close.

Overall, investors have a variety of funds in different asset classes from which to choose. But investors should think of this type of investment as a stock investment even if the fund holds bonds. That’s because using borrowed money magnifies the overall investment risk.

Employment: It’s The Trend That Matters

Last week, the Bureau of Labor Statistics (BLS) published the August monthly “employment report” which showed an increase in employment of 201,000 jobs. It was also the 94th consecutive positive jobs report which is one of the longest in U.S. history.

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 there were a reported 201,000 jobs created in the month of August, the two prior months were quietly revised lower by 50,000 jobs. For the 3-months combined, the average rate of job growth between June and August was just 185,333 which stands decently below the 211,000 average rates of job growth over the last five years.

Then there is the whole issue of seasonal adjustments which try to account for temporary changes to employment due to seasonal workers. The chart below shows the swings between the non-seasonally adjusted and seasonally adjusted data.

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 actually the “trend” of the data which is far more important to understand.

The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current annual rate of employment growth is 1.6% which is lower than any previous employment level prior to a recession in history.

But while this is a long-term view of the trend of employment in the U.S., what about right now? The chart below shows employment from 1999 to present.

While the recent employment report was slightly above expectations, the annual rate of growth is slowing. The chart above shows two things. The first is the trend of the household employment survey on an annualized basis. Secondly, while the seasonally-adjusted reported showed 201,000 jobs being created, the actual household survey showed a loss of 423,000 jobs which wiped out all of the job gains in June and July as summer workers returned to school. 

There are many that do not like the household survey for a variety of reasons. However, even if we use the 3-month average of the seasonally-adjusted employment report, we see the exact same picture. (The 3-month average simply smooths out some of the volatility.)

But here is something else to consider.

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. A simpler method to use for smoothing volatile monthly data is using a 12-month moving average of the raw data as shown below.

Notice that near peaks of employment cycles the employment data deviates from the 12-month average but tends to reconnect 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. 

But there is more to this story.

A Function Of Population

One thing which is never discussed when reporting on employment is the “growth” of the working age population. Each month, new entrants into the population create “demand” through their additional consumption. Employment should increase to accommodate for the increased demand from more participants in the economy. Either that or companies resort to automation, off-shoring, etc. to increase rates of production without increases in labor costs. The chart below shows the total increase in employment versus the growth of the working age population.

The missing “millions” shown in the chart above is one of the “great mysteries” about one of the longest economic booms in U.S. history. This is particularly a conundrum when the Federal Reserve talks about the economy nearing “full employment.” The Labor Force Participation Rate below shows this great mystery.

Of course, as we are all very aware, there are many people who are working part-time, going to school, etc. But even when we consider just those working “full-time” jobs, particularly when jobless claims are reaching record lows, the percentage of full-time employees is still well below levels of the last 35 years.

“With jobless claims at historic lows, and the unemployment rate at 4%, then why is full-time employment relative to the working-age population at just 49.82% which is down from 49.9% last month?”

It’s All The Baby Boomers Retiring

One of the arguments often given for the low labor force participation rate is that millions of “baby boomers” are leaving the workforce for retirement. This argument doesn’t carry much weight given that the “Millennial” generation, which is significantly larger, is simultaneously entering the workforce. The other problem is shown below, there are more individuals over the age of 55, as a percentage of that age group, in the workforce today than in the last 50-years.

Of course, the reason they aren’t retiring is that they can’t. After two massive bear markets, weak economic growth, questionable spending habits,and poor financial planning, more individuals over the age of 55 are still working because they simply can’t “afford” to retire.

However, for argument sake, let’s assume that every worker over the age of 55 retires. If the “retiring” argument is valid, then employment participation rates should soar once that group is removed. The chart below is full-time employment relative to the working-age population of 16-54.

Importantly, note in the first chart above the number of workers over the age of 55 increased last month. However, employment of 16-54 year olds declined from 50.43% to 50.35%. It is also, the lowest rate since 1985, which was the last time employment was increasing from such low levels.

The other argument is that Millennials are going to school longer than before so they aren’t working either. (We have an excuse for everything these days.) The chart below strips out those of college age (16-24) and those over the age of 55.

With the prime working age group of labor force participants still at levels seen previously in 1988, it does raise the question of just how robust the labor market actually is?

Low initial jobless claims coupled with the historically low unemployment rate are leading many economists to warn of tight labor markets and impending wage inflation. If there is no one to hire, employees have more negotiating leverage according to prevalent theory. While this seems reasonable on its face, further analysis into the employment data suggests these conclusions are not so straightforward.

Strong Labor Statistics

Michael Lebowitz recently pointed out some important considerations in this regard.

“The data certainly suggests that the job market is on fire. While we would like nothing more than to agree, there is other employment data which contradicts that premise.”

For example, if there are indeed very few workers in need of a job, then current workers should have pricing leverage over their employers.  This does not seem to be the case as shown in the graph of personal income below.

Furthermore, a closer inspection of the BLS data reveals that, since 2008, 16 million people were reclassified as “leaving the workforce”. To put those 16 million people into context, from 1985 to 2008, a period almost three times longer than the post-crisis recovery, a similar number of people left the workforce.

Why are so many people struggling to find a job and terminating their search if, as we are repeatedly told, the labor market is so healthy? To explain the juxtaposition of the low jobless claims number and unemployment rate with the low participation rate and weak wage growth, a calculation of the participation rate adjusted unemployment rate is revealing.

When people stop looking for a job, they are still unemployed, but they are not included in the U-3 unemployment calculation. If we include those who quit looking for work in the data, the employment situation is quite different. The graph below compares the U-3 unemployment rate to one that assumes a constant participation rate from 2008 to today. Contrary to the U-3 unemployment rate of 3.90%, this metric implies an adjusted unemployment rate of 8.69%.

Importantly, this number is much more consistent with the data we have laid out above, supports the reasoning behind lower wage growth, and is further confirmed by the Hornstein-Kudlyak-Lange Employment Index.

(The Hornstein-Kudlyak-Lange Non-Employment Index including People Working Part-Time for Economic Reasons (NEI+PTER) is a weighted average of all non-employed people and people working part-time for economic reasons expressed as the share of the civilian non-institutionalized population 16 years and older. The weights take into account persistent differences in each group’s likelihood of transitioning back into employment. Because the NEI is more comprehensive and includes tailored weights of non-employed individuals, it arguably provides a more accurate reading of labor market conditions than the standard unemployment rate.)

One of the main factors driving the Federal Reserve to raise interest rates and reduce its balance sheet is the perceived low level of unemployment. Simultaneously, multiple comments from Fed officials suggest they are justifiably confused by some of the signals emanating from the jobs data. As we have argued in the past, the current monetary policy experiment has short-circuited the economy’s traditional traffic signals. None of these signals is more important than employment.

As Michael noted:

“Logic and evidence argue that, despite the self-congratulations of central bankers, good wage-paying jobs are not as plentiful as advertised and the embedded risks in the economy are higher. We must consider the effects that these sequences of policy error might have on the economy – one where growth remains anemic and jobs deceptively elusive.

Given that wages translate directly to personal consumption, a reliable interpretation of employment data has never been more important. Oddly enough, it appears as though that interpretation has never been more misleading. If we are correct that employment is weak, then future rate hikes and the planned reduction in the Fed’s balance sheet will begin to reveal this weakness soon.”

As an aside, it is worth noting that in November of 1969 jobless claims stood at 211,000, having risen slightly from the lows recorded earlier that year. Despite the low number of claims, a recession started a month later, and jobless claims would nearly double within six months. This episode serves as a reminder that every recession followed interim lows in jobless claims and the unemployment rate. We are confident that the dynamics leading to the next recession will not be any different.

But then again, maybe the yield-curve is already giving us the answer. With the Fed already slated to hike interest rates further, the only question is “what breaks first?”

Don’t Fear The Yield Curve?

In July of this year, James McCusker penned an article entitled “Don’t Fear The Yield Curve” in which he stated:

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.”

I didn’t think much of the article at the time as it was an outlier. However, now, given the yield curve continues to trail lower, despite the many calls of “bond bears” swearing rates are going to rise, the number of voices in the “this time is different” camp has grown.

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,”Ryan Detrick, LPL

“In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

First, the yield curve is simply the difference in the yields of different maturities of bonds. However, in this particular case, we are discussing the difference between the 2-year and the 10-year rate on U.S. Treasury bonds.

Historically speaking, the yield curve has been a consistent predictor of weaker economic times in the U.S. As James noted:

“The yield curve itself does not present a threat to the U.S. economy, but it does reflect a change in bond investor expectations about Federal Reserve actions and about the durability of our current economic expansion.”

Importantly, yield curves, like valuations, are “terrible” with respect to the “timing” of the economic slowdown and/or the impact to the financial markets. So, the longer the economy and markets continue to grow without an event, or sign of weakness, investors begin to dismiss the indicator under the premise “this time is different.” 

James did hit on an important point but misses the mark.

“Much of our economy relies on debt, and the so-called ‘entitlement’ sector of government spending is dependent on investors parting with cash to purchase trillions of dollars of the federal government’s debt. That means that the investor expectations reflected in the yield curve have some weight. However, it is good to remember that the negative yield curve may simply be the result of a delayed reaction of long-term interest rates to the economy’s expansion. If long-term rates were to rise, the inversion of the yield curve would disappear.”

He is right that we are in a debt-driven economy. Corporate, household, margin, student, and government debt are at all- time highs. That debt has a cost. It must be serviced. Therefore, as rates rise, the cost of servicing rises commensurately. This is particularly the case with variable rate, credit card, and other debt which are tied directly to short-term rates which is impacted by changes in the overnight lending rates (aka Fed monetary policy).

As rates rise on the short-end, and as expected rates of future returns fall, money is shifted toward the “safety” of longer-dated U.S. Treasuries not only by domestic investors, but also foreign investors which are seeking safety from a stronger dollar, weaker economic growth, or reduced financial market expectations.

While there are many calls to ignore the yield curve, some of the most economically sensitive commodities. like Copper, are providing a cause for concern. Per Jesse Colombo: 

“Copper, which is known as “the metal with a PhD in economics” due to its historic tendency to lead the global economy, is down nearly 4 percent today alone and 22 percent since early-June. Copper’s bear market of the past couple of months is worrisome because it signals that a global economic slowdown is likely ahead.”

Copper Daily Chart

Even exports from South Korea, which acts as a leading indicator of economic activity has turned sharply lower as well.

While “sentiment” data was previously extremely elevated over “hopes” that “Trumponics” would create an broad-based economic surge, as noted recently, such has not been the case and “sentiment” is now catching “down” with reality.

Of course, one really needs to look no further than the bond market which is also screaming the Fed is once again, as they always have, making a monetary policy mistake. The chart below shows, GDP as compared to both the 5- and 10-year inflation “breakeven” rates. As noted, there was a significant boost to economic activity following three massive hurricanes and two major wildfires in 2017. That bump to activity only served to “pull forward” future economic activity, increasing short-term inflationary pressures, which are now beginning to subside.

The message is quite simple.

The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q3)

Furthermore, the AAA-Junk yield curve is also beginning to suggest problems for companies which have binged on debt issuance to support share buybacks over the last decade.

The annual rate of change for bank loans and leases as well has residential homes loans have all started declined as higher rates are crimping demand.

While none of this suggests a problem is imminent, nor does it RULE OUT higher highs in the markets first, there is mounting evidence the Fed is headed towards making another mistake in their long line of creating “boom/bust” cycles.

Looking back through history, the evidence is quite compelling that from the time the first rate hike is induced into the system, it has started the countdown to the next recession.

The Federal Reserve is quickly becoming trapped by its own “data-dependent” analysis. Despite ongoing commentary of improving labor markets and economic growth, their own indicators have been suggesting something very different. This is why the scrapped their Labor Market Conditions Index and are now trying to come up with a “new and improved” yield curve to support their narrative. 

Tightening monetary policy further will simply accelerate the time frame to the onset of the next recession. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

The only question is the timing.

It is unlikely this time is different. There are too many indicators already suggesting higher rates are impacting interest rate sensitive, and economically important, areas of the economy. The only issue is when investors recognize the obvious and sell in the anticipation of a market decline.

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

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

The Longest Bull Market In History & What Happens Next

“Barring a breathtaking plunge, the bull market in U.S. stocks on Aug. 22 will become the longest in history, and optimistic investors argue it has miles to go before it rests.”Sue Chang, MarketWatch

Depending on how you measure beginnings and endings, or what constitutes a bear market or the beginning of a bull market, makes the statement a bit subjective. However, there is little argument the current bull market has had an exceptionally long life-span.

But rather than a “siren’s song” luring investors into the market, maybe it should serve as a warning.

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

It should be remembered that when records are broken that was the point where previous limits were reached.  Also, just as in horse racing, sprinting or car races, the difference between an old record and a new one are often measured in fractions of a second.

Therefore, when a “record level” is reached it is NOT THE BEGINNING, but rather an indication of the PEAK of a cycle. Records, while they are often broken, are often only breached by a small amount, rather than a great stretch. While the media has focused on record low unemployment, record stock market levels, and record 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.

The chart below has been floating around the “web” in several forms as “evidence” that investors should just stay invested at all times and not worry about the downturns. When taken at “face value,” it certainly appears to be the case. (The chart is based up Shiller’s monthly data and is inflation-adjusted total returns.)

The problem is the entire chart is incredibly deceptive.

More importantly, for those saving and investing for their retirement, it’s dangerous.

Here is why.

The first problem is the most obvious, and a topic I have addressed many times in past missives, you must worry about corrections.

Most investors don’t start seriously saving for retirement until they are in their mid-40’s. This is because by the time they graduate college, land a job, get married, have kids and send them off to college, a real push toward saving for retirement is tough to do as incomes, while growing, haven’t reached their peak. This leaves most individuals with just 20 to 25 productive work years before retirement age to achieve investment goals. 

This is where the problem is. There are periods in history, where returns over a 20-year period have been close to zero or even negative.”

Currently, we are in one of those periods.

Lies, Damned Lies, And Statistics

Secondly, percentages are deceptive.

Back to the first chart above, while the mainstream media and bloggers love to talk about gains and losses in terms of percentages, it is not an apples to apples comparison.

Let’s look at the math.

Assume that an index goes from 1000 to 8000.

  • 1000 to 2000 = 100% return
  • 1000 to 3000 = 200% return
  • 1000 to 4000 = 300% return
  • 1000 to 8000 = 700% return

A 700% return is outstanding, so why worry about a 50% correction in the market when you just gained 700%?

Here is the problem with percentages.

A 50% correction does NOT leave you with a 650% gain.

A 50% correction is a subtraction of 4000 points which reduces your 700% gain to just 300%.

Then the problem now becomes the issue of having to regain those 4000 lost points just to break even.

Let’s look at the S&P 500 inflation-adjusted total return index in a different manner.

The first chart shows all of the measurement lines for all the previous bull and bear markets with the number of years required to get back to even.

What you should notice is that while the original chart above certainly makes it appear as if “bear markets” are no “big deal,” the reality is that in many cases bear markets wiped out essentially a substantial portion, if not all, of the the previous bull market advance. This is shown more clearly when we convert the percentage chart above into a point chart as shown below.

Here is another way to view the same data. The table and chart below overlays the point AND percentage of gain and loss for each bull and bear market period going back to 1900 (inflation-adjusted).

Again, the important thing to note is that while record “bull markets” are a great thing in the short-term, they are just one half of the full-market cycle. With regularity, the following decline has mostly erased the previous gain.

Broken Records

While the financial media is anticipating a new “record” being set for this “bull market,” here is something to think about.

  • Bull markets END when everything is as “good as it can get.”
  • Bear markets END when things simply can’t “get any worse.”

While everything is certainly firing on all cylinders in the market and economy currently, for investors this should be taken as a warning sign rather than an invitation to pile on additional risk.

In the near term, over the next several months, or even a year, markets could very likely continue their bullish trend as long as nothing upsets the balance of investor confidence and market liquidity.

This bull market will easily set a “new bull market record.”

But, as I said, “records are records” for a reason. As Ben Graham stated back in 1959:

“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’

The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound,  then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.

In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”

He is right, of course, things are little different now than they were then.

For every “bull market” there MUST be a “bear market.” 

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering “passive” approaches will also “pace” the decline.

Understanding that your investment returns are driven by actual dollar losses, and not percentages, is important in the comprehension of what a devastating effect corrections have on your financial outcome. So, before sticking your head in the sand and ignoring market risk based on an article touting “long-term investing always wins,” ask yourself who really benefits?

This time will not be “different.”

If the last two bear markets haven’t taught you this by now, I am not sure what will.

Maybe the third time will be the “charm.”

Boiling A Turkey

There is an age old fable describing a frog being slowly boiled alive. The premise is that if a frog is put suddenly into boiling water, it will try and save itself. However, if the frog is put in tepid water which is then brought to a boil slowly, it will not perceive the danger and will be cooked to death. The metaphor is often ascribed to the inability, or unwillingness, of people to react to or be aware of threats which arise gradually rather than suddenly.

This metaphor was brought to mind as I was writing last weekend’s newsletter discussing the issue of Turkey and the potential threat posed to the global economy. Specifically, I was intrigued by the following points from Daniel Lacalle:

“The collapse of Turkey was an accident waiting to happen and is fully self-inflicted.”

It is yet another evidence of the train wreck that monetarists cause in economies. Those that say that ‘a country with monetary sovereignty can issue all the currency it wants without risk of default’ are wrong yet again. Like in Argentina, Brazil, Iran, Venezuela, monetary sovereignty means nothing without strong fundamentals to back the currency.

Turkey took all the actions that MMT lovers applaud. The Erdogan government seized control of the central bank, and decided to print and keep extremely low rates to ‘boost the economy’ without any measure or control.

Turkey’s Money Supply tripled in seven years, and rates were brought down massively to 4,5%.

However, the lira depreciation was something that was not just accepted by the government but encouraged.  Handouts in fresh-printed liras were given to pensioners in order to increase votes for the current government, subsidies in rapidly devaluing lira soared by more than 20% (agriculture, fuel, tourism industry) as the government tried to compensate the loss of tourism revenues due to security concerns with subsidies and grants.

Loss of foreign currency reserves ensued, but the government soldiered on promoting excessive debt and borrowing. Fiscal deficits soared, and the rapidly devaluing lira led to a rising amount of loans in US dollars.

This is the typical flaw of monetarists, they believe monetary sovereignty shields the country from external shocks and loans in foreign currencies soar because no one wants to lend in a constantly-debased currency at affordable rates. Then the central bank raises rates but the monetary hole keeps rising as the money supply continues to grow to pay for handouts in local currency.”

Frog Meets Water 

If any of Daniel’s commentary sounds familiar, you shouldn’t be surprised. The U.S. has been doing much of the same for the last several decades under the same faulty Keynesian/MMT set of beliefs.

But, lets make a big distinction, the U.S. is not Turkey.

While the U.S. may be vastly different than Turkey in many respects, such doesn’t mean pursing the same policies will have a different result.

For example, as Daniel notes, Turkey has provided “handouts” to secure votes. But the U.S. has done, and continues to do the same thing via programs like “paid leave,” “child tax credits,” a smörgåsbord of welfare and entitlement programs. In fact, government assistance programs now make up a record level of disposable personal incomes as 1-in-4 households depend on some form of government program.

This continued push to provide more governmental assistance, and the rise of “socialist” political leanings, should not come as a surprise in an economy where there is an annual deficit of more than $3250 to maintain the standard of living after consumers have exhausted wages, savings and credit.

This is not just about securing votes of the less fortunate. For example, military spending, corporate tax cuts and banking de-regulation to name a few examples, help line the pockets of shareholders and corporate executives and certainly influence their voting patterns.

Since there is simply not enough tax revenue to fund these programs, the government must rely on debt issuance to fund the shortfall. More importantly, since fiscal policies like “tax reform” lower government revenue, when those programs are not offset with real spending cuts, deficits increase more quickly.

Despite assurances from the current Administration that tax reform would lead to higher tax revenues and reduce the deficit – it is actually quite the opposite that has occurred. As shown below, spending has surged while tax receipts have stagnated. As a result the deficit is set to explode and the amount of government debt outstanding will increase by over $1 trillion in each of the next four years.

While most modern economists believe that debt and deficits have little to no consequence, the data suggests otherwise. While deficits continue to be a “talking point” for conservative politicians wanting to win elections, unbridled spending has become the “fiscal policy” of choice. Of course, economic growth has been the ultimate sacrifice. The surge in the deficit in the coming months will reverse the recent spat of economic growth as the boost from a slew of natural disasters last year and tax related boosts fade.

As I stated, in order to fund that spending, the money has to come from either taxpayers or debt issuance. As shown in the next two charts, government debt as percentage of economic growth continues to climb.

The saving grace currently is that interest rates remain at some of the lowest levels on record historically speaking. While that may seem good, lower rates only feed more economic problems as Michael Lebowitz recently discussed in Wicksell’s Elegant Model:

“Where capital is involved, discipline is either applied or neglected through the mechanism of interest rates. To apply a simple analogy, in those places where water is plentiful, cheap, and readily available through pipes and faucets, it is largely taken for granted. It is used for the basic necessities of bathing and drinking but also to wash our cars and dogs. In countries where clean water is not easily accessible, it is regarded as a precious resource and decidedly not taken for granted or wasted for sub-optimal uses. In much the same way, when capital is easily accessible and cheap, how it is used will more often be sub-optimal.”

Those low rates have allowed the government to issue substantial levels of debt without having to “pay” a significant financial consequence as of yet. However, even with the government currently paying some of the lowest effective interest rates in history for the debt outstanding, debt payments have risen to the highest level on record.

At the current run rate, which will massively accelerate if rates do indeed rise, the “debt service” will become on the largest budget items for the U.S. in the not too distant future. Currently, debt service and social welfare consume almost 75% of every tax dollar and in the next decade are slated to consume almost 100%. This leaves all other spending, and there is a lot of it, a function of debt issuance.

Issuing more debt to fund a debt problem is not economically viable long-term as the majority of socialist countries eventually come to realize.

Not unlike Turkey, the U.S. has also engaged in a massively increasing its money supply. The result of which has not been surprising. Beginning in 1980, the surge in the monetary base along with household debt has led to an unsurprising and very predictable outcome.

Of course, with wages and economic growth stagnant, and the purchasing power of the dollar continuing its long-term decline, the need for debt and government assistance will continue to increase.

Given the slowing demographic trends, the structural changes to the economy which continues to erode productivity, and the inevitable increase in debt, the net effect will continue to slow rates of economic growth as deflationary pressures build.

As Jesse Colombo noted earlier this week:

“Turkey’s economy has become reliant on cheap credit, and the recent interest rate hikes mean that the country’s cheap credit era has come to an end. Higher interest rates are going to cause a credit bust in Turkey, leading to a serious economic crisis.

While most commentators believe that Turkey’s current turmoil is the result of U.S. sanctions, the reality is that the country’s crisis was already ‘baked into the cake’ years ago. The recent political clash with the U.S. is simply the catalyst for the coming Turkish economic crisis, but it is not the actual cause. I am also highly concerned that Turkey’s current turmoil will lead to further contagion in emerging markets, which have also similarly thrived due to ultra-loose global monetary conditions that are now coming to an end.”

The U.S. Is Not Turkey.

However, there are many more similarities than most politicians and economists wish to admit. The biggest of which is our current dependence on “cheap debt” to fund everything from Government handouts to corporate buybacks, capital expenditures, and household consumption.

Despite hopes of economic resurgence, the reality is likely quite the opposite. Economic trends are hard to reverse and governmental policy trends are impossible to change.

The good news is that the U.S. will eventually start making meaningful fiscal policy reforms. The bad news, like Turkey, is that those changes will come through “force” rather than “choice.” 

But such has been the case for every empire in history from the Romans, to the Greeks, to the British.

Without real, substantive change, the U.S. will likely face a similar outcome.

We have the time to make the right choices.

The only question is do we have the will?

Or, are we simply the “Turkey” in the pot of water.

8-Measures Say A Crash Is Coming, Here’s How To Time It

Mark Hulbert recently penned a very good article discussing the “Eight Best Predictors Of The Stock Market,” to wit:

“The stock market’s return over the next decade is likely to be well below historical norms.

That is the unanimous conclusion of eight stock-market indicators with what I consider the most impressive track records over the past six decades. The only real difference between them is the extent of their bearishness.

To illustrate the bearish story told by each of these indicators, consider the projected 10-year returns to which these indicators’ current levels translate. The most bearish projection of any of them was that the S&P 500 would produce a 10-year total return of 3.9 percentage points annualized below inflation. The most bullish was 3.6 points above inflation.

The most accurate of the indicators I studied was created by the anonymous author of the blog Philosophical Economics. It is now as bearish as it was right before the 2008 financial crisis, projecting an inflation-adjusted S&P 500 total return of just 0.8 percentage point above inflation. Ten-year Treasuries can promise you that return with far less risk.”

Here is one of the eight indicators, a chart of Livermore’s Equity-Q Ratio which is essentially household’s equity allocation to net worth:

The other seven are as follows:

As Hulbert states:

“According to various tests of statistical significance, each of these indicators’ track records is significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine.

However, the differences between the R-squared of the top four or five indicators I studied probably aren’t statistically significant, I was told by Prof. Shiller. That means you’re overreaching if you argue that you should pay more attention to, say, the average household equity allocation than the price/sales ratio.”

As I discussed in “Valuation Measures and Forward Returns:”

“No matter, how many valuation measures I use, the message remains the same. From current valuation levels, the expected rate of return for investors over the next decade will be low.”

This is shown in the chart below, courtesy of Michael Lebowitz, which shows the standard deviation from the long-term mean of the “Buffett Indicator,” or market capitalization to GDP, Tobin’s Q, and Shiller’s CAPE compared to forward real total returns over the next 10-years. Michael will go into more detail on this graph and what it means for asset allocation in the coming weeks.

The Problem With Valuation Measures

First, let me explain what “low forward returns” does and does not mean.

  • It does NOT mean the stock market will have annual rates of return of sub-3% each year over the next 10-years.
  • It DOES mean the stock market will have stellar gains in some years, a big crash somewhere in between, or several smaller ones, and the average return over the decade will be low. 

This is shown in the table and chart below which compares a 7% annual return (as often promised) to a series of positive returns with a loss, or two, along the way. (Note: the annual average return without the crashes is 7% annually also.)

From current valuation levels, two-percent forward rates of return are a real possibility. As shown, all it takes is a correction, or crash, along the way to make it a reality.

The problem with using valuation measures, as Mark Hulbert discusses, is that there can be a long period between a valuation warning and a market correction. This was a point made by Eddy Elfenbein from Crossing Wall Street:

“For the record, I’m a bit skeptical of these metrics. Sure, they’re interesting to look at, but I try to place them within a larger framework.

It’s not terribly hard to find a measure that shows an overvalued market and then use a long time period to show the market has performed below average during your defined overvalued period. That’s easy.

The difficulty is in timing the market.

Even if you know the market is overpriced, that doesn’t tell you much about how to invest today.”

He is correct.

So, if valuation measures tell you a problem is coming, but don’t tell you what to do, then Wall Street’s answer is simply to “do nothing.” After all, you will eventually recover the losses….right?

However, getting back to even and actually reaching your financial goals are two entirely different things as we discussed recently in “Crashes Matter.”

There is an important point to be made here. The old axioms of “time in the market” and the “power of compounding” are true, but they are only true as long as the principal value is not destroyed along the way. The destruction of the principal destroys both “time” and “the magic of compounding.”

Or more simply put – “getting back to even” is not the same as “growing.”

Is there a solution?

Linking Fundamentals To Technicals

I have often discussed an important point in reference to our portfolio management process:

“Fundamentals tell us ‘what’ to buy or sell, technicals tell us the ‘when.'”

Fundamentals are a long-term view on an investment. From these fundamental underpinnings, we can assess and assign a “valuation” to an investment to determine whether it is over or undervalued. Of course, in the famous words of Warren Buffett:

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

In the financial markets, however, psychology can drive prices farther, and further, than logic would dictate. But such is the nature of every stage of a bull market cycle where the “momentum” chase, or rather the physical manifestation of “greed,” comes to life. This is also the point where statements such as “this time is different,” “fundamentals have changed,” or a variety of other excuses, are used to justify rampant speculation in the markets.

Despite the detachment from valuations, as markets continue to escalate higher, the fundamental warnings are readily dismissed in exchange for any data point which supports the bullish bias.

Eventually, it has always come to a rather ignominious ending.

But why does it have to be one or the other?

Currently, the Equity Q-ratio, as graphed above, is at levels that have historically denoted very poor future returns for investors. In other words, if you went to cash today, it is quite likely that over the next 10-years the value of your portfolio would be roughly the same. 

However, before that “mean reverting event” occurs the market will most likely continue to advance. So, there you are, sitting on the sidelines waiting for the crash.

“Damn it, I am missing out. I should have just stayed in.” 

The feeling of “missing out” can be overpowering as the momentum driven market rises. Like gravity, the more the market rises, the greater the pull to “jump back in” becomes. Eventually, and typically near the peak of the market cycle, investors capitulate to the pressure.

Understanding that price is a reflection of short-term market psychology, the trend of prices can give us some clue as to the direction of the market. As the old saying goes:

“The trend is your friend, until it isn’t.” 

While the Equity Q-ratio implies low forward returns, technical analysis can give us the “timing” as to when “psychology” has begun to align with the underlying “fundamentals.”.

In the chart below we have added vertical “gold” bars which denote when negative price changes warrant reducing equity risk in portfolios. (The chart uses quarterly data and triggers a signal when the 6-month moving average crosses the 2-year moving average.)

Since 1951, this “equity reduction” signal has only occurred 17-times. Yes, since these are long-term quarterly moving averages, investors would not have necessarily “top ticked” and sold at the peak, nor would they have bought the absolute bottoms. However, they would have succeeded in avoiding much of the capital destruction of the declines and garnered most of the gains.

The last time the Equity-Q ratio was above 40% was during the late 2015/2016 correction and the technical signal warned that a reduction of risk was warranted.

The mistake most investors make is not getting “back in” when the signal reverses. The value of technical analysis is providing a glimpse into the “stampede of the herd.” When the psychology is overwhelmingly bullish, investors should be primarily allocated towards equity risk. When its not, equity risk should be greatly reduced.

Unfortunately, investors tend to not heed signals at market peaks because the belief is that stocks can only go up from here. At bottoms, investors fail to “buy” as the overriding belief is the market is heading towards zero.

In a recent post, It’s Not Too Early To Be Late, Michael Lebowitz showed the historical pain investors suffered by exiting a raging bull market too early. However, he also showed that those who exited markets three years prior to peaks, when valuations were similar to today’s, profited in the long-run.

While technical analysis can provide timely and useful information for investors, it is our “behavioral issues” which lead to underperformance over time.

Currently, with the Equity Q-ratio pushing the 3rd highest level in history, investors should be very concerned about forward returns. However, with the technical trends currently “bullish,” equity exposure should remain near target levels for now.

That is until the trend changes.

When the next long-term technical “sell signal” is registered, investors should consider heeding the warnings.

Yes, even with this, you may still “leave the party” a little early.

But such is always better than getting trapped in rush for the exits when the cops arrive.

Was Q2-GDP Really All That Extraordinary?

Last week, while I was on vacation, I penned a report prior to the release of the second quarter GDP report in which I noted the following:

“Tomorrow, the US Department of Commerce will report its advance estimate of 2Q GDP which will be the long-awaited evidence that “Trumponomics” is working. The current estimates for the initial print run the gamut from 3.9% to over 5% annualized growth. Regardless of the actual number, the White House spokesman will be quick to take credit for success in turning America’s economy around.

But is that really the case? First, there are several things to remember about the initial print on economic growth.

  • The initial estimate is based on the collection of estimates from Wall Street economists.  With no real data in just yet, the initial estimate just a “guess.”
  • The number is annualized. So, a growth of 1% in the economy is reported as 4%. However, as we know from the first quarter, quarterly growth can vary widely in a given year.
  • Lastly, a one-quarter surge in economic growth doesn’t make much difference in the long-term trajectory of economic growth, or in this case, ongoing weakness.  The chart below shows the change in economic growth by decade.”

As noted, the 1% growth rate in the second quarter was multiplied by 4-quarters to reach the proclaimed 4.1% growth rate. However, there is little evidence to support the notion that such mathematical projections have much validity. The chart below shows inflation-adjusted GDP growth on a quarterly basis as compared to economist expectations of sustained growth over the next 3-quarters. Not surprisingly, economic growth tends to vary widely from those expectations. More importantly, spikes in economic growth tend to lead lower rates over subsequent quarters.  

As we now know, the actual first estimate aligned with the 4% assumption made last week along with the expectation the current Administration, and media pundits, would go “all giddy.”

However, from a portfolio management standpoint, I am more interested in the “devil in the details” as economic growth is key to sustained growth in corporate revenue and profits. From an investment standpoint, it is more important to understand the sustainability of economic growth when projecting forward returns and modeling asset allocations around those assumptions. There are also several other important considerations with respect to the most recent GDP report.

Economy Gets A $1 Trillion Boost

With the release of the Q2 GDP report, and not covered by any of the mainstream media, was an adjustment the economic data going all the way back to 1929.

As noted by Wolf Richter:

“What the Bureau of Economic Analysis released Friday as part of its GDP report was a huge pile of revisions and adjustments going back years. It included an adjustment to the tune of nearly $1 trillion in ‘real’ GDP. And it lowered further its already low measure of inflation.

Comprehensive updates of the National Income and Product Accounts (NIPAs), which are carried out about every five years, are an important part of BEA’s regular process for improving and modernizing its accounts to keep pace with the ever-changing U.S. economy. Updates incorporate newly available and more comprehensive source data, as well as improved estimation methodologies. The timespan for this year’s comprehensive update is 1929 through the first quarter 2018.

Where did a bulk of the change come from? A change in the calculation of “real” GDP from using 2009 dollars to 2012 dollars which boosted growth strictly from a lower rate of inflation.  As noted by the BEA:

“For 2012-2017, the average rate of change in the prices paid by U.S. residents, as measured by the gross domestic purchasers’ price index, was 1.2 percent, 0.1 percentage point lower than in the previously published estimates.”

Of course, when you ask the average household about “real inflation,” in terms of healthcare costs, insurance, food, energy, etc., they are likely to give you quite an earful that the cost of living is substantially higher than 1.2%. Nonetheless, the chart below shows “real” GDP both pre- and post-2018 revisions.

Importantly, the entire revision is almost entirely due to a change in the inflation rate. On a nominal basis, there was virtually no real change at all. In other words, stronger economic growth came from a mathematical adjustment rather than increases in actual economic activity.

Population Matters

When the media reports on economic growth, employment gains, retail sales, personal consumption expenditures or a variety of other measures, there is little consideration given to increases in the population.

With respect to economic growth, population increases matter. In an economy that is 70% driven by personal consumption expenditures, adding more consumers to the population will positively impact economic growth. The increase in demand from additional consumers will lead to an increase in retail sales, employment gains, etc. However, as we showed previously, while there is much “hype” about employment gains in the economy, the reality is that employment has failed to keep pace with population growth.

The chart below shows the difference between “real” GDP growth and “real” GDP growth per capita.

As you can see, once you adjust for population, the growth rate of the economy looks very different. However, we can see a clearer representation of the difference when looking at the average growth rate per decade. I have projected the data out, based on current assumptions, through 2025.

There is a significant difference between reported economic growth rates and GDP per capita. Currently, at just a 1.4% annual growth rate in GDP per capita going forward, the expectations for higher returns on investments must be reconsidered. It is unlikely, with debt to GDP ratios elevated, interest rates rising, and wages stagnant that higher rates of growth can be sustained.

It Wasn’t Really 4%

As was quoted previously, the second quarter GDP report was inflated by a number of one-off factors that will dissipate in the quarters ahead.

An unusually large number of one-off factors appear to have boosted 2Q GDP, many of which are directly related to escalating trade concerns. As companies and countries race to secure supplies that may become expensive later on, exports have surged and inventories have swelled. If these trends are one-time adjustments (and our economists believe they are), the ‘payback’ in 2H could be significant. Enjoy the 2Q GDP number, which may be the last best print for a while.”

Our friends at the Committee for a Responsible Federal Budget provided a good piece of commentary showing the impacts of recent legislation and political actions.

Most of this growth comes from the one-time surge in consumption that accompanies deficit-financed legislation. We recently estimated that other deficit-financed bills would generate a further 0.2 percent of growth.

At the same time, many analysts believe the second-quarter growth numbers are artificially inflated by shifts in consumption to avoid the new tariffs announced this quarter. Most significantly, China appears to have accelerated purchases of soybeans, crude oil, and other exports before new tariffs went into effect. Pantheon Macroeconomics estimated the soybean surge alone could account for as much 0.6 percentage points of the growth rate. These accelerated purchases mean faster growth now at the expense of slower growth later.

Assuming CBO’s numbers apply evenly on a quarterly basis and Pantheon’s numbers are correct, these temporary factors alone account for 1.4 percentage points of annual growth – meaning without them the second-quarter growth rate would fall to 2.7 percent. Even this 2.7 percent figure is likely inflated by the accelerated export of other goods, as well as one-time recovery effects.”

“Growth of 4.1 percent is a fast quarterly growth rate, the highest since the third quarter of 2014 (4.9 percent). Nevertheless, it’s notable that this growth rate is based on several temporary and predictable factors. But importantly, growth often fluctuates quarter to quarter – and over the course of the year, economic growth is likely to be significantly slower.”

We concur with that outlook and expect a significant softening of economic growth over the next couple of quarters. Furthermore, while a one-quarter anomaly is certainly good for media sound bytes, it is a far different matter when it comes to investing capital. The recent pop in economic growth did little to change the long-run dynamics of the economy as I showed previously. More importantly, the quality of economic growth continues to deteriorate due to structural shifts in the economic backdrop.

In modeling assumptions for future returns on invested capital, expectations of weaker economic growth rates must be considered. As we discussed in our third chapter of “Myths of Stocks For The Long Run” if:

  • GDP maintains a 2% annualized growth rate, AND
  • There are NO recessions….ever, AND
  • Current market cap/GDP stays flat at 1.25, AND
  • The current dividend yield of roughly 2% remains,

Using Dr. John Hussman’s formula we would get forward returns of:

(1.02)*(.8/1.25)^(1/30)-1+.02 = 2.5%

But there’s a “whole lotta ifs” in that assumption.

More importantly, if we assume that inflation remains stagnant at 2%, as the Fed hopes, this would mean a real rate of return of just 0.5%.

Economic growth matters, and it matters a lot.

As an investor, it is important to remember that in the end corporate earnings and profits are a function of the economy and not the other way around. Historically, GDP growth and revenues have grown at roughly equivalent rates.

Forget the optimism surrounding “Trumpenomics” and focus on longer-term economic trends which have been declining for the past 30+ years. The economic trend is a function of a growing burden of debt, increasing demographic headwinds and, very importantly, declining productivity growth. I see little to make me believe these are changing in a meaningful way.

Lastly, do not forget that interest rates, despite recent increases, are near historical lows and the Feds balance sheet is still 4 times as large as it was before the financial crisis of 2008. Further, the U.S. Treasury will borrow $1.3 trillion this year which will directly feed economic growth. Just ask yourself where would the economy be if this extreme monetary and fiscal policy were not in place.

Still think everything is “hunky dory?”

The Mirage That Will Be Q2-GDP

Tomorrow, the US Department of Commerce will report its advance estimate of 2Q GDP which will be the long-awaited evidence that “Trumponomics” is working. The current estimates for the initial print run the gamut from 3.9% to over 5% annualized growth. Regardless of the actual number, the White House spokesman will be quick to take credit for success in turning America’s economy around.

But is that really the case? First, there are several things to remember about the initial print on economic growth.

  • The initial estimate is based on the collection of estimates from Wall Street economists.  With no real data in just yet, the initial estimate just a “guess.”
  • The number is annualized. So, a growth of 1% in the economy is reported as 4%. However, as we know from the first quarter, quarterly growth can vary widely in a given year.
  • Lastly, a one-quarter surge in economic growth doesn’t make much difference in the long-term trajectory of economic growth, or in this case, ongoing weakness.  The chart below shows the change in economic growth by decade.

  • In both the chart above, and below, I have penciled in a 4% increase in economic growth for the second quarter. Making similar adjustments for wages and productivity, we find the 5-year averages change very little. More importantly, current action is more typical of a late cycle expansion as opposed to the beginning of a new one.

Secondly, while the print will undoubtedly be a strong one, and not unexpected following a weak Q1 growth rate, the question is whether it is sustainable? A recent note from Goldman Sachs suggests some caution:

“An unusually large number of one-off factors appear to have boosted 2Q GDP, many of which are directly related to escalating trade concerns. As companies and countries race to secure supplies that may become expensive later on, exports have surged and inventories have swelled. If these trends are one-time adjustments (and our economists believe they are), the ‘payback’ in 2H could be significant. Enjoy the 2Q GDP number, which may be the last best print for a while.”

This is likely correct. As 2018 has seen a steady increase in trade tensions, and trade actions, between the US and its trading partners, we have already begun to see some of the negative impacts from those actions. Just this past week Boeing ($BA), General Motors ($GM) and Whirlpool ($WHR) all had disappointing reports with comments directly related to the negative impact of tariffs on their results. They are surely not going to be the last as the US has slapped tariffs on washing machines and solar panels in January, on steel and aluminum in March, and on US$34 billion of goods from China on July 6. Now, the administration is talking about another 25% tariff on close to $200 billion in foreign-made automobiles later this year.

Morgan Stanley also made very similar comments in their recent analysis about the unusually large number of one-off factors which appear to have boosted 2Q GDP, most of which are directly related to escalating trade concerns.

“As companies and countries race to secure supplies that may become expensive later on, exports have surged and inventories have swelled. If these trends are one-time adjustments (and our economists believe they are), the ‘payback’ in 2H could be significant. Enjoy the 2Q GDP number, which may be the last best print for a while.

The ‘stockpiling’ in exports could be responsible for 1.5 percentage points of our 4.7% 2Q GDP estimate. ‘Stockpiling’ also appears to be at work for US companies, albeit to a more limited extent. The inventory build in 2Q is tracking at +US$38 billion, versus a +US$10 billion rate in the prior two quarters. And what’s more interesting is the areas where those inventories are building, which have material overlaps with trade: electrical goods, machinery equipment, motor vehicles and parts.”

In other words, the contribution to Q2 GDP from inventories alone would be roughly 2.2%, or roughly 50%, of the total increase. Such would be the single biggest combined contribution since 4Q11 when the U.S. was restocking auto inventories following the tsunami-related shutdown of Japan. 

These one-off adjustments are unsustainable and simply represent the pull-forward of demand that will be given back over the subsequent quarters. Following the economic reboot in Q4 of 2011, as Japan’s manufacturing came back online, the next five quarters averaged just 1.6%.

Another reason, the second quarter economic growth print may be a “one-time” bonanza, is that tariffs are not only impacting U.S. companies and their profitability, it is also filtering through the rest of the economy as recently noted by ECRI:

“As the chart shows, real personal income and consumer spending growth are both in cyclical downturns.”

“Contrary to the notion of a ‘strengthening’ economy, consumer spending growth has fallen to a 4 ¼-year low, as personal income growth continues to undershoot spending growth.

The consumer — which makes up about 70% of the economy — is getting hit with a six-year highs in inflation, so real wages are actually lower than a year ago.

The chart also shows that the income shortfall relative to spending is increasing, and since 2015 the cumulative shortfall is over 1% of GDP. Necessarily, that gap is financed by consumers taking on more debt.

Away from the trade war rhetoric, which hasn’t really made a big impact yet, the lack of real income gains is why many are having a harder time making ends meet.

The expected strength in Q2 GDP growth comes in large part from energy production and a temporary fiscal boost, which are both non-cyclical events. Of course, higher gas prices also hurt the consumer.”

With wage growth stagnant, corporations struggling to pass through rising commodity and tariff related costs and debt service requirements on the rise as the Fed continues to hike rates, the drag from the consumption side of the economic equation will likely dwarf the current boosts in the next two quarters.

Furthermore, as I noted previously, tax cuts and reform, tariffs and other fiscal remedies promoted by the current administration fail to address the main drag to economic growth over time. The debt.

“It now requires $3.71 of debt to create $1 of economic growth which will only worsen as the debt continues to expand at the expense of stronger rates of growth.”

In fact, as recently noted by our friends at the Committee for a Responsible Federal Budget, the U.S. deficit is set to surge. To wit:

“The White House Office of Management and Budget recently released its annual mid-session review which updated deficit projections in its fiscal year 2019 budget request. The report projected deficits will reach $1.085 trillion in FY 2019 under their budget, which is double the $526 billion called for in the FY 2018 budget.”

The report specifically addresses the biggest point of concern:

“The last time the nation experienced trillion-dollar deficits was during a serious economic downturn, no less – lawmakers took the issue seriouly. PAYGO laws were established, a fiscal commission was formed, new discretionary spending caps were implemented and policymakers entered a multi-year debate on how best to bring down long-term debt levels.

This time around, with the emergence of trillion-dollar deficits during a period of economic strength – when we should be saving for future downturns – few seem to even take notice. On our current course, debt will overtake the size of the entire economy in about a decade, and interest will be the largest government program in three decades or less. This will weaken both our economy and our role in the world.”

Of course, the debt commission failed, what few spending cuts that were put in place have been fully repealed and unsurprisingly surging debt levels continue to surge as economic growth remains weak.

Furthermore, while many in the current administration like to use the Congressional Budget Office (CBO) projections as they are always overly optimistic, it is important to note the CBO gives no weight to the structural changes which continue to plague economic assumptions. The combination of tariffs and tax cuts combined with the major headwinds to economic growth are daunting.

  • Spending hikes
  • Demographics
  • Surging health care costs
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Financialization 
  • Global debt

These factors will continue to send the debt to GDP ratios to record levels. The debt, combined with these numerous challenges, will continue to weigh on economic growth, wages and standards of living into the foreseeable future.

So, while the economic report on Friday will be a “rosy” picture in the short-term, it is likely going to be the best print we see between now and the onset of the next recession.

The Data Is In: Tax Cuts And The Failure To Trickle Down

Back in February, I discussed some of the early indications of what we were seeing following the passage of “tax cut” bill last December. To wit:

“The same is true for the myth that tax cuts lead to higher wages. Again, as with economic growth, there is no evidence that cutting taxes increases wage growth for average Americans. This is particularly the case currently as companies are sourcing every accounting gimmick, share repurchase or productivity increasing enhancement possible to increase profit growth.

Not surprisingly, our guess that corporations would utilize the benefits of ‘tax cuts’ to boost bottom line earnings rather than increase wages has turned out to be true. As noted by Axios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks.  This is ‘financial engineering gone mad’ and something RIA analyst, Jesse Colombo, noted recently:

‘How have U.S. corporations been deploying their new influx of capital? Unlike in prior cycles – when corporations favored long-term business investments and expansions – corporations have largely focused on juicing their stock prices via share buybacks, dividends, and mergers & acquisitions. While this pleases shareholders and boosts executive compensation, this short-term approach is detrimental to the long-term success of American corporations. The chart below shows the surge in share buybacks and dividends paid, which is a direct byproduct of the current artificially low interest rate environment. Even more alarming is the fact that share buybacks are expected to exceed $1 trillion this year, which would blow all prior records out of the water. The passing of President Donald Trump’s tax reform plan was the primary catalyst that encouraged corporations to dramatically ramp up their share buyback plans.'”

SP500 Buybacks & Dividends By Year

“What is even more unwise about the current share buyback mania is the fact that it is occurring at extremely high valuations, which is tantamount to ‘throwing good money after bad.’”

And, in the time since that writing, there is scant evidence that wages, or employment, are improving for the masses versus those in the executive “C-suite.” 

Nonetheless, while the markets have been rising, investors continue to bank on strong earnings going forward, but should they?

Jamie Powell tackles that question for the Financial Times:

Zion Research Group, an independent consultancy focused on Accountancy and Tax based in New York City, have combed over last quarter’s earnings- sifting out the organic growth from the accountancy and tax shenanigans. Yet the degree to which it boosted profits may come as a surprise, particularly when broken down by sector.

First off, we should note that Zion Research limited its analysis to 351 of the S&P 500’s constituents, removing businesses whose first quarter did not end on March 31, and only keeping those whose effective tax rate was between 0 to 45 per cent as to, in its words, ‘remove whacky outliers’.

Here are the key findings:

‘On average, it appears as if tax rates dropped by 588 bps from 25.7 per cent in 1Q17 to 19.8 per cent in 1Q18 for the S&P 500 companies analyzed. We estimate that lower tax rates boosted GAAP earnings in the aggregate by 9%.

In the aggregate, we estimate that lower tax rates resulted in about $18.3 billion of incremental net income in 1Q18, accounting for nearly half of the $37.0 billion (17.6%) in year-over-year earnings growth for the 351 companies we analyzed.’

In other words, nearly half of the quarter’s earnings growth came from tax cuts for those selected companies. Furthermore, of the 351 companies analyzed, only 273 got a boost to 1Q18 earnings from lower taxes, while 63 companies had a “tax drag” due to write-downs of deferred tax assets.

More from Zion:

“98 companies [of the 258] relied on taxes for more than half of their earnings growth, including 35 where all the growth was tax related. At the other end of the spectrum, 41 companies actually saw a tax-related drag on earnings growth.”

Buyback Bonanza

However, there is more to Zion’s story. While earnings growth was indeed derived from tax cuts, it was also the extensive use of buybacks used to boost bottom lines earnings per share that is important. While the mainstream media, and the Administration, rushed to claim that tax cuts would lead to surging economic growth, wages, and employment, such has yet to be the case. Instead, companies have used their tax windfall to buyback shares instead.

As Matt Egan noted for CNN Money:

“Corporate America threw Wall Street a record-shattering party last quarter. Flooded with cash from the Republican tax cut, US public companies announced a whopping $436.6 billion worth of stock buybacks, according to research firm TrimTabs.

Not only is that most ever, it nearly doubles the previous record of $242.1 billion, which was set during the first three months of the year.”

The Heisenberg Report looked at the divisor change in the major indices to confirm the same.

There’s an argument to be made that if you’re looking to explain how it is that U.S. equities held up in Q2 amid all the headline risk, buybacks are a good place to start. I highlighted the following chart from JPMorgan in a previous post, but I’ll use it again here in the interest of backing up that contention:”

“Normative discussions aside, the corporate bid is in place and that’s a form of real-life ‘plunge protection’. You don’t need any conspiracy theories to employ the ‘plunge protection’ characterization. Recall that back in February, amid the equity rout, Goldman’s buyback desk had its second busiest week in history. Here’s a quote from a note dated February:

‘The Goldman Sachs Corporate Trading Desk recently completed the two most active weeks in its history and the desk’s executions have increased by almost 80% YTD vs. 2017.’

The point here, is that when it comes to the ‘who will be the marginal buyer of U.S. equities?’ question, I’m not entirely sure it needs answering in the near term as long as buybacks continue and as long as earnings continue to come in strong. Additionally, you can expect the buyback bid to be even more pronounced in the event there’s a sell off.”

The “buyback bid” not only supports stock prices in the short-term, but as I discussed recently in “Q1-Earnings Review,” there is evidence which suggests the economy is not as fully robust as may appear in headline data.

“Looking back it is interesting to see that much of the rise in ‘profitability’ since the recessionary lows have come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. As shown in the chart below, there has been a stunning surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 336%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which has only increased by a marginal 49% during the same period.”

“Furthermore, while the majority of buybacks have been done with ‘repatriated’ cash, it just goes to show how much cash has been used to boost earnings rather than expanding production, making productive acquisitions or returning cash to shareholders. 

Ultimately, the problem with cost-cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. Eventually, you simply run out of people to fire, costs to cut and the ability to reduce labor costs.” 

When Does The Party End?

While tax cuts have been, and will be, fantastic for bottom line earnings in the first half of this year, the real question becomes who will be the marginal buyer of equities once the “windfall bonanza” for corporations subsides. There are two points of concern which should be considered.

The first is those profit expectations are on the decline already as noted by BofA in a recent report:

“A a net -9% of respondents think global profits will not improve in the next 12 months, down 53ppt from Jan’18 and the lowest since Feb’16. This means that a majority of investors now believe that profits have topped out and will slide in the coming year.

The second is margin expansion. Going forward increasing margins will become tougher as higher labor costs, rising energy prices, higher interest costs, tariffs and a stronger dollar weigh on bottom line profitability. More importantly, the dramatic surge in earnings growth in the first two quarters will dissipate quickly as year-over-year comparisons become more problematic.

As Eric Parnell recently penned:

“Share buyback activity is currently breaking records, perhaps in unsustainable ways. Eventually, this activity will slow. If history and logic is any guide, it will be when the U.S. economy falls back into recession and corporations need to circle the wagons and keep the cash that might otherwise be allocated to buybacks on their balance sheets instead. And if the forecasters along with the Treasury yield curve that are predicting an economic slowdown as soon as 2019 prove to be correct, this scaling back in buyback activity may be coming sooner rather than later once the tax cut sugar high finally wears off.

While the key market trends remain decidedly positive for now, and portfolios should remain tilted toward equity exposure, understand that all cycles end. The only questions are “when” and “what causes it?” 

As we have repeatedly written since last December, tax cuts were destined to only wind up in one place – in the pockets of shareholders and C-suite executives. But in an economy which is nearly 70% driven by the consumption of the bottom 90%, a fiscal policy which specifically targeted corporations (which are major political donors) was not likely the best strategy to promote a long-term increase in economic prosperity.

Unsurprisingly, with the data now in, we once again come to find out that “trickle down” economics never actually trickles.

Some Questions On Employment & Wages

Last week, the Bureau of Labor Statistics published the latest monthly “employment report” which showed an increase in employment of 213,000 jobs. It was also the 93rd consecutive positive jobs report which is one of the longest in U.S. history. Not surprisingly, the report elicited exuberant responses from across the financial media spectrum such as this from Steve Rick, chief economist for CUNA Mutual Group:

“The employment report this month demonstrates yet again the robust strength of the labor market. After a red-hot May, June kept up steady momentum in jobs and certainly hit back at any worries among economists who thought hiring was beginning to plateau after an inconsistent past few months.”

There is little argument the steak of employment growth is quite phenomenal and comes amid hopes the economy is beginning to shift into high gear.

But if employment is as “strong” as is currently believed, then I have a few questions for you to ponder. These questions are important to your investment outlook as there is a high correlation between employment, economic growth and, not surprisingly, corporate profitability.

Let’s get started.

Prelude: The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current annual rate of employment growth is 1.6% which is lower than any previous employment level prior to a recession in history.

Question: Given the low rate of annual growth in employment, and the length of the employment gains, just how durable is the job market against an exogenous economic event? More importantly, how does 1.6% annualized growth in employment create sustained rates of higher economic growth?


Prelude: One thing which is never discussed when reporting on employment is the “growth” of the working age population. Each month, new entrants into the population create “demand” through their additional consumption. Employment should increase to accommodate for the increased demand from more participants in the economy. Either that or companies resort to automation, off-shoring, etc. to increase rates of production without increases in labor costs. The next chart shows the total increase in employment versus the growth of the working age population.

Question: Just how “strong” is employment growth, really? 


Prelude: The missing “millions” shown in the chart above is one of the “great mysteries” about one of the longest economic booms in U.S. history. This is particularly a conundrum when the Federal Reserve talks about the economy nearing “full employment.”

The next several charts focus on the idea of “full employment” in the U.S. While Jobless Claims are reaching record lows, the percentage of full time versus part-time employees is still well below levels of the last 35 years. It is also possible that people with multiple part-time jobs are being double counted in the employment data.

Question: With jobless claims at historic lows, and the unemployment rate at 4%, then why is full-time employment relative to the working age population at just 49.9%?


Prelude: One of the arguments often given for the low labor force participation rates is that millions of “baby boomers” are leaving the workforce for retirement. This argument doesn’t carry much weight given the significantly larger “Millennial” generation which is entering into the workforce simultaneously.

However, for argument sake, let’s assume that every worker over the age of 55 retires. If the “retiring” argument is valid, then employment participation rates should soar once that group is removed. The chart below is full-time employment relative to the working-age population of 16-54.

Question: At 50.43%, and the lowest rate since 1981, just how big of an impact are “retiring baby boomers” having on the employment numbers?


Prelude: One of the reasons the retiring “baby boomer” theory is flawed is, well, they aren’t actually retiring. Following two massive bear markets, weak economic growth, questionable spending habits and poor financial planning, more individuals over the age of 55 are still working than at any other time since 1970.

The other argument is that Millennials are going to school longer than before so they aren’t working either. The chart below strips out those of college age (16-24) and those over the age of 55. Those between the ages of 25-54 should be working.

Question: With the prime working age group of labor force participants still at levels seen previously in 1988, just how robust is the labor market actually?


Prelude: Of course, there are some serious considerations which need to be taken into account about the way the Bureau of Labor Statistics measures employment.  The first is the calculation of those no longer counted as part of the labor force. Beginning in 2000, those no longer counted as part of the labor force detached from its longer-term trend. The immediate assumption is all these individuals retired, but as shown above, we know this is exactly the case.

Question: Where are the roughly 95-million Americans missing from the labor force? This is an important question as it relates to the labor force participation rate. Secondly, these people presumably are alive and participating in the economy so exactly how valid is the employment calculation when 1/3 of the working-age population is simply not counted?


Prelude: The second questionable calculation is the birth/death adjustment. I addressed this in more detail previously, but here is the general premise.

Following the financial crisis, the number of “Births & Deaths” of businesses unsurprisingly declined. Yet, each month, when the market gets the jobs report, we see roughly 200,000 plus jobs attributed to positive net business creation.

Included in those reports is the ‘ADJUSTMENT’ to account for the net number of new businesses (jobs) that were “birthed” (created) less “deaths” (out of business) during the reporting period. Since 2009, the number has consistently “added” roughly 800,000 jobs annually to the employment numbers despite the fact the number of businesses was actually declining.

The chart below shows the differential in employment gains since 2009 when removing the additions to the monthly employment number through the “Birth/Death” adjustment. Real employment gains would be roughly 7.04 million less if you actually accounted for the LOSS in jobs. 

We know this number is roughly correct simply by looking at the growth in the population versus the number of jobs that were estimated to have been created.

Question: If we were truly experiencing the strongest streak in employment growth since the 1990’s would not national compensation be soaring?


Prelude: If the job market was as “tight” as is suggested by an extremely low unemployment rate, the wage growth should be sharply rising across all income spectrums. The chart below is the annual change in real national compensation (less rental income) as compared to the annual change in real GDP. Since the economy is 70% driven by personal consumption, it should be of no surprise the two measures are highly correlated.

Side Question: Has “renter nation” gone too far?

However, if we dig in a bit further, we see that real rates of average hourly compensation remains virtually non-existent.

Question: Again, if employment was as strong as stated by the mainstream media, would not compensation, and subsequently economic growth, be running at substantially strong levels rather than at rates which have been more normally associated with past recessions?


I have my own assumptions and ideas relating to each of these questions. However, the point of this missive is simply to provide you the data for your own analysis. The conclusion you come to has wide-ranging considerations for investment portfolios and allocation models.

Does the data above support the notion of a strongly growing economy that still has “years left to run?”  

Or, considering the fact the Fed is tightening monetary policy by raising rates and reducing liquidity, does the data suggest a “monetary policy” accident and recession are an under-appreciated risk?

But then again, maybe the yield-curve is already telling the answer to these questions. That however depends on which yield curve you look at. For our latest on the Fed’s shifting narrative on the value of the yield curve please read our latest article – The Mendoza Line.

Everyone’s Got A Plan

“There’s still room for stock markets to rise and worries of an impending recession are premature.” – Mickey Levy, Berenberg Capital Markets

This is a common view of much of the mainstream analysis as common threads still relatively low interest rates,  corporate profitability, and low unemployment rates are set to keep the bull market running well into the foreseeable future. But much of the rally since the 2009 recessionary lows has been an influence of outside factors. Interest rates are low because of the Federal Reserve’s actions, corporate profitability is high due to share repurchases, accounting rule changes following the financial crisis, and ongoing wage suppression.

But now, all of that is beginning to change. Interest rates are rising, the yield spread is flattening, and Central Banks globally are “beginning the end” of the “Quantitative Easing” experiment. As I noted recently:

“Combine a ‘trade war’ with a Federal Reserve intent on removing monetary accommodation, both through higher rates and reduction in liquidity, and the market becomes much more exposed to an unexpected exogenous event which sparks a credit-related event. (Of course, it isn’t just the Fed, but also the BOJ and ECB.)”

This is no small matter, although it is being dismissed as such. There has been a direct correlation between the “equity bull market” and the expansion of the Fed’s balance sheet. Yet, much to the Fed’s dismay, little of the asset surge translated into actual economic growth.

But now, that support is being withdrawn and as such the market, unsurprisingly, has run into trouble.

However, such shouldn’t matter if the economy, which ultimately drives earnings, is indeed firing on all cylinders as is commonly stated.

Let’s take a look at a few charts.


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. Therefore, in order for individuals to consume at a rate to provide for sustainable, organic (non-Fed supported), economic growth they must be employed 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.


Question:  Does the current level of employment support current asset valuations and the assumption of a continued bull market?


Personal Consumption Expenditures (PCE)

Following through from employment; once individuals receive their paycheck they then must consume goods and services in order to live. Personal Consumption Expenditures (PCE) is a measure of that consumption and comprises roughly 70% of GDP currently.

PCE is also 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 comes into companies the more inclined businesses are to cut costs, including employment, to maintain profit margins.

The chart below is a comparison of the annualized change in PCE to businesses fixed investment and employment.


Question: Do the current levels of PCE and Fixed Investment support current valuations or expectations of continued “strong” employment?


Revenue Growth

As we continue to “follow the money,” as stated, what consumers earn and spend drives revenue growth. As I discussed just recently in “Q1-Earnings Review,” there is evidence which suggests the economy is not a fully robust as it may appear in headline data. To wit:

“Looking back it is interesting to see that much of the rise in “profitability” since the recessionary lows have come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. As shown in the chart below, there has been a stunning surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 336%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which has only increased by a marginal 49% during the same period.”

“Furthermore, while the majority of buybacks have been done with ‘repatriated’ cash, it just goes to show how much cash has been used to boost earnings rather than expanding production, making productive acquisitions or returning cash to shareholders. 

Ultimately, the problem with cost-cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. Eventually, you simply run out of people to fire, costs to cut and the ability to reduce labor costs.” 


Question:  Do weak rates of top-line revenue growth support the current market narrative?


Corporate Profits As % Of GDP

Following the corporate profit story, we can look directly at corporate profits. Over the last several years, companies have manufactured profitability through a variety of accounting gimmicks, expanded share buybacks through increased leverage and continued increases in productivity. However, that profitability has come at the expense of “Main Street” as employment and wages have not risen. As shown, the annual rate of change in personal incomes has been on a decline since the turn of the century. This is a function of both the structural shift in employment (higher productivity = less employment and lower wage growth) and the drive to increase corporate profitability in the midst of weaker consumption. The chart below shows the disparity between corporate profits and employment and wages.

While corporate profitability has surged since the financial crisis, those profits have come at the expense of employees. Since 2009, wages for “non-supervisory employees,” which is roughly 83% of the current workforce, is lower today than at the turn of the century.

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. As you will see the last time that corporate profits diverged from GDP it was unable to sustain that divergence for long and economic growth subsequently declined with profits.


Question: How long can corporate profit growth remain detached from slower rates of economic growth?


Margin Debt Vs. Junk Bond Yields

As stated above, global Central Banks have lulled investors into an expanded sense of complacency. The problem is it has led to a willful blindness and disregard of the underlying fundamentals as asset prices have risen with seemingly reckless abandon. The complete lack of “fear” in the markets combined with a “chase for yield” has driven “risk” assets to record levels. The rise in leverage also supports this idea.

The chart below shows the relationship between margin debt (leverage), stocks and junk bond yields. This didn’t end well last time as the reversion in the assets triggered repeated margin calls leading to a cycle of forced liquidations.


Question:  What is the possibility of this divergence being maintained indefinitely?


Being bullish on the market in the short term is fine – you should be. Central Banks have rushed in every burning building with a “fire hose” of liquidity each time a crisis has presented itself. So far it has worked.

However, the problem is that a crisis, which will be unexpected, inevitably will trigger a reversion back to the fundamentals. What will that catalyst be? I don’t have a clue and neither does anyone else. But disregarding reality in a quest to chase market-based returns has always ended badly when the “herd” inevitability turns.

It has never been, and will not be, a slow and methodical process but rather a stampede with little regard to valuation or fundamental measures. As prices decline it will trigger margin calls which will induce more indiscriminate selling. The vicious cycle will repeat until margin levels are cleared and selling is exhausted.

The reality is that the stock market is extremely vulnerable to a sharp correction. Currently, complacency is near record levels and no one sees a severe market retracement as a possibility. The common belief is that there is “no bubble” in assets and the Federal Reserve has everything under control. The question you have to answer, is whether or not such is actually the case? 

“Wall Street is a street with a river at one end and a graveyard at the other.” – Fred Schwed, Jr. 

Don’t Expect Another Free Lunch In The Markets

The most recent quarterly letter from Grantham, Mayo, van Otterloo (GMO) contains an interesting argument about bonds. Over the past five years, bonds have provided great performance, but also more diversification from stocks than they have since the Great Depression. That, along with a tamer stock market, has helped balanced portfolios have lower volatility than usual. Indeed the Vanguard Balanced Index Fund (VBAIX) has a five-year standard deviation of 6%, according to Morningstar. Over the longer term, volatility of balanced portfolios has been around 10%.

Ben Inker, author of the letter, argues that if an investor, over the last five years, had wanted to target a volatility of 10% — the historical long-term volatility of a balanced portfolio – such would have entailed a leveraged portfolio of 143% stocks, 96% bonds, and -139% cash. Moreover, levering up a balanced portfolio 139% would mean achieving returns of more than 7% annualized over cash, according to GMO’s asset class return forecast.

But Inker isn’t advocating using such leverage, as so many “risk parity” portfolios do. This situation amounts to a free lunch that Inker doubts will persist into the future. It’s possible that risk and risk premia have fallen so that levering up to achieve returns is less dangerous than it used to be. But it’s more likely that the recent “easy” environment is a temporary one in Inker’s opinion. As he puts it:

”Even if the natural volatility of the economy has fallen over time and even if policy response is better than it was 80 years ago, neither markets nor economies are all that well-behaved. Stability breeds instability, as Human Minsky pointed out 40 years ago.”

Why do stocks usually have a premium over bonds?

To arrive at his conclusion, however, Inker recounts some recent history, reminding readers of the basic difference between stocks and bonds along the way.

First stocks are riskier to buyers than issuers. Companies can go bankrupt, after all, and the equity is usually worth nothing in that instance. But, according to Inker, that “idiosyncratic risk” is not why stock investors have achieved such a premium historically. The other reason why stocks typically offer a long term premium over bonds is that equity losses occur at exactly the moment it is most painful to own them.

After all, stocks usually go down when the whole economy goes down. So, if you have a stock-heavy portfolio, your portfolio is likely to tank exactly when you lose your job, compounding your misery.

However, if fears of economic downturns have diminished, then the risk premium that stocks usually have over bonds might dry up. It wouldn’t make sense for stocks to offer higher long term returns in an environment that suddenly became safe and free from recessions. And Inker argues that’s what happened right before the Financial Crisis. Riskier assets were poised to deliver lower long term returns than less risky assets. And as much of a shock as the crisis was to this point of view:

“The rapid recovery corporate cash flow in the aftermath and the consequent lower levels of distress than previous cycles experienced have served to assuage investors’ economic concerns.” 

The passage of time from the last crisis has also convinced today’s investors that they could withstand a new one regardless of how they behaved last time.

Not only have fears of economic downturns receded, but it has seemed easier than ever to protect portfolios. High quality bonds did their job in the last crisis (provided you held enough of them). Recessions help high quality bonds in two ways: deflation makes existing coupons more attractive, and central banks lower rates.

What has made bond performance (and bonds’ low correlation to stocks) so astonishing in recent years is that bonds have posted great returns in the absence of a recession. Bonds are not supposed to behave quite this well and in quite this uncorrelated fashion from stocks in non-recessionary environments. Don’t look for that negative correlation to continue, and don’t try to juice your returns by levering up a balanced portfolio.