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The Wisdom of Peter Fisher

“In recent years, numerous major central banks announced objectives of achieving more rapid rates of inflation as strategies for fostering higher standards of living. All of them have failed to achieve their objectives.” – Jerry Jordan, former Cleveland Federal Reserve Bank President

In March 2017, former Treasury and Federal Reserve (Fed) official, Peter R. Fisher, delivered a speech at the Grant’s Interest Rate Observer Spring Conference entitled Undoing Extraordinary Monetary Policy. It is one of the most insightful and compelling assessments of the Fed’s post-financial crisis policy actions available.

Now a professor at the Tuck School of Business at Dartmouth, Fisher is a true insider with experience in the government and private sector that affords him unique insight. Given the recent policy “pivot” by Chairman Powell and all members of the Fed, Fisher’s comments from two years ago take on fresh relevance worth revisiting.

In the past, when Fed leadership discussed normalizing the Fed’s post-crisis policy actions, they exuded confidence that it can and will be done smoothly and without any implications for the economy or markets. Specifically, in a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” More recently, Janet Yellen and others have echoed those sentiments. Current Fed Chairman Jerome Powell, tasked with normalizing policy, appears to be finding out differently.

Define “Normal”

Taking a step back, there are important issues at stake if the Fed truly wants to unshackle the market economy from the influences of extreme monetary policy and the harm it may be causing. To normalize policy, the Fed first needs to explicitly define “normal.”

For instance:

  • The Fed should take steps to raise interest rates to what is considered “normal” levels. Normal can be characterized as a Federal Funds target rate in line with the average of the past 30 years or it might be a level that reflects sufficient “dry powder” were the Fed to need that policy tool in a future economic slowdown.
  • The Fed should reduce the size of their balance sheet. In this case, normal under reasonable logic would be the size of the balance sheet before the financial crisis either in absolute terms or as a percentage of nominal gross domestic production (GDP). Despite some reductions, it is not close on either count.

The Fed consistently feeds investors’ guessing games about what they deem appropriate. There appears to be little rigor, debate, or transparency about the substance of those decisions. Neither Ben Bernanke nor Janet Yellen offered details about how they would accurately characterize “normal” in either context. The reason for this seems obvious enough. If they were to establish reasonable parameters that defined normal levels in either case, they would be held accountable for differences from their prescribed benchmarks. It might force them to take actions that, while productive and proper in the long-run, may be disruptive to the financial markets in the short run. How inconvenient.

In most instances, normal is defined as something that conforms to a standard or that which has been common under historical experience. Begin by looking at the Fed Funds target rate. A Fed Funds rate of 0.0% for seven years is not normal, nor is the current rate range of 2.25-2.50%.

As illustrated in the chart below, in each of the past three recessions dating back to 1989, the Fed cut the fed funds rate by an average of 5.83%. In that context, and now resting at less than half the average historical pre-recession level, a Fed Funds rate of 2.25-2.50% is clearly abnormal and of greater concern, insufficient to combat a downturn.

Interest rates should mimic the structural growth rate of the economy. As we have illustrated in prior analysis and articles, particularly Wicksell’s Elegant Model, using a 7-year cycle for economic growth reflective of historical expansions, that time-frame should offer a reasonable proxy for “structural” economic growth. The issue of greater concern is that, contrary to the statement above, structural growth appears to be imitating the level of interest rates meaning the more the Fed suppresses interest rates, the more growth languishes.

Next, let’s look at the Fed balance sheet. Quantitative tightening began in late 2017 gradually increasing as the Fed allowed their securities bought during QE to mature without replacing them. As shown in the blue shaded area in the chart below, QT reduced the Fed balance sheet by about $500 billion, but it remains absurdly high at nearly $4.0 trillion. As a percentage of GDP, it has dropped from a peak of 25.3% to 19%. Before the point at which QE was initiated in September 2008, the size of the Fed balance sheet was roughly $900 billion or 6% of nominal GDP and was in a tight range around that level for decades. Now, with the Fed halting any further reductions in the balance sheet, are we to assume 20% of GDP to be a normal level? If so, what is the basis for that conclusion?

The bottom line: simple analysis, straight-forward logic, and common sense dictate that monetary policy remains abnormal.

Fisher helps us understand why the Fed is so hesitant to normalize policy, despite their outward confidence in being able to do so.

Second-Order Effects

As Fisher stated in his remarks at the conference, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” This is a powerfully important statement highlighting second-order effects. He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.” Prophetic indeed.

The “easy” part of getting rates and the balance sheet back to “normal” is now proving to be not so easy. What the Fed did not account for when they unleashed unprecedented policy was the habits and behaviors among governments, corporations, households, and investors. Modifying these behaviors will come at a debilitating cost.

Think of it like this: Nobody starts smoking cigarettes with a goal of smoking two packs a day for 30 years, but once introduced, it is difficult to stop. Furthermore, trying to stop smoking can be very painful and expensive. NOT stopping is medically and scientifically proven to be even more so.

Fisher goes on to explain in real-world terms how two households are impacted in an environment of extraordinary policy actions. One household possesses savings; the other does not. Consider their traditional liabilities such as mortgage and auto loans, “but also their future consumption expenditures, their liability to feed and clothe themselves in the future.” The family with savings may feel wealthier from gains in their invested savings and retirement accounts as a result of extraordinary policies pushing financial markets higher, but they also must endure an increase in the cost of living. In the final analysis, they end up where they started. “They may… perceive a wealth effect but, ultimately, there is only a wealth illusion.”

As for the family without savings, they had no investments to go up in value, so there is no wealth effect. This means that their cost of living rose and, wages largely stagnant, it occurred without any form of a commensurate rise in income. That can only mean their standard of living dropped. As Fisher states, given extraordinary policy imposed, “There was no wealth effect, not even a wealth illusion, just a cruel hoax.” He further adds, “…the next time you hear that the net-wealth of American households is at an all-time high, do spend a minute thinking about the present value of the unrecorded future consumption expenditures, particularly of households with no savings.”

What is remarkable about Fisher’s analysis is contrasting it with the statements of Fed officials who say they are acting in the best interest of all U.S. citizens. Quoting from George Orwell’s Animal Farm, “All animals are equal, but some animals are more equal than others.”

A man can easily drown crossing a stream that is on average 3 feet deep. Household wealth as a macro measure of monetary policy success in a period when wealth inequality is at such extremes perfectly illustrates this imperfection. As Fisher states, “Out of both humility and self-preservation, let’s hope the Fed finds a way to stop targeting the level of wealth.”

Linear Extrapolation

Fisher also addresses the issue of Fed forward guidance stating, “Implicit in forward guidance…is the idea that dampening short-term market uncertainty and volatility is a good thing. But removing uncertainty from our capital markets is not, in my view, an unambiguous blessing.”

Forward guidance, whereby the Fed provides expectations about future policy, targets an optimal level of volatility without being clear about what “optimal” means. How does the Fed know what is optimal? As we have stated before, a market made up of millions of buyers and sellers is a much better arbiter of prices, value, and the resulting volatility than is the small group of unelected officials at the Fed. Yet, they do indeed falsely portray an understanding of “optimal” by managing the prices of interest rates but theirs is a guess no better than yours or mine. Based upon their economic track record, we would argue their guess is far worse.

Fisher goes on to reference John Maynard Keynes on the subject of extrapolative expectations which is commonly used as a basis for asset pricing. Referring to it as the “conventional valuation” in his book The General Theory of Employment, Interest and Money, Keynes said this reflects investors’ assumptions “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.” Connecting those dots, Fisher states that “forward guidance is the process through which the Fed – through its more explicit influence on the expected rate of interest – becomes the much more explicit owner of the “conventional valuation” of asset prices… the Fed now has a heightened responsibility and sensitivity to asset pricing.

That conclusion is critically important and clarifies the behavior we see coming out of the Eccles Building. In becoming the “explicit owner” of valuations in the stock market, the Fed now must adhere to a pattern of decisions and actions that will ultimately support the prices of risky assets under all circumstances. Far from rigorous scrutiny of doubts and assumptions, the Fed fails in every way to apply the scientific method of analyzing their actions before and after they take them. So desperate are they to manage the expectations of the public, their current posture leaves no latitude for uncertainty. As Fisher further points out, the last time we saw evidence of a similar stance was in 2007 when the Fed rejected the possibility of a nation-wide decline in house prices.


Fisher fittingly sums up by restating the point he made at the beginning:

“…the Fed and other central banks appear to have avoided being candid about the uncertainty (of extraordinary monetary policies) in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.”

The power of Fisher’s perspectives is in his candor. Now at a time when the Fed is proving him correct on every count, it is worthwhile to refresh our memories. We would encourage investors to read the transcript in full. Given the clarity of the insights he shares, summarized here, their importance cannot be overstated.

Undoing Extraordinary Monetary Policy

RIA Pro Supplement for Beware of the Walking Dead

In Beware of the Walking Dead, we revealed an analysis illustrating those companies in the S&P 1500 that qualify as zombie corporations. As promised in the article, we are providing a full list of those companies here for RIA Pro members.

According to James Grant of Grant’s Interest Rate Observer, zombie companies fail to generate enough operating income to cover the interest on their outstanding debt. The screen we used evaluates companies based on their three-year average for that metric. Those companies highlighted in yellow in Table 1 are the worst offenders with three consecutive years of a negative zombie metric. The remaining zombie companies are in Table 2.

The list of stocks that qualify as zombies under this definition is based on Bloomberg data through Q1 2019, revealing a total of 128 companies or 9% of the S&P 1500. The listing below also includes the three-year annualized total rate of return on those stocks as well as S&P rating and rating outlook when available.

Beware of the Walking Dead

In a previous article, The Fed’s Body Count, we stated:

“Markets and economies, like nature itself, are beholden to a cycle, and part of the cycle involves a cleansing that allows for healthy growth in the future. Does it really make sense to prop up dead “trees” in the economy rather than allow them to fall and be used as a resource making way for new growth?”

We come back to that thought in this article inspired by the notion that investors find themselves in a forest increasingly littered with dead trees. In today’s market parlance, the dead trees (corporations) are called zombies.  This article details the corporate zombie concept in-depth and provides a few examples to illustrate the topic.

The Walking Dead

It is no small irony that one year after the end of the great recession, a television show about the zombie apocalypse quickly became one of the most successful shows on TV. The Walking Dead features a large cast of “survivor” characters under near-constant threat of attack from mindless zombies, or “walkers” as they are called.

In the investment world, the term zombie has a special connotation generally referring to a company that might otherwise not be around had the Federal Reserve not suppressed interest rates for so long. The zombie label is fitting as these companies do not die as they should and at the same time, they devour capital and resources that could otherwise be used by healthy companies. They are a drain on the economy.

Although not a matter of life and death, investing in zombie companies or failing to understand the implications of their existence poses a unique risk to one’s economic well-being.

Zombies Defined

The generic description used for zombified companies is too obtuse to use to precisely identify such companies. If the suppression of interest rates served a key role in maintaining these firms, what would be the circumstances fundamental to that condition?

Corporate zombies are generally described as companies that cannot function without bailouts and/or those firms that can only afford to service the interest on their debt while deferring repayment of principal indefinitely. In our view, those definitions do not go far enough.

In a recent interview, James Grant of Grant’s Interest Rate Observer offered what seems to be the most precise definition – zombie companies fail to generate enough operating income to cover the interest on their outstanding debt. Furthermore, that condition would have to persist for more than one year to eliminate any anomalous results.

In other words, a corporation that fails to cover its interest expense can, for a time, keep borrowing to make up the shortfall, especially if money is cheap. On the other hand, true zombie status is revealed, and the “headshot” of demise ultimately comes, when the company runs out of borrowing runway. That circumstance can unfold rather quickly in an economic downturn or a period of rising interest rates when the negative differential between operating income and interest expense widens further.

Operating Income is defined as gross revenue minus wages, cost of goods sold, and selling, general and administrative expenses (SG&A). Operating income does not include items such as investments in other companies, taxes, or interest expense. Isolating the difference between operating income and interest expense is a way of comparing the revenue that a company expects to become profit versus the cost incurred for borrowed funds. It is a variation of a leverage ratio.

Zombie Hunt

We analyzed the broad S&P 1500 to identify companies having zombie characteristics under Grant’s definition. Namely, does their interest expense exceed their operating income and has it done so when averaged over the last three years?

The list of stocks that qualify as zombies under this definition using Bloomberg data through Q1 2019 reveals 204 companies or 13.5% of the S&P 1500. Some of these companies do not show any interest expense but have operating income losses, so we removed those companies. That leaves 128 companies or 9% of the members of the index. Using a stricter methodology of requiring three consecutive years of interest expense exceeding operating income returns 43 companies that meet the criteria or roughly 3% of the index. These 43 companies are the worst in class of the zombie population.

While defining and identifying the zombies is a good start, what we care about is a divergence between fundamentals and valuations. In other words, we want to truly protect ourselves from the zombies who appear alive due solely to a well-performing share price. In doing this, we find that 34% of the 128 companies have positive 3-year annualized total returns. Of these firms, the average 3-year annualized return of that population through June 30, 2019, is 13.6%. There are also another 11 companies that have been relatively stable as defined by annualized total returns of zero to -5%.

Such returns do not reflect the underlying fundamentals of companies that cannot service their debt and are a recession away from going bankrupt. The graph below charts operating income less interest expense with the three-year total returns for the 128 zombie companies.

Data Courtesy Bloomberg

For the 128 companies represented in the graph, they either have weak revenue generation and/or onerous debt levels. That, however, raises another issue for consideration – just how bad is the situation if the company cannot cover the interest expense on their debt due to weak demand for their products and/or services? Equally concerning, what if there is so much debt that even solid demand for their products and accompanying revenues do not cover that expense?

Deeper Dive

Awareness of this issue and quantifying it is useful and important to help us understand the kinds of imbalances that exist in the economy. At the same time, while most zombie companies would not exist were it not for years of suppressed interest rates, those that do should be priced for the uncertainty of an economic downturn and the higher probability of their demise in that event. As mentioned, many are not. Out of the 128 companies whose operating income cannot cover interest expense, many are priced at valuations that imply they are a normal going concern.

To gain a better perspective of zombies, we selected three individual candidates to explore in-depth. As discussed, the market is crawling with these companies that bear very similar characteristics. A table of the relevant fundamental statistics for each company is shown below each summary.

RIA Pro subscribers are being provided a complete list of zombie companies beyond the three detailed below.

Rent-A-Center, Inc. (RCII)

RCII, a BB-rated company with a stable outlook, operates and franchises rent-to-own merchandise stores offering electronics, appliances, and furniture under “flexible rental purchase agreements” (lucrative financing plans). Based in Plano, Texas, they have 14,000 employees and a market capitalization of $1.3 billion. RCII stock has a three-year annualized return of 30.7% and three-year average EBITDA (earnings before interest taxes depreciation and amortization) through the end of 2018 of $51.2 million. Meanwhile, three-year average net income and free cash flow are negative $30.0 million and negative $106.2 million respectively.

Their zombie metric of operating income less interest expense was positive $18.3 million in 2018, but the three-year average is negative $69.9 million. Additionally, revenue for 2018 was the lowest since 2006 at $2.66 billion and total debt for the company increased by 52% (from $540 million to $825 million) in the first quarter of this year alone. It is hard to imagine the consumer showing enough strength to bail out the circumstances facing RCII. However, apart from us, most analysts are constructive in their outlook.

Scientific Games Corp. (SGMS)

Based in Las Vegas, Nevada, SGMS is a single-B-rated company with a stable outlook that provides gambling products and services under four operating divisions of gaming, lottery, digital, and social. The company has 9,700 employees and a market cap of $1.7 billion. Despite a significant correction since June 2018, SGMS stock has a stellar three-year annualized return of 29.2%. Given their negative earnings per share, the current price-to-earnings (PE) multiple cannot be calculated, but the expected PE for the end of the year based on earnings projections is 1,693. The company generated over $3.3 billion in revenue in 2018 but had net income of negative $352 million. The company sports a net debt obligation (net of cash) of $8.8 billion at the end of 2018.

Their zombie metric is -$332 million and has been negative every year since 2008. Despite their fundamentals, through June 30, 2018, SGMS produced a 47% 3-year annualized return showing the power and irrationality of momentum investing. The enthusiasm for SGMS revolves around the legalization and commercialization of nation-wide sports betting. Over the last ten years, insider selling dominated executive transaction flows. Our guess is they will wish they had sold even more.

The Williams Companies (WMB)

WMB, based in Tulsa, Oklahoma, is an energy infrastructure company focused on connecting North America’s hydrocarbon resources to markets for natural gas. The company owns and operates midstream gathering and processing assets, and interstate natural gas pipelines. It has 5,300 employees and a market cap of $33 billion. WMB is rated BBB by Standard & Poors with a negative outlook. Through the end of June 2019, WMB shares have a 3-year annualized total return of 14.0%. Net income for 2018 was -$155 million on revenue of $8.7 billion. Revenue grew at a three-year average of 5.7%, but net income was negative in three of the past four years. The company has net debt outstanding of over $22 billion, which is up 200% from $7.4 billion in 2011. Interest expense on that debt has exceeded operating income (zombie metric) in each of the past four years. Since 2017, insider selling of company shares was 4.4 times larger than insider purchases.

The following table compares our three zombies:

Data Courtesy Bloomberg


Loose monetary policy contributed to the financial crisis as the Fed held interest rates at 1.0% in 2003-2004 despite an economy that was rebounding and a housing bubble that was inflating well beyond its natural means. The Fed also imprudently used forward guidance to keep rates low for “a considerable period” which further prompted investors to speculate. In a troubling parallel, and proving lessons learned in finance are cyclical, not cumulative, the Fed has maintained and extended emergency policies following the crisis for nearly a decade. New bubbles have since replaced those that popped in 2008.

Upon receiving the Alexander Hamilton award in 2018, Stan Druckenmiller said, “If I were trying to create a deflationary bust, I would do exactly what the world’s central banks have been doing for the past six years.” The important point of his comment is that the deflationary episodes most feared by central bankers are caused by imploding asset bubbles. Those asset bubbles are invariably caused, in large part, by imprudent monetary policies that encourage market participants – households, corporations, and governments – to misallocate resources.

Corporate zombies are but one example. Their existence is evident, but the true extent to which they populate the market landscape cannot be known. Our analysis here reveals only the easiest to identify but rest assured, when economic twilight comes, many more zombies will be fully exposed.