Tag Archives: Michael Lebowitz

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

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The Best Of “The Lance Roberts Show



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Our Best Tweets Of The Week

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

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

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The Best Of “The Lance Roberts Show


Video Of The Week A

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


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

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

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The Best Of “The Lance Roberts Show


Video Of The Week A

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


Our Best Tweets Of The Week

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

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

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The Best Of “The Lance Roberts Show


Video Of The Week

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


Our Best Tweets Of The Week

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

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

The Week In Blogs


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What You Missed At RIA Pro

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The Best Of “The Lance Roberts Show


Video Of The Week

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


Our Best Tweets Of The Week

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

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

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The Best Of “The Lance Roberts Show


Video Of The Week

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


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Surging Repo Rates- Why Should I Care?

A subscriber emailed us regarding our repurchase agreement (repo) analysis from Tuesday’s Daily Commentary. Her question is, “why should I care about a surge in repo rates?” The commentary she refers to is at the end of this article.

Before answering her question, it is worth emphasizing that it is rare for overnight Fed Funds or Repo rates to spike, as happened this week, other than at quarter and year ends when bank balance sheets have little flexibility. Clearly, balance sheet constraints due to the end of a quarter or year are not causing the current situation.  Some say the current situation may be due to a lack of bank reserves which are used to make loans, but banks have almost $2 trillion in excess cash reserves. Although there may likely be an explanation related to general bank liquidity, there is also a chance the surge in funding costs is due to a credit or geopolitical event with a bank or other entity that has yet to be disclosed to the public.

Before moving ahead, let us take a moment to clarify our definitional terms.

Fed Funds are daily overnight loans between banks that are unsecured, or not collateralized. Overnight Repo funding are also daily overnight loans but unlike Fed Funds, are backed with assets, typically U.S. Treasuries or mortgage-backed securities. The Federal Reserve has the authority to conduct financing transactions to add or subtract liquidity to ensure overnight markets trade close to the Fed Funds target. These transactions are referred to as open market operations which involve the buying or selling of Treasury bonds to increase or decrease the amount of reserves (money) in the system. Reserves regulate how much money a bank can lend. When reserves are limited, short-term interest rates among and between banks rise and conversely when reserves are abundant, funding costs fall. QE, for instance, boosted reserves by nearly $3.5 trillion which enabled banks to provide liquidity to markets and make loans at low interest rates.

Our financial system and economy are highly leveraged. Currently, in the U.S., there is over $60 trillion in debt versus a monetary base of $3.3 trillion. Further, there is at least another $10-15 trillion of dollar-based debt owed outside of the U.S. 

Banks frequently have daily liquidity shortfalls or overages as they facilitate the massive amount of cash moving through the banking system. To balance their books daily, they borrow from or lend to other banks in the overnight markets to satisfy these daily imbalances. When there is more demand than supply or vice versa for overnight funds, the Fed intervenes to ensure that the overnight markets trade at, or close to, the current Fed Funds rate.

If overnight funding remains volatile and costly, banks will increase the amount of cash on hand (liquidity) to avoid higher daily costs. To facilitate more short term cash on their books, funds must be conjured by liquidating other assets they hold. The easiest assets to sell are those in the financial markets such as U.S. Treasuries, investment-grade corporate bonds, stocks, currencies, and commodities.  We may be seeing this already. To wit the following is from Bloomberg:  

“What started out as a funding shortage in a key U.S. money market is now making it more costly to get hold of dollars globally. After a sudden surge in the overnight rate on Treasury repurchase agreements, demand for the dollar is showing up in swap rates from euros, pounds, yen and even Australia’s currency. As an example, the cost to borrow dollars for one week in FX markets while lending euros almost doubled.”

A day or two of unruly behavior in the overnight markets is not likely to meaningfully affect banks’ behaviors. However, if the banks think this will continue, they will take more aggressive actions to bolster their liquidity.

To directly answer our reader’s question and reiterating an important point made, if banks bolster liquidity, the financial markets will probably be the first place from which banks draw funds. In turn, this means that banks and their counterparties will be forced to reduce leverage used in the financial markets. Stocks, bonds, currencies, and commodities are all highly leveraged by banks and their clientele. As such, all of these markets are susceptible to selling pressure if this occurs.

We leave you with a couple of thoughts-

  • If the repo rate is 3-4% above the Fed Funds rate, the borrower must either not be a bank or one that is seriously distressed. As such, is this repo event related to a hedge fund, bank or other entity that blew up when oil surged over 10% on Monday? Could it be a geopolitical related issue given events in the Middle East? 
  • The common explanation seems to blame the massive funding outlays due to the combination of Treasury debt funding and corporate tax remittances. While plausible, these cash flow were easy to predict and plan for weeks in advance. This does not seem like a valid excuse.

In case you missed it, here is Tuesday’s RIA repo commentary:  Yesterday afternoon, overnight borrowing costs for banks surged to 7%, well above the 2.25% Fed Funds rate. Typically the rate stays within 5-10 basis points of the Fed Funds rate. Larger variations are usually reserved for quarter and year ends when banks face balance sheet constraints. It is believed the settlement of new issue Treasury securities and the corporate tax date caused a funding shortage for banks. If that is the case, the situation should clear up in a day or two. Regardless of the cause, the condition points to a lack of liquidity in the banking sector. We will follow the situation closely as it may impact markets if it continues.

Quick Take: Revising The Data

“The United States economy is an extremely complex and dynamic system. Trying to measure the level and pace of economic growth, employment, inflation, and productivity are very difficult, if not impossible tasks. The various government and private agencies bearing the responsibility for such measurement do their best in what must be acknowledged as a highly imperfect effort. Initial readings are always revised, sometimes heavily, especially at key turning points in the economy.”  –The Fed Body Count (LINK)

In the preliminary annual employment benchmark revision based on state unemployment insurance records, the Labor Department recently revised job gains recorded in the period from April 2018 through March 2019 down by 501,000. As shown below, that is the largest downward revision in the past ten years. The unusually large negative adjustment means that job growth averaged only 170,000 per month versus the previous estimate of 210,000 per month for the period.

Two of the biggest revisions came in the bellwether industries of leisure & hospitality and retail, down 175,000 and 146,000 respectively. Professional and business services employment was revised lower by 163,000. The economy needs to produce 150,000- 200,000 jobs per month in order to keep the unemployment rate from rising. What this report from the Bureau of Labor Services (BLS) suggests is that employment was significantly weaker than believed through March 2019 and the unemployment rate may not be as good as is generally believed.

That downward revision is surprising given the tax cuts, large boost to fiscal spending, and solid GDP growth throughout 2018. Unfortunately, it appears that while the tax cuts helped corporate bottom lines, few companies used their windfall towards endeavors that generate economic activity. As we have harped on in the past, stock buybacks and larger dividends have little effect on economic growth.

These labor market revisions argue that the momentum in the economy is far weaker than previously believed.

The numbers in themselves are disappointing but more importantly and as described in previous articles, such revisions tend to reveal themselves points in time when the economy is at critical turning points. For investors, economic uncertainty may be further cause for defensive posturing.

The graph below shows the cyclical nature of the unemployment rate. Importantly to today, the rate tends to level out prior to rising into a recession. Today’s unemployment rate is showing signs of leveling off but has yet to increase. These revisions coupled with slowing growth makes employment a key indicator to follow.

Steepening Yield Curve Could Yield Generational Opportunities : Michael Lebowitz on Real Vision

On July 1st, Michael Lebowitz was interviewed by Real Vision TV. In the interview he discussed our thoughts on the yield curve, corporate bonds, recession odds, the Federal Reserve, and much more. In particular, Michael pitched our recent portfolio transactions NLY and AGNC, which were both discussed in the following RIA PRO article: Profiting From a Steepening Yield Curve.

Real Vision was kind enough to allow us to share their exclusive video with RIA Pro clients. We hope you enjoy it.

To watch the Video please click HERE

Economics on Gilligan’s Island

Economics on Gilligan’s Island

Famed economist Henry Hazlitt wrote the economics classic, Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics. The book is quite popular and has sold well over one million copies. While the content is brilliant, what makes it distinctive is the simple clarity he uses to explain complex economic concepts.

We try our best to follow in Hazlitt’s footsteps and explain economics without the complexity and jargon so often used by trained economists. One of our techniques is to bring an economic concept to its most basic level so that it’s easily understood by all readers. While at 720Global, we produced an animated video, The Animated Virtuous Cycle, which allows a ten-year-old to understand the complex economic topic of productivity.

In this paper, we lead with a few instances where we have taken Hazlitt’s approach to better explain economic concepts. Following those excerpts, we use Gilligan’s Island as a means of illustrating productivity and its importance for the health of an economy and the prosperity of its people.

As a refinement of our recent article, Productivity: What it is and Why it Matters, we hope this approach allows more readers to grasp the importance of productivity growth. Falling productivity growth helps to explain the link between many of the mounting economic and social troubles we face. Equally important, from an investor’s perspective, productivity growth is the driver of current and future cash flows for almost every investment imaginable. 

If you want to skip to our simple primer on productivity, go to the section entitled “Gilligan’s Island”.

Greetings From Stiltsville

The following excerpt came from our article, Greetings From Stiltsville: Deficit Spending is not a Free Lunch. We created the fictitious island of Stiltsville to demonstrate why GDP is a poor measure of economic growth.  

Imagine an island called Stiltsville, where a person’s value is based solely on their height. In order to increase their value, people living on the island used to wear platform shoes. A person wearing six-inch platform shoes would suddenly be more valuable than a person of similar height who wore normal footwear. Eventually, platform shoes were replaced by stilts, three-foot stilts were be replaced by six-foot stilts, and so on. People eventually rose to be the height of giraffes. The main point is that, on an island where height is valued above all else, people will try to game the situation to their advantage by increasing their height by any means available.

People from other lands would look at the people of Stiltsville and recognize their obsession with height greatly distorts their perception of value.  They would also likely conclude that distorted perceptions result in actual distortions in productivity, because:

  • People waste time and money thinking about how to increase their height, and
  • Walking around in platform shoes or stilts does not necessarily increase a person’s productivity, and instead most likely impairs it

Now imagine a world in which the health of an economy is perceived to be based on one metric; Gross Domestic Product (GDP). GDP is simply the total amount of spending in an economy. GDP, as currently measured, does not distinguish between “good” spending and “bad” spending. GDP does not distinguish between consumption spending and investment spending. GDP also does not distinguish whether spending is generated by existing wealth, by going into debt temporarily, or by going into debt permanently. In this world, every dollar spent on education or new means of production, is counted the same as every dollar spent on epic bachelor parties and video games. 

This world, the world of GDP accounting, is the world we live in. More spending today than occurred yesterday is considered economic growth. Growth, regardless of how it happens or at what cost, is highly sought after by politicians, economists and central bankers.

The Fallacy of Macroeconomics

In our RIA Pro article, The Fallacy of Macroeconomics, we show why the current mindset governing what constitutes economic growth is deeply flawed. In this article, we swapped Stiltsville for Glenn Villeneuve, a real person living off the grid in a remote part of Alaska.

To help you appreciate the benefit of creating value through production, we elicit the National Geographic Channel’s Life Below Zero. The documentary tracks the lives of several people that live largely independent, “off-the-grid”, in the wilds of Alaska. Of particular interest is Glenn Villeneuve, who does not appear to rely on help from the outside world, nor many of the innovations of modern society, including electricity and power tools. Assessing Glenn’s daily activities, we better illustrate the measurement of a personal economy. While this example does not represent the norm, it does provide a microcosm of a simple economy to allow us to contrast the circumstances of Villeneuve with the fallacy of an economic perspective focused on consumption.

A typical day for Glenn involves some of the following activities in which he produces goods: hunting, trapping, fishing, sourcing water, and chopping lumber. Other parts of his day are spent consuming prior production such as eating, drinking, sleeping, and warming up by a fire. The first set of activities involves productive endeavors that add economic value. The second set of activities involves consuming the value he created. Note that there is also an intermediate stage in which the value he created is stored (saved) for future consumption.

Throughout the show, Glenn consistently extols efficiency or the benefits of using the least amount of energy and the most amount of ingenuity to add value to his camp. After watching an episode or two, a viewer quickly realizes that without this supply side mindset Glenn would quickly exhaust his resources and become a victim of the harsh Alaskan climate.

Most of our days are quite different than Glenn’s, but nevertheless they are filled with similar pursuits. We sit at a desk providing legal services, picking grapes from a vine, building houses and millions of others jobs in which we create value. While most of us do not “eat what we kill” and consume the value we create directly, we earn the value in the form of currency. As a store of that value, currency then affords us a medium of exchange for something we need or want when it suits us.

Just as portrayed in Glenn’s example, the harder we work and the more innovative and productive we are, the more value we create. It is in this straightforward incentive that the prosperity of a populace grows and scarcity is diminished.

The Fed’s Mandate to Pick your Pocket

In a recent article entitled, The Fed’s Mandate to Pick your Pocket, we used the analogy of three people stranded on a deserted island to explain inflation.

Inflation is everywhere and always a monetary phenomenon.” – Milton Friedman

This oft-cited quote from the renowned American economist Milton Friedman suggests something important about inflation. What he implies is that inflation is a function of money, but what exactly does that mean?

To better appreciate this thought, let’s use a simple example of three people stranded on a deserted island. One person has two bottles of water, and she is willing to sell one of the bottles to the highest bidder. Of the two desperate bidders, one finds a lonely one-dollar bill in his pocket and is the highest bidder. But just before the transaction is completed, the other person finds a twenty-dollar bill buried in his backpack. Suddenly, the bottle of water that was about to sell for one-dollar now sells for twenty dollars. Nothing about the bottle of water changed. What changed was the money available among the people on the island.

As we discussed in What Turkey Can Teach Us About Gold, most people think inflation is caused by rising prices, but rising prices are only a symptom of inflation. As the deserted island example illustrates, inflation is caused by too much money sloshing around the economy in relation to goods and services. What we experience is goods and services going up in price, but inflation is actually the value of our money going down.

Gilligan’s Island

Having traveled to Stiltsville, The Brooks Range of Alaska and a deserted island, we now bring you to Gilligan’s Island. This widely popular 1960’s television sitcom portrayed the island home of seven castaways.  Despite the comic ventures of the half-witted first mate, Gilligan, and the rest of the castaways, the setting provides a nice canvas to illustrate how a nation’s prosperity can only permanently grow with the help of productivity.

As we stated in, Productivity: What it is and Why it Matters“Economic growth is a direct function of productivity which measures the amount of leverage an economy can generate from its two primary inputs, labor and capital. Without productivity, an economy is solely reliant on the two inputs. Due to the limited nature of both labor and capital, they cannot be depended upon to produce durable economic growth over long periods of time.”

Given the three factors that create prosperity – labor, capital, and productivity – we discuss how the three elements of economic growth can be employed on Gilligan’s Island and the benefits and drawbacks of each. We greatly simplify this analysis by assuming that the only product the castaways produce are coconuts. Further, the coconuts can be sold to Robinson Crusoe Island (RC Island), and as a result the castaways on Gilligan’s Island can buy whatever goods they desire. 


While there are many facets to labor such as education, training, work ethic and incentives, the biggest factor is demographics. Demographics describe the composition of a population. On Gilligan’s Island, all seven inhabitants, even the socialite Mrs. Howell, are capable of picking coconuts for long hours each day. Given this construct, there are two ways the island can increase its economic production; work more hours and/or have babies.

If each person were to increase their daily workload by two more hours, they would pick more coconuts and exchange them for more money and other goods. This would certainly make them more prosperous. However, picking hours are limited by what is physically possible and the number of hours of daylight. At some point, their ability to work more reaches a limit. 

The other way to increase the island’s economic activity is to have babies that will eventually work. If, for instance, the population were to double to 14, then we might assume the coconut production would also eventually double and therefore economic activity would double. That is true, but the level of activity and prosperity per person would remain the same.

In both examples, there is a limit to the number of people that can fit on the island and the number of hours that can be worked. While additional hours and babies can increase economic activity and prosperity, both have a definitive maximum.


Capital includes natural, man-made and financial resources.” The capital in our example is coconut trees and coconuts. In our most basic example, the only other potential source of capital is borrowing money from RC island.

Thurston Howell III, the once prominent millionaire, has devised a way to buy more stuff than is possible through daily coconut picking activities. He approaches RC island and asks to borrow money. RC island agrees and lends the Islanders money which is then spent.

Now, in addition to what they can buy from their coconut sales, they have the additional purchasing power of debt. This method makes Gilligan’s Island seemingly more prosperous, but only temporarily. In the future, they will not be able to borrow any more money and must use their income from coconut sales to pay back the debt. The buying power gained from the debt will be paid back in the future plus interest. Credit can raise the level of consumption, but it is temporary and limited.


Fortunately, Gilligan’s Island has the Professor. The resident genius realized the ultimate bounds of borrowing, working more hours and having babies. All three tactics could certainly provide more but were limited and flawed. He knew that capital, either saved or borrowed, and a little ingenuity could be used to permanently increase the number of coconuts they pick without requiring more hours of work or more people.

The Professor suggested they cut one month’s intake of caviar to buy ladders. The ladders allow them to get up and down the trees quicker and produce more coconuts in less time. Also, he suggested they borrow money to buy genetically modified coconut trees that produce five times as many coconuts as the trees currently on the island. By doing so, each trip up the tree would yield five more coconuts than before. The debt would have to be paid back with interest, but the extra revenue would more than offset the extra expense. They could also use their savings or debt to buy tools that could be used to make many different products from the coconuts. These products would generate more revenue per coconut.

This illustration demonstrates how productivity acts as leverage to get more out of labor and capital and expand the prosperity of an island and, for that matter, a nation.  


The concepts presented here are grossly simplified, but they apply to our modern, multifaceted economy every bit as much as they do to Gilligan’s Island. As a nation, we can keeping gaming GDP growth with largely unproductive debt or we can save and invest more. It is easier to borrow and spend, but it offers only a short-term means of raising consumption. It is not a permanent, long-term solution. Saving and investing comes with a temporary, short-term cost but the long -term benefits more than outweigh that sacrifice.

This lesson applies to the economy and the generation of demand for the products and services that drive the revenue and profits available to investors. It also applies to the value of individual investments themselves. With this precious of understanding of productivity and its value we should be asking if the companies we invest in are using capital to wisely invest in their future or are they using it for other less-productive purposes? This is not a binary question in most cases as most companies do both, however we all but guarantee that, over the long run, companies focused on investments where productivity growth trumps short-term profits will benefit at the expense of companies focused elsewhere.

For related research on this important concept we recommend reading The Death of the Virtuous Cycle and watching our short video The Animated Virtuous Cycle.

Price To Forecasted Hope

There are countless ways to evaluate equities, and they all have glaring flaws. Equity valuation is not a science with predictive formulas. It is subjective, and the formulas themselves and the interpretation of the results rely on an estimate of what the future holds.

Some models use historical data under the assumption that the current trend will be predictive of the future while others use forecasts that differ from the past. It is a rare occasion that the past neatly maps out the future or, for that matter, that anyone accurately predicts the future. No model represents the holy grail of investing, but understanding their inputs and outputs can reveal a lot about relative valuations and the sentiment of a market. As investors, we need to take into account all types of valuation techniques and their assumptions, especially those that may not confirm our current investment thesis.

Differences between various valuation models allows one to construct a bearish or bullish outlook simply by choosing the model that produces the appropriate outcome. Recently, Price to Forward Earnings (P/fE) has been flashing a buy signal and has been used by many investors as evidence that stocks are cheap. At the same time, as shown below, most other traditional valuation models are pointing to a market that is anywhere from 65% to 95% overvalued. What gives?

Choosing E?

Price to earnings is one of the most popular forms of equity valuation. It is a logical approach given that earnings, the profits available after all expenses, are ultimately what investors are buying. The basic price to earnings ratio (P/E) simply tells us what multiple the market is paying for profits. For instance, a P/E of 20 means investors are willing to pay 20 times the current level of earnings to own shares of the company. Theoretically, in this case, if a company’s earnings are flat for eternity, the investor will earn a 5% (1/20) annual return. If future earnings exceed current earnings, the return will be greater than 5%, and the return will be less than 5% if the opposite is true about earnings..

To provide a framework allowing for the comparison of current P/E valuations to prior valuations or valuations between other stocks or indexes, the E (earnings) in the ratio can be historical, recent or forecasted.  

Our preferred method, Cyclically Adjusted Price to Earnings (CAPE), compares today’s price versus inflation-adjusted earnings over the preceding ten year period. If you believe that future earnings growth will follow the longer term trend of years past, this valuation tool provides a dependable relative valuation metric.  

(Use Code: BEAR MARKET for a 30-day free trial)

The most commonly used P/E is based on earnings from the trailing twelve months (TTM). The reason we are not as comfortable with this approach is that, at times, one year earnings periods can differ markedly from prior periods due to one-off events. For instance, earnings over the last 12 months are considerably higher than the previous few years due to the corporate tax cut. As a result, TTM P/E is lower, but does that make stocks cheaper? That is not a trick question and can be answered yes or no depending on other factors. Regardless of your preference, both TTM and CAPE P/E ratios use earnings data that has occurred in the past.

Another popular way to calculate P/E uses estimates of forward earnings for the next 12 months. Theoretically, this approach is the best of the three methods. When you are buying a stock or an index, it is the earnings in the future that matter, not those in the past.

While the price to forward earnings (P/fE) ratio seems like the smartest approach, it is much harder to use as predicting earnings can be very difficult. In fact, the point at which one needs to be most vigilant about avoiding overpriced equities often is the time when misplaced confidence is highest in equities. Of greater concern, most investors rely on forward earnings forecasts from Wall Street. While Wall Street banks may employ the best analysts and have access to knowledge that you and I do not, they are biased. To put it bluntly, Wall Street banks and brokers make money by selling stocks.

This opinion is not cynical, this is how the world works. McDonald’s, for instance, is always quick to point out the health benefits of their salads, but have they ever tried to dissuade customers from ordering a Big Mac, jumbo fries and a large Coke? In fact, they entice customers to order that exact “super-size” combination through pricing deals.

Data Supporting our Cynicism

Given that Wall Street is in the business of selling stocks, they tend to be optimistic. The graph below points this out by showing the difference between forecasted earnings and the true earnings that were released 12 months after the forecasts. The gray-shaded area plots the percentage difference.

Note the following:

  • On average, forward earnings expectations are 16.5% higher than actual earnings
  • During the last three recessions, forward earnings were 50% greater than actual earnings
  • Forward earnings are greater than actual earnings 85% of the time

The ebbs and flows of earnings from quarter to quarter and year to year graphically hide some of the perpetual optimism. The next graph uses the historical earnings trend line (dotted blue) from the graph above to compare to forward estimates. This modification of the first graph allows us to compare more reliable earnings trends to forecasts.

As shown, forward forecasts have been consistently overly optimistic since 1994 except for the 2008/09 recession. While the reliability of optimism is worth stressing, the level of current optimism, represented by the gray shaded area showing the percentage difference, indicates that current forward earnings estimates are the highest they have been compared to the longer term earnings trend over this 25-year period.

Current P/fE

The graph below charts P/fE. As shown, the current P/fE level is below the average of the last 28 years and, dare we say, cheap.

Given this set of information, stating that stocks are cheap on the basis of forward earnings and P/fE alone is foolish. The graph below contrasts current P/fE with various one-year earnings forecasts. To help pick one of the horizontal lines associated with different annual earnings growth rates consider:

  • 2012-2017 earnings grew at 4.67%
  • 2018 grew at 21.77%
  • 2019 expected to grow at 20% (1.56 vs 1.30)

We should also note that growth associated with the tax cuts have a one-year shelf life. While earnings may be higher as companies pay fewer taxes, the growth rate of those earnings should revert towards trend levels as they are married to economic activity.

As shown, forward P/fE is only as good as the forecast. Even if earnings grow at 15% in 2019, which would be impressive, the ratio goes from below to above average. In more pessimistic scenarios, such as a reversion to the longer-term trend growth or a mild recession, the ratio becomes very expensive. Traditionally, this is what happens as the economy moves in to a recession but Wall Street analysts are slow to react.


  • The growth benefits of the tax cut are not recurring
  • Will buybacks continue to boost EPS?
  • Revenue growth has been running 4%, can corporate profit margins keep expanding?
  • Forecasted earnings are overly optimistic 85% of the time
  • Forecasted earnings have never predicted a recession or a big drop in earnings
  • In the event no recession emerges, then wage pressures are likely to negatively impact earnings and margins

Instead of restating our thoughts on the current “value” exposed by P/fE, we leave you with a simple thought and graph. At current levels, price to forecasted earnings are as “cheap” as they were in November 2007. Oddly enough, the National Bureau of Economic Research (NBER), which is responsible for identifying the dates when U.S. recessions begin and end, mark December 2007 as the beginning of the Great Recession. That was not a good time to own “cheap” stocks.

Two Percent for the One Percent

Gradual inflation has a numbing effect. It impoverishes the lower and middle class, but they don’t notice.”—Andrew Bosomworth, PIMCO Germany, as quoted in Der Spiegel

Media reports and political candidates have been stressing the rising wealth and income inequality gaps in the United States. They do so to advance their agendas, but the problem is real and they are justified in raising it. At the same time, both groups are largely overlooking an important piece of the puzzle in the way they talk about it. To properly diagnose this important problem, we need to understand the role the Federal Reserve plays in managing economic growth and how it contributes to these rising imbalances. This article examines the Federal Reserve’s monetary policy objectives and their stated inflation goals to help you better appreciate the role they play in this troubling and growing problem.  

Populism on the Rise

The political success of Donald Trump, Bernie Sanders and more recently Alexandra Ocasio-Cortez leave scant doubt that populism is on the rise. Voters from both parties are demanding change and going to extremes to achieve it. Much of what is taking place is rooted in the emergence of the greatest wealth inequality gap since the roaring ’20s.

Over the last twenty years, the “1%” have been able to accumulate wealth at an ever-increasing rate. According to the Economic Policy Institute, the top 1% take home 21% of all income in the United States, the largest share since 1928. The graph below, while slightly dated, shows the drastic change in income trends that have occurred over the last 35 years.

Graph Courtesy: New York Times – One Broken Economy, in One Simple Chart

This grab for riches by the few is coming at the expense of the many. There are a variety of social, political and economic factors driving the growing discrepancy, but there is one critical factor that is being ignored.

Enter the Federal Reserve

The Federal Reserve Act, as amended in 1977, contains three mandates dictating the management of monetary policy. They are 1) maximize employment, 2) maintain stable prices, and 3) keep long-term interest rates moderate.

These broadly-worded objectives afford the Federal Reserve great latitude in interpreting the Act. Among these, the Fed’s mandate for stable prices is worth a closer look. The Fed interprets “stable prices” as a consistent rate of price increases or inflation. Per the Federal Reserve Bank of Chicago, “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for Personal Consumption Expenditures (PCE), is most consistent over the longer run with the Federal Reserve’s statutory mandate.” 

Understanding why the wealth gap has exploded in recent years requires an appreciation for how this small but consistent rate of inflation harms the poor and middle class while simultaneously enriching the already wealthy.

Wealth is defined as that which is left after consumption and the accumulated results of those savings over time.

With that in mind consider inflation from the standpoint of those living paycheck to paycheck. These citizens are often paid on a bi-weekly basis and spend all of their income throughout the following two weeks. In an inflationary state, one’s purchasing power or the amount of goods and services that can be purchased per dollar declines as time progresses. Said differently, the value of work already completed declines over time.  While the erosion of purchasing power is imperceptible in a low inflation environment, it is real and reduces what little wealth this class of workers earned. Endured over years, it has adverse effects on household wealth.

Now let’s focus on the wealthy. A large portion of their earnings are saved and invested, not predominately used to pay rent or put food on the table. While the value of their wealth is also subject to inflation, they offset the negative effects of inflation and increase real wealth by investing in ways that take advantage of rising inflation. Further, the Fed’s historically low-interest-rate policy, which supports 2% inflation, allows the more efficient use of financial leverage to increase wealth.

Some may counter that daily laborers living week to week get pay raises that offset inflation. That may be true, but it also assumes inflation is measured correctly. The Fed relies upon the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) metrics as gauges of inflation. While widely accepted, we all have firsthand experience of the rapid rise in the cost of health care, higher education, rents, and many other essential goods and services that suggests far greater inflation than the Fed’s 2% objective. The truth is that inflation is not measurable with any real accuracy.

John Williams, of Shadow Stats, calculates inflation based on the methods used by the Bureau of Labor Statistics in 1980. Currently, his calculation has CPI running at 9.9% per year, much higher than the latest 2.2% CPI reported. The difference between Williams’ calculation and the BLS’ reported figure is caused by the numerous adjustments the BLS has made to the CPI calculation over the years which has reduced reported inflation. Economists argue that the BLS adjustments provide better accuracy. Maybe, but the record level of wealth inequality and public dissatisfaction offers hard evidence to the contrary. Disagreements notwithstanding, the loss of wealth due to inflation, whether at 2% or 10%, is punishing for those spending everything as it limits their ability to save and accumulate wealth.

Economic growth as measured by Gross Domestic Production (GDP) is the holy grail of all measures of economic advancement. Rising GDP in a debt-based economy depends on credit growth which explains why inflation is so important to policy-makers. The logical conclusion is that the Fed’s primary purpose for running a consistent rate of inflation is to foster credit growth. The growth of credit benefits those who have collateral to borrow against, employ leverage and invest. Again, it is the wealthy that benefit from this. For everyone else, it is a merciless master that makes it difficult if not impossible to maintain one’s standard of living.

The more of one’s wealth that is used for consumption, the more one is subject to the ills of inflation. Additionally, this circumstance also drives a negative feedback loop in that inflation also quietly incents people to consume since goods and services will be more expensive tomorrow than they are today.

While we illustrate the extremes in this article, one can envision how the middle class, which increasingly spend the majority of their wages on consumption and invest little or nothing, also fall into the inflation trap.


The central banking scheme of supporting economic growth through increasing levels of debt only makes sense if “growth at all cost” uniformly benefits all citizens, but it does not. There is a big difference between growth and prosperity. Furthermore, an inflationary policy that aims to minimize the burden of debt while at the same time aggravating the growth of those burdens is taking a serious toll on global economic and social stability.

As we are finding, the United States is not immune to these disruptions.  The source of these problems are accumulating and compounding as a result of the public’s failure to understand why it is happening. This will ultimately lead to further policy-making errors. Until the Fed’s policies are publicly discussed, re-examined and ultimately reconsidered, the problems will not resolve themselves.

Productivity: What It Is & Why It Matters

The Kansas City Federal Reserve posted the Twitter comment and graph below highlighting a very important economic theme. Although productivity is a basic building block of economic analysis, it is one that few economists and even fewer investors seem to appreciate.

The Kansas City Fed’s tweet is 100% correct in that wages are stagnating in large part due to low productivity growth. As the second chart shows, it is not only wages. The post financial-crisis economic expansion, despite being within months of a record for duration, is by far the weakest since WWII.

Productivity growth over the last 350+ years is what allowed America to grow from a colonial outpost into the world’s largest and most prosperous economic power. Productivity is the chief long-term driver of corporate profitability and economic growth. Productivity drives investment returns whether we recognize it or not.

Despite its foundational importance to the economy, productivity is not well understood. There is no greater proof than the hordes of Ivy League trained PhD’s at the Federal Reserve who have promoted extremely easy monetary policy for decades. It is this policy which has sacrificed productivity at the altar of consumption and short-term economic gains.

For more on the interaction between monetary policy and economic growth please read Wicksell’s Elegant Model.

What Drives Economic Activity

Economic growth is a direct function of productivity which measures the amount of leverage an economy can generate from its two primary inputs, labor and capital. Without productivity, an economy is solely reliant on the two inputs. Due to the limited nature of both labor and capital, they cannot be depended upon to produce durable economic growth over long periods of time.

Leveraging labor and capital, or becoming more productive, provides the dynamism to an economy. Unfortunately, productivity requires work, time, and sacrifice. It’s a function of countless factors including innovation, education, government policies, and financial incentives.


Labor, or human capital, is largely a function of the demographic makeup of an economy and its employees’ skillset and knowledge base. In the short run, increasing labor productivity is difficult. Realizing changes to skills training and education take time but they do have meaningful effect. Similarly, changes in birth rate patterns require decades to influence an economy.

Within the labor force, the biggest trend affecting current and future economic activity, both domestic and globally, is the so called “silver tsunami”, or the aging of the baby boomers. This outsized cohort of the population, ages 55 to 73 are beginning to retire at ever greater rates. As this occurs, they tend to consume less, rely more on financial support from the rest of the population, and withdraw valuable skills and knowledge from the workforce. The vast number of people in this demographic cohort makes this occurrence more economically damaging than usual. As an example, the old age dependency ratio, which measures the ratio of people aged greater than 65 to the working population ages 18-64, is expected to nearly double by the year 2035 (Census Bureau).

While the implications of changes in demographics and the workforce composition are numerous, they only require one vital point of emphasis: the significant economic contributions attributable to the baby boomers from the last 30+ years will diminish from here forward. As they contribute less, they will also require a higher allotment of financial support, becoming more dependent on younger workers.

Finally, immigration is also an important component in the labor force equation. Changes in immigration policies and laws are easier to amend to foster more immediate growth but political dynamics argue that pro-immigration policies and laws are not likely within the next few years.


Capital includes natural, man-made and financial resources. Over the past 30+ years, the U.S. economy benefited from significant capital growth, in particular debt. The growth in debt outstanding, a big component of capital, is shown broken out by sector in the graph below. The increase is stark when compared to the relatively modest level of economic activity that accompanied it (black line).

This divergence in debt and economic growth is a result of many consecutive years of borrowing funds for consumptive purposes and the misallocation of capital, both of which are largely unproductive endeavors. In hindsight we know these actions were unproductive as highlighted by the steadily rising ratio of debt to GDP shown above. The graph below tells the same story in a different manner, plotting the amount of debt required to generate $1 of economic growth. Simply, if debt were used for productive activities, economic growth would have risen faster than debt outstanding.Data Courtesy: Bloomberg, St. louis Federal Reserve

Data Courtesy: Bloomberg, St. Louis Federal Reserve


Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4 to 6%. While there is no exact measure of productivity, total factor productivity (TFP) is considered one of the best measures. Data for TFP can found at the San Francisco Federal Reserve- (http://www.frbsf.org/economic-research/indicators-data/total-factor-productivity-tfp/)

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

Data Courtesy: San Francisco Federal Reserve

The graph below plots 10 year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line).

The stagnation of productivity growth started in the early 1970’s. To be precise it was the result, in part, of the removal of the gold standard and the resulting freedom the Fed was granted to foster more debt. For more information on this please read our article: The Fifteenth of August.  The graph above reinforces the message from the other debt related graphs – over the last 30 years the economy has relied more upon debt growth and less on productivity to generate economic activity.Data Courtesy: Bloomberg, St. Louis and San Francisco Federal Reserve

Demoting Productivity

Government deficit spending is sold to the public as economically beneficial. However, the simple fact that government debt as a ratio of GDP has continually grown, tells you this is a lie. Further, there is not just a financial cost to running deficits but an opportunity cost that is underappreciated or ignored altogether. The capital misallocated towards the government was not employed for ventures that may have resulted in economically beneficial productivity gains.

The government is not solely to blame. The Federal Reserve has used monetary policy to prod economic growth and deprive the economy of full economic recessions that clean up mal-investment. They have bailed out the largest enablers of unproductive debt. Their policies encourage public and private debt expansion, much of which has been unproductive as shown in this article.

We the people, also play a role. We drive bigger cars and live in bigger houses for example. We tend to spend more lavishly than generations past. Too much of this unproductive consumption is done with borrowed money and not savings. While these luxuries are nice, the economic benefits are very short-term in nature and come at the expense of the long-term benefits of more productive investment.


Given the finite ability to service debt outstanding and aforementioned demographic challenges, future economic growth, if we are to have it, will need to be based largely on gains in productivity. Current economic circumstances serve as both a wet blanket on economic growth and are clearly weighing on productivity by diverting capital away from productive uses in order to service that debt. Ill-conceived policies that impose an over-reliance on debt and demographics have largely run their course.

The change required will be neither easy nor painless but it is necessary.  Policy-makers will either need to become immediately responsive and take action to address these issues or discipline will be imposed by other involuntary means.

This is not just an economics story. Importantly, as investors in assets whose value and cash flows are dependent on these economic forces, we urge caution when the valuation of those assets is high as it is today amid such a challenging economic backdrop.

Wait for the Fat Pitch : Buy and Hold vs Active Management

Ted Williams described in his book, ‘The Science of Hitting,’ that the most important thing – for a hitter – is to wait for the right pitch. And that’s exactly the philosophy I have about investing – wait for the right pitch, and wait for the right deal. And it will come… It’s the key to investing.” – Warren Buffett

Many investment managers tempt investors with historical returns by using them as indicators of future return expectations. Unfortunately, even if they are clairvoyant, a buy and hold strategy based on a “known” long term return is likely not in a client’s best interest. Buy and hold strategies that are solely focused on a long-term total return fail to consider the current state of valuations, the risk reward profile, and therefore the path of returns the market may take between now and the future. Importantly, they also ignore investor circumstances and whether he or she is a young worker in savings mode or a retiree who must draw living expenses from their account.

Even with a “known” return, it may be comforting to think one can buy and hold without any reservations. The reality is that, in many circumstances, such a strategy leaves a lot to be desired. On the path between today and tomorrow, there will inevitably be periods where returns are well above original expectations accompanied by a lower level of risk. There will also be periods where returns are lower than expected and the risk is greater.

This paper is theoretical in nature, but the simple message underlying the article is, as stated in the opening quote, you do not have to swing at every pitch. Patience rewards the prudent.

Destination vs Path

Let’s take a time machine back to January 1st 2005. Given that we are coming from the future, we know the following facts about the S&P 500:

  • January 1, 2005 price: 1181.41
  • 2015 Cyclically-adjusted P/E (CAPE): 26.49
  • Earnings growth 2005-2015: 7.68%
  • Dividend yield 2005-2015: 2.04%:
  • Dec 31, 2015 price: 1524.53
  • Annualized total return 2005-2015: 7.59%

In 2005, most investors would have considered the prospect of a 7.59% annualized return as favorable on a nominal basis as well as in comparison to U.S. ten-year Treasury notes, which yielded 4.22% at the time. Armed with that information, we guess that many investors would elect to buy and hold and earn 7.59%.

Let’s add a few more facts to the story. In January 2005, market valuations as measured by CAPE were at 26.59, which was a premium of 67% to the average (15.93) up to that time using data since 1900. In 2005, investors knew that if prices reverted to valuation means over the course of the ensuing ten year period, with earnings and dividends constant, the total return over the entire period would be -0.21%. Such a return compares poorly to the 4.22% annualized, risk-free returns offered by the ten-year U.S. Treasury note in 2005.

As it turned out, CAPE valuations did revert to their mean and even slightly below by March 2009. However, they expanded afterwards and by 2015 closed at levels nearly identical to 2005. The variation in the multiples investors were willing to pay for earnings (CAPE) factored largely into returns from 2005 to 2015. As a result, the actual path of annual returns was quite different from the straight line 7.59% many were expecting.

For anyone who was fully invested, and like today many were, that volatility imposed terrific stress. Furthermore, because of the reversion to the mean, there were opportunities to grow wealth at a faster rate than 7.59%, but it required having some cash on hand in order to take advantage of those opportunities.

The following graph compares the expected price of the S&P 500, assuming a market return of 7.59% every year for the ten-year period, to actual prices. Despite the same final price, note the wide price differences that occurred over the period. These divergences represented opportunities to change your investment posture, to increase or reduce risk, and better your realized total returns.

The following illustration adds bars to the graph above to highlight the expected returns in 2005 and the revised annual expectations in each ensuing year.

With the benefit of hindsight, we know an investor did not need to settle for the 7.59% guaranteed 10-year annualized return in 2005. In 2009, the expected return until 2015 would be more than double the original 7.59%.

Let’s consider an alternative way an investor might have invested over the ten year period.

The following table and graph compares a hypothetical, actively-managed portfolio versus a rigid buy and hold portfolio. The active investor, in our example, used a more conservative allocation when equity valuations were high. Conversely, when valuations normalized, the investor takes more risk by reallocating to a predominately equity-oriented portfolio.

As shown in the graph above, the actual dollar returns of the active versus buy and hold portfolios differed from the dotted straight line expected return. The table above the graph shows that the active portfolio beat the buy and hold portfolio by approximately 1.50% a year, and importantly, did so while taking less risk. The Sharpe ratio in the table, measuring returns as a percentage of risk, clearly favors the active approach.

The premise here is illustrative, and we urge you not to take the data too literally. We could have made the active allocations look a lot better by reducing equities to zero before the financial crisis, or we could have made them worse by not increasing the allocation to equites in the post-crisis era. The point of this exercise is not to play Monday morning quarterback, but to provide a simple example of how a more thoughtful active approach can use valuations to reduce risk and increase returns.   

The Path for the Next Ten Years

In Stocks versus Bonds: What to own over the next decade, we showed that under three optimistic scenarios in which valuations remain historically rich but mean revert to a still high level, (CAPE 24.80 = +1 standard deviation from the mean) annualized equity returns are likely to range from 0.71% to 4.62%. Under what we deem to be an average scenario, investors with a ten-year holding period should weak total returns. As such, a buy and hold strategy currently provides poor return expectations when compared to historical equity returns.

Given that the odds favor CAPE regressing towards its mean, or possibly below it, within the next ten years, logic and reason argue that better opportunities likely lie ahead. Why not take the conservative approach today when valuations stand at historically high levels?  Doing so may allow you the opportunity to swing at the fat pitch tomorrow.

By some measures, as shown below, equity valuations are at levels never witnessed in the modern era. Whether “this time is different” or valuations are sharply out of line and will correct, is up for debate. We simply urge you to consider that there are potential future opportunities that can only be seized by exhibiting caution today.


The point being made here is essential; risk management is generous. Based on the past 100 years of market data, there is no evidence that long-term returns are penalized by taking a defensive investment posture at high valuations. Investors today do not need to buy and hold stocks and remain heavily invested when expected returns are paltry. The historical record, though imprecise, affords an excellent map for navigating and managing risk.

Patience is an investor’s friend, and time has a habit of delivering better opportunities to those inclined to exercise it.  Each investor can determine his own “strike zone” and is well-served to exercise patience until a fat pitch comes along.

Trump’s Volley – Hoover’s Folly?

“You load sixteen tons, what do you get?
Another day older and deeper in debt
Saint Peter don’t you call me ’cause I can’t go
I owe my soul to the company store” 
– Sixteen Tons by Tennessee Ernie Ford

Shortly following Donald Trump’s election victory we penned a piece entitled Hoover’s Folly. In light of Trump’s introduction of tariffs on steel and other selected imports, we thought it wise to recap some of the key points made in that article and provide additional guidance.

While the media seems to treat Trump’s recent demands for tariffs as a hollow negotiating stance, investors are best advised to pay attention. At stake are not just more favorable trade terms on a few select products and possibly manufacturing jobs but the platform on which the global economic regime has operated for the last 50 years. So far it is unclear whether Trump’s rising intensity is political rhetoric or seriously foretelling actions that will bring meaningful change to the way the global economy works. Either as a direct result of policy and/or uncharacteristic retaliation to strong words, abrupt changes to trade, and therefore the role of the U.S. Dollar as the world’s reserve currency, has the potential to generate major shocks in the financial markets.

Hoover’s Folly

The following paragraphs are selected from Hoover’s Folly to provide a background.

In 1930, Herbert Hoover signed the Smoot-Hawley Tariff Act into law. As the world entered the early phases of the Great Depression, the measure was intended to protect American jobs and farmers. Ignoring warnings from global trade partners, the new law placed tariffs on goods imported into the U.S. which resulted in retaliatory tariffs on U.S. goods exported to other countries. By 1934, U.S. imports and exports were reduced by more than 50% and many Great Depression scholars have blamed the tariffs for playing a substantial role in amplifying the scope and duration of the Great Depression. The United States paid a steep price for trying to protect its workforce through short-sighted political expedience.

Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business-friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.  

From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

The Other Side of the Story

The President recently tweeted the following:

Regardless of political affiliation, most Americans agree with President Trump that international trade should be conducted on fair terms. The problem with assessing whether or not “trade wars are good” is that one must understand the other side of the story.

Persistent trade imbalances are the manifestation of explicit global trade agreements that have been around for decades and have historically received broad bi-partisan support. Those policies were sponsored by U.S. leaders under the guise of “free trade” from the North American Free Trade Agreement (NAFTA) to ushering China in to the World Trade Organization (WTO). During that time, American politicians and corporations did not just rollover and accept unfair trade terms; there was clearly something in it for them. They knew that in exchange for unequal trade terms and mounting trade deficits came an implicit arrangement that the countries which export goods to the U.S. would also fund that consumption. Said differently, foreign countries sold America their goods on credit. That construct enabled U.S. corporations, the chief lobbyists in favor of such agreements, to establish foreign production facilities in cheap labor markets for the sale of goods back into the United States.

The following bullet points show how making imports into the U.S. easier, via tariffs and trade pacts, has played out.

  • Bi-partisan support for easing multi-lateral trade agreements, especially with China
  • One-way tariffs or producer subsidies that favor foreign producers were generally not challenged
  • Those agreements, tariffs, and subsidies enable foreign competitors to employ cheap labor to make goods at prices that undercut U.S. producers
  • U.S. corporations moved production overseas to take advantage of cheap labor
  • Cheaper goods are then sold back to U.S. consumers creating a trade deficit
  • U.S. dollars received by foreign producers are used to buy U.S. Treasuries and other dollar-based corporate and securitized individuals liabilities
  • Foreign demand for U.S. Treasuries and other bonds lower U.S. interest rates
  • Lower U.S. interest rates encourage consumption and debt accumulation
  • U.S. economic growth increasingly centered on ever-increasing debt loads and declining interest rates to facilitate servicing the debt

Trade Deficits and Debt

These trade agreements subordinated traditional forms of production and manufacturing to the exporting of U.S. dollars. America relinquished its role as the world’s leading manufacturer in exchange for cheaper imported goods and services from other countries. The profits of U.S.-based manufacturing companies were enhanced with cheaper foreign labor, but the wages of U.S. employees were impaired, and jobs in the manufacturing sector were exported to foreign lands. This had the effect of hollowing out America’s industrial base while at the same time stoking foreign appetite for U.S. debt as they received U.S. dollars and sought to invest them. In return, debt-driven consumption soared in the U.S.

The trade deficit, also known as the current account balance, measures the net flow of goods and services in and out of a country. The graph below shows the correlation between the cumulative deterioration of the U.S. current account balance and manufacturing jobs.

Data Courtesy: St. Louis Federal Reserve (NIPA)

Since 1983, there have only been two quarters in which the current account balance was positive. During the most recent economic expansion, the current account balance has averaged -$443 billion per year.

To further appreciate the ramifications of the reigning economic regime, consider that China gained full acceptance into the World Trade Organization (WTO) in 2001. The trade agreements that accompanied WTO status and allowed China easier access to U.S. markets have resulted in an approximate quintupling of the amount of exports from China to the U.S.  Similarly, there has been a concurrent increase in the amount of credit that China has extended the U.S. government through their purchase of U.S. Treasury securities as shown below.

Data Courtesy: St. Louis Federal Reserve and U.S. Treasury Department

The Company Store

To further understand why the current economic regime is tricky to change, one must consider that the debts of years past have not been paid off. As such the U.S. Treasury regularly issues new debt that is used to pay for older debt that is maturing while at the same time issuing even more debt to fund current period deficits. Therefore, the important topic not being discussed is the United States’ (in)ability to reduce reliance on foreign funding that has proven essential in supporting the accumulated debt of consumption from years past.

Trump’s ideas are far more complicated than simply leveling the trade playing field and reviving our industrial base. If the United States decides to equalize terms of trade, then we are redefining long-held agreements introduced and reinforced by previous administrations.  In breaking with that tradition of “we give you dollars, you give us cheap goods (cars, toys, lawnmowers, steel, etc.), we will most certainly also need to source alternative demand for our debt. In reality, new buyers will emerge but that likely implies an unfavorable adjustment to interest rates. The graph below compares the amount of U.S. Treasury debt that is funded abroad and the total amount of publicly traded U.S. debt. Consider further, foreigners have large holdings of U.S. corporate and securitized individual debt as well. (Importantly, also note that in recent years the Fed has bought over $2 trillion of Treasury securities through quantitative easing (QE), more than making up for the recent slowdown in foreign buying.)

Data Courtesy: St. Louis Federal Reserve

The bottom line is that, if Trump decides to put new tariffs on foreign goods, we must presume that foreign creditors will not be as generous lending money to the U.S. Accordingly, higher interest rates will be needed to attract new sources of capital. The problem, as we have discussed in numerous articles, is that higher interest rates put a severe burden on economic growth in a highly leveraged economy. In Hoover’s Folly we stated: Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

It seems plausible that a trade war would result in potentially controversial intervention from the Federal Reserve. The economic cost of higher interest rates would likely be too high a price for the Fed to sit idly by and watch. Such policy would be controversial because it would further blur the lines between monetary and fiscal policy and potentially jeopardize the already tenuous independent status of the Fed.

Importantly, this is not purely a problem for the U.S. Still the world’s reserve currency, the global economy is dependent upon U.S. dollars and needs them to transact. Any disruption in economic activity as a result of rising U.S. interest rates, the risk-free benchmark for the entire world, would most certainly go viral. That said, for the godless Communist regimes of China and Russia, a moral barometer is not just absent, it is illegal. Game theory, considering those circumstances and actors, becomes infinitely more complex.


Investors concerned about the ramifications of a potential trade war should consider how higher interest rates would affect their portfolios. Further, given that the Fed would likely step in at some point if higher interest rates were meaningfully affecting the economy, they should also consider how QE or some other form of intervention might affect asset prices. While QE has a recent history of being supportive of asset prices, can we assume that to be true going forward?  The efficacy of Fed actions will be more closely scrutinized if, for example, the dollar is substantially weaker and/or inflation higher.

There will be serious ramifications to changing a global trade regime that has been in place for several decades. It seems unlikely that Trump’s global trade proposals, if pursued and enacted, will result in more balanced trade without further aggravating problems for the U.S. fiscal circumstance.  So far, the market response has been fidgety at worst and investors seem to be looking past these risks. The optimism is admirable but optimism is a poor substitute for prudence.

In closing, the summary from Hoover’s Folly a year ago remains valid:

It is premature to make investment decisions based on rhetoric and threats. It is also possible that much of this bluster could simply be the opening bid in what is a peaceful renegotiation of global trade agreements. To the extent that global growth and trade has been the beneficiary of years of asymmetries at the expense of the United States, then change is overdue. Our hope is that the Trump administration can impose the discipline of smart business with the tact of shrewd diplomacy to affect these changes in an orderly manner. Regardless, we must pay close attention to trade conflicts and their consequences can escalate quickly. 

Stocks Vs. Bonds & What To Own Over The Next Decade

Imagine a world with two investment options, apples and oranges. Investors are best served to reduce their holdings of apples and to replace them with oranges when demand for apples drives the price too high. The simple logic in this example is applicable across the full spectrum of economics, and it holds every bit as true in today’s complex world of investing. The question every investor should have is, “When does the price of “apples” make “oranges” the preferred holding”? Most of the time, answering that question is not easy. Occasionally however, the evidence becomes too obvious to ignore.

Replace apples and oranges with stocks and bonds and you have defined the majority of investors’ asset allocation schematic. Unlike our fruit example, the allocation decision between stocks and bonds, is based on many factors other than the price of those two assets relative to each other. Among them, recent performance and momentum tend to be a big influence in both raging bull markets and gut-wrenching bear markets. In both extremes, valuations tend to take a back seat despite historical data providing ample evidence that equity valuations alone should drive allocation decision.

Current equity valuations and nearly 150 years of data leave no doubt that investors are best served to ignore yesterday’s stock market momentum and gains and should be shifting to bonds, as we will demonstrate.


How often do you hear someone touting a stock because its share price is low, or advising you to sell because the price is too high? This nonsense does not come from just Uber drivers and novice investors; it is the primary programming line-up of the main-stream business media.  The share price on its own is meaningless. However, the stock price times the number of shares outstanding provides the market capitalization (market cap) or the dollar value of the company. Inexplicably, market cap is a number you rarely hear from those giving stock tips.

Market cap allows investors to take the aforementioned corporate worth and compare it to earnings, cash flow, revenues and a host of other fundamental data to provide a logical valuation platform for comparison to other investment options.

While we use a slew of different valuation techniques, we tend to prefer the Cyclically-Adjusted Price-to-Earnings (CAPE) Ratio as devised by Nobel Prize winning economist and Yale professor Robert Shiller. The ratio adjusts for inflation and as importantly, uses ten years of earnings data to derive a price to earnings ratio that encompasses business cycles. Shiller’s approach eliminates short-term noise that tends to make the more popular one-year trailing price-to-earnings ratio erratic and potentially misleading.

Currently, the CAPE on the S&P 500 is 33.41. Looking back as far as 1871, today’s valuation has only been exceeded by a brief period in the late 1990’s. To help link return expectations and CAPE valuations we plot below every historical monthly instance of CAPE to the respective forward ten-year returns. Each of the 1,525 dots represents the intersection of CAPE and the ten year total return that followed since 1871.

Data Courtesy: Robert Shiller

Apples or Oranges

While the analysis is telling, investors should compare the returns versus those from a ten-year U.S. Treasury note to determine whether the returns on stocks adequately compensated investors for the additional risk.

The graph below shows the returns above minus the prevailing ten-year U.S. Treasury note.  Essentially, the graph shows the excess or shortfall of the returns provided by stocks versus those of ten-year Treasury Notes in the ten years following each monthly CAPE instance. Negative returns indicate the 10-year Treasury yield exceeded the 10-year total return on stocks.

Data Courtesy: Robert Shiller

To better highlight the data and put a finer point on current prospects, consider the bar chart below.

Data Courtesy: Robert Shiller

The chart above aggregates the data from the prior chart into ranges of CAPE as shown on the x-axis. It also displays the mean, maximum and minimum of the excess ten year returns of stocks at the various CAPE ranges. This information can be used to create expectations for future performance given a stated CAPE.

With the current CAPE at 33.41 as circled, investors should expect an annualized excess return for ten years of -2.04%. Based on historical data which includes 32 full business cycles dating back to 1871, the best excess return experienced for all instances of CAPE over 30 is 0.39%. Over this 147 year period, there have been 57 monthly instances in which the CAPE was above 30. Only four of these instances provided an excess return over Treasuries and the average was a paltry twenty basis points or 0.20%.

Call us cynical, but the prospect of equity market excess returns  for the next ten years measuring in the fractions of a percent is not nearly enough compensation for the distinct possibility of underperforming a risk-free asset for ten years.


History, analytical rigor and logic all argue in favor of shifting one’s allocations away from stocks. Investors have no doubt become accustomed to the easy gains provided by equity markets over the past ten years, and old habits are hard to break but we know valuations to be mean-reverting. Given current extremes, this comparison offers compelling evidence that compounding wealth most effectively depends on breaking that habit.

Deficits Do Matter

The Federal Reserve (Fed) has increased the Fed Funds rate by 125 basis points or 1.25% since 2015, which had little effect on bonds until recently. Of late, however, yields on longer-maturity bonds have begun to rise, contributing to anxiety in the equity markets.

The current narrative from Wall Street and the media is that higher wages, better economic growth and a weaker dollar are stoking inflation. These forces are producing higher interest rates, which negatively affects corporate earnings and economic growth and thus causes concern for equity investors. We think there is a thick irony that, in our over-leveraged economy, economic growth is harming economic growth.

Despite the obvious irony of the conclusion, the popular narrative has some merits. Fortunately, the financial markets provide a simple way to isolate how much of the recent increase in longer-term bond yields is due to growth-induced inflation expectations. Once inflation is accounted for, we shine a light on other factors that are playing a role in making bond and equity investors nervous.

Given the importance of interest rates on economic growth and stock prices, understanding the supply and demand for interest rates, as laid out in this article, will provide benefits for those willing to explore beyond the headlines.

Nominal vs. Real

Since September of 2017, the yield on the five-year U.S. Treasury note has risen 90 basis points while the ten-year U.S. Treasury note has increased 75 basis points. At the same time, inflation, as measured by annual changes in CPI, declined slightly from 2.20% to 2.10%. Recent inflation data, while important in understanding potential trends, is by definition historical. As such, forecasts and expectations for inflation over the remaining life of any bond are much more relevant.

Treasury Inflation Protected Securities (TIPS) are a unique type of bond that compensates investors for changes in inflation. In addition to paying a stated coupon, TIPS also pay holders an incremental coupon equal to the rate of inflation for a given period. In technical parlance, TIPS provide a guaranteed real (after inflation) return. Non-TIPS, on the other hand, provide a nominal (before inflation) return. The real returns on bonds without the inflation protection component are subject to erosion by future rates of inflation. To gauge the market’s expectations for inflation, we can simply subtract the yield of TIPS from that of a comparable maturity nominal bond.

During the same six month period mentioned above, yields on five and ten-year TIPS increased 30 basis points. As shown below, this means that 60 basis points of the 90 basis point increase in the five-year note and 45 basis points of the 75 basis point increase in the ten-year note are a result of non-inflationary factors. The graphs below highlights the recent period in which five and ten-year yields rose at a faster pace than inflation expectations.

Data Courtesy: St. Louis Federal Reserve

Data Courtesy: St. Louis Federal Reserve

By isolating the widening gap between nominal and real yields on Treasury notes of similar maturities, we establish that there are other factors besides inflation that account for about two-thirds of the recent march higher in yields. Below, we summarize the potential culprits affecting both the supply and demand for U.S. Treasury debt offerings, which should help uncover the factors other than inflation that are driving yields higher.

Supply Factors

The most obvious influence driving yields higher, in our opinion, is the prospect of larger Federal deficits in the coming years. The tax reform package boosts the deficit over the next ten years by an estimated $1.5 trillion, and the recent two-year continuing resolution (CR) for government spending adds an additional $300 billion of debt to the U.S. Treasury’s ledger. We remind you these are in addition to Congressional Budget Office (CBO) forecasts for sharply increasing deficits due to social security and other previously promised entitlements.

As if deficit spending approaching that of the financial crisis of 2008 is not shameful enough, the administration’s latest budget proposal is even more daunting. Based on the proposed budget, if we optimistically assume that the current economic expansion can last for ten more years without a recession and that GDP can grow by about 1.50% more than that of the last decade, then the deficit will grow by “only” approximately $8 trillion by 2027. Keep in mind; debt outstanding tends to grow by a larger amount than stated deficits due to accounting gimmicks used by the Treasury. Before including Trump’s budget proposal, the trajectory of Federal debt outstanding is forecast by the Office of Management and Budget (OMB) to increase by $1.1 trillion on average in each of the next five years.

To put that into context with the nation’s ability to pay off the debt, the economy has grown by approximately $500 billion a year on average over the last three years. Federal tax receipts as a percentage of GDP over the last three years have declined from 11.5% to 11.1%. If the economy grows $500 billion, we should expect an additional $55 billion of tax revenue. These numbers emphasize the extent to which elected officials from both parties have radicalized the budget process and the acute state of fiscal irresponsibility now in play.

Don’t dismiss the magnitude of $20 Trillion in U.S. debt and it projected growth rate. It is larger than the debts of the next four largest debtor nations combined. 

Demand Factors

“Deficits don’t matter.” This frequently quoted statement leads many to believe that our nation’s debts will always be funded by willing and able creditors. To their point, rapidly increasing federal debt levels of the last thirty years have been easily funded and at increasingly lower interest rates.

To better gauge whether we can expect said support to fund the increase in projected debt issuance, we analyze the two largest holders of publically traded Treasury securities, foreign investors and the Federal Reserve.

Foreign investors hold 43% of all publically held Treasury securities outstanding, commonly referred to as “marketable debt held by the public.” China and Japan top the list, with each holding over $1 trillion of Treasury debt. The graph below compares foreign holdings of U.S. Treasury debt and the entire stock of public U.S. Treasury debt.

Data Courtesy: St. Louis Federal Reserve

Will foreign buyers continue to grow their holdings by over $400 billion each year?

To help answer that question, consider:

  • Over the last year, foreign holders have purchased approximately 5% of new debt compared to a range of 40-60% since the recession of 2008.
  • Since 2015, foreign holders have increased their Treasury security holdings by $151 billion while $1.591 trillion of new Treasury debt has been issued.
  • Since 2015, Japan has reduced holdings of US. Treasuries by 12% or $141 billion.
  • Since 2015 China has reduced holdings of US. Treasuries by 4% or $52 billion.

The second largest holder of U.S. Treasuries is the Federal Reserve. Quantitative Easing (QE) was a major part of the Feds economic stimulus and bailout program of the 2008/09 financial crisis and continues to this day. QE is essentially the act of printing money to purchase debt securities from the market. According to the Federal Reserve Bank of St. Louis, Fed holdings of U.S. Treasury securities rose from $474 billion in March 2009 to a peak of $2.40 trillion in December 2014, an increase of 416%. That balance was held stable through the end of 2017. To put that into context, as of September 2017, mutual funds, pension funds, and insurance companies held a combined $2.47 trillion of Treasury debt.

As we discussed in the Fed Giveth (LINK), the Fed has recently begun reducing the size of their balance sheet, and therefore its holdings of Treasury securities are slowly shrinking. They began in late 2017 by reducing the amount of Treasuries held by $6 billion per month and will increase the pace by $6 billion every three months until they reach $30 billion per month. This schedule, if reliable, implies that the Fed will reduce their Treasury holdings by $225 billion in 2018 and $351 billion in 2019. In this way, the reduction in Federal Reserve holdings is an incremental supply of Treasury securities to the market. And when the supply of bonds increases, yields should rise.

The absence of the Fed as large Treasury holders and the reductions in holdings and new purchases of Treasuries by China and Japan should have similar effects on yields, although the magnitudes may be different. So, rising yields are not just about inflation, whether realized or expected, it is also about the changes taking place in supply and demand simultaneously.


Vice President Dick Cheney was quoted in 2002 as saying “deficits don’t matter.” With the staggering accumulated deficits of the past few years, we are about to test Cheney’s theory. The powerful economic environment of the 1980’s and 1990’s allowed for the accumulation of federal, corporate and personal debt. In this millennium, the growth of debt accelerated, but the tailwinds supporting economic growth have weakened substantially.

Just because we were easily able to fund deficits of years past does not mean we should be so naïve as to think it will be easy going forward. As described above, the circumstances we face today are far more challenging than those of past years. The confluence of these events argues that investors should prepare for a new paradigm and not get caught flatfooted trusting in outdated narratives.

We leave you with a bit of wisdom from investment guru Bob Farrell, Former Chief Stock Market Analyst Merrill Lynch

“In the early stages of a new secular paradigm, therefore, most are conditioned to hear only the short-term noise they have been conditioned to respond to by the prior existing condition.  Moreover, in a shift of long-term significance, the markets will be adapting to a new set of rules while most market participants will be still playing by the old rules.”

Strategies for Tomorrow

Most investors, knowingly or not, rely on long-only, passive strategies. They may shift holdings between stocks, bonds, and cash at various intervals, but generally, their portfolio returns mimic those of well-known stock and bond indices.

A recent graph from Goldman Sachs, as shown below, serves as a prescient reminder that this popular portfolio strategy may be worth reconsidering in the current environment.

The graph shows bull and bear market periods based on a portfolio comprised of 60% equities and 40% bonds. This graph uniquely allows the reader to simultaneously visualize both returns and the duration of the respective bullish or bearish periods.  Focusing on the current bullish period, here are two important takeaways that investors must consider:

  • The current bull market in stocks and bonds is 8.7 years old and only about five months shorter than the longest bullish period since at least 1900. That period, the “roaring twenties” preceded the Great Depression.
  • Total returns for the current recovery are the third highest over the past 118 years, eclipsing both 2008 and 1999, which both resulted in significant (over 50%) drawdowns.

This chart should give investors pause. While it does not necessarily imply the bottom will fall out as it did in the 1930’s, or even 1999 and 2008, it does suggest that asset markets are historically stretched when measured in both return and the duration. Over the coming years, it is highly likely that a sizeable portion of those returns will be lost.

The graph above fails to factor in one consideration that may make the next correction different from the last four. During the last four recessions and related equity market corrections, a balanced portfolio (60/40) benefited greatly from gains in fixed income assets. The graph below compares total returns during those periods of a portfolio that is 100% invested in the S&P 500 versus one that is allocated to the S&P 500 and U.S. 10 year Treasury notes in a 60:40 ratio.

As shown, the addition of bonds and reduction of equities resulted in positive returns during the recessions of 1981 and 1991. During the last two recessions, bonds helped to cut the portfolio’s losses in half.

Looking forward, an important question we must consider is will bonds help minimize losses as they have done in the past. In the prior two recessions, the ten year U.S. Treasury note yields were greater than 4% and nearly double those of today. The significance is that a higher yield provides more room for yields to decline and thus bond prices to increase. Further, the higher yield provides more coupon income to help offset equity losses.

Investors relying on gains on bond holdings to offset losses on stock holdings should consider that while bonds may produce gains, said gains are likely more limited than at any time in the past.

What’s an Investor to do?

Given the historical precedence, we think it is appropriate for investors to consider alternative wealth management strategies. Below, we describe a few strategies that are not dependent upon positive stock and bond market direction to generate positive returns.

Global macro – By far the most complex and difficult of strategies, managers use a fundamental assessment of global economic dynamics to establish long or short positions in every asset class available to them.

Deep value – This strategy seeks to limit investments to those securities that are heavily discounted and/or extremely out of favor and thus appear to have very limited downside risk. This strategy tends to have longer holding periods than most.

Option strategy – Managers employing this strategy predominately engage in the exchange-traded options market (put/calls) and/or over-the-counter options (swaptions). At times, options are combined with long or short positions in the underlying securities to create the desired profile.

Event-drivenThis is a strategy focused on identifying specific catalysts related to a company, a sector or an economy and positioning for the ultimate realization of that event.

Arbitrage – In this approach, managers look for pricing anomalies among related instruments and seek to extract risk-free profits by being long or short those instruments at the same time.

Volatility –  Now viewed as an asset class like stocks, bonds and commodities, this strategy uses long or short positions and options to produce returns through low (and rising) or high (and falling) price swings in those instruments.

Long/Short – Predominantly used by managers in the equity markets to pair a long position in one stock against a short position in another with the intent of limiting market risk while taking advantage of perceived richness and cheapness in selected securities.

Trend Following – This strategy is generally a technical approach which relies upon the momentum of price action in a security or an index to generate profits. Managers use long or short positions as a trend establishes itself, then take profits and reverse positions as the trend weakens or reverses.

Fund of Funds – Firms with expertise in identifying talented investment managers look to diversify investment dollars among many managers and strategies, including some of the strategies listed above.

The strategies listed above represent a subset of strategies commonly used by those seeking returns that are not highly correlated with market returns. Like any strategy, those summarized above tend to cycle through periods where they are effective and times when they are less so. Thus, like any strategy, timing is important.

The overly simplistic approach of buy-and-hold fails to acknowledge that given a deep enough correction, most investors will eventually react by selling to stop the mental anguish. This usually occurs very near the worst possible time – at the bottom. To continually build wealth through good and bad markets, investors require a diverse, alternative set of strategic tools. Further, traditional bond/stock strategies of yesterday had the benefit of a cushion provided by fixed income assets. Given the low level of rates, we must question the validity of relying on bonds to hedge a portfolio in the next turndown.

By ignoring history and shunning alternative strategies, investors will, in time, lose much of the wealth they have accumulated over the prior years. Compounding wealth does not require keeping up with high-flying markets in good times, it demands prudent decision-making to avoid large losses when markets sour.

It is important to stress that the strategies detailed above are typically beyond the scope of amateurs and do contain substantial risks of loss. We highly recommend speaking with a knowledgeable investment manager, and conducting extensive due diligence, before investing in such strategies.

Will The “Real” Real GDP Please Stand Up?

Last Friday, Gross Domestic Product (GDP or the domestic economic growth rate) for the fourth quarter of 2017 was released. Despite being 0.3% short of expectations at 2.6% annual growth, it nonetheless produced enthusiasm as witnessed by the S&P 500 which jumped 25 points.  One of the reasons for the optimism following the release was a strong showing of the consumer which notched 2.80% growth in real personal consumption. The consumer, representing about 70% of GDP, is the single most important factor driving economic growth and therefore we owe it to ourselves to better understand what drove that growth. This knowledge, in turn, allows us to better assess its durability.

There are three core means which govern the ability of individuals to spend. The most obvious is income and wages earned. To help gauge the effect of changes in income we rely on disposable income, or the amount of money left to spend after accounting for required expenses. Real disposable personal income in the fourth quarter, the same quarter for which GDP data was released, grew at a 1.80% year over year rate. While other indicators of wage growth are slightly higher, we must consider that payroll gains are not evenly distributed throughout the economy. In fact as shown below 80% of workers continue to see flat to declining growth in their wages.

While this may have accounted for some of the growth in consumption we need to consider the two other means of spending over which consumers have control, savings and credit card debt.

Savings: Last month the savings rate in the United States registered one of the lowest levels ever recorded in the past 70 years. In fact, the only time it was lower was in a brief period occurring right before the 2008/09 recession. At a rate of 2.6%, consumers are spending 97.4% of disposable income. The graph below shows how this compares historically.

As shown above, the savings rate is less than half of that which occurred since the 2008/09 recession and well below prior periods.

There are two ways to think about the record low level of savings. Optimistically, we can claim that consumers are confident about future job prospects and wage growth and therefore feel as though they do not need to save. More realistically, we can assume that consumers are in a bind and are reducing their savings to make ends meet. More recently, the higher price of education and health coverage are likely culprits for pushing consumers to skimp on savings.

Credit Card Debt: In addition to reducing savings to meet basic needs or even splurge for extra goods, one can also use credit card debt. Confirming our suspicion about savings, a recent sharp increase in revolving credit (credit card debt) is likely another sign consumers are having trouble maintaining their standard of living. Over the last four quarters revolving credit growth has increased at just under 6% annually which is almost twice as fast as disposable income. Further, the 6% credit card growth rate is about three times faster than that of the years following the recession of 2008/09.

Adjusted GDP

While the GDP data represents actual consumption, we again ask if it is sustainable. In the case of the last few quarters, in particular, we must answer that question based on the ability for savings to decline further and credit card usage to remain high. As such, we normalized GDP based on the savings rates and credit card usage growth of the post-recession era. In our opinion, this gives us a realistic reading of what GDP would be like without the benefits of sharply reduced savings rates and unsustainable usage of credit cards.

Savings: If we recalculate the amount of consumption that would have occurred had the savings rate remained at the post-recession savings rate of 5.50%, we compute that $281 billion of savings was sacrificed over the last four quarters.

Credit Cards: The amount of revolving debt has been increasing at 6% annually over the last four quarters which is double the rate of income, or the ability to pay for the debt. If we assume instead a more normal 3% usage growth rate, which is in line with income growth, we estimate that additional credit accounted for $20 billion of spending above and beyond what is sustainable.

Over the last four quarters, real GDP rose by $421 billion, resulting in a 2.60% annual increase. If we adjust consumption to more normal levels of spending and credit usage, the increase in GDP is a mere 0.71%, hardly robust.


Can savings decline further and credit increase more? The answer is yes, but to do so savings would hit all-time lows and the rate of credit growth would greatly exceed the rate of income growth. Despite the hype of post-tax reform corporate bonuses, wages and salaries continue to muddle along at a very uninspiring rate.  This data further tells the story of an indebted consumer that is being forced to spend more income on non-discretionary items such as rent, education, healthcare and energy and in response is using credit and savings to fund those purchases.

This story will get interesting when the first-quarter 2018 GDP is released and the hangover from the holiday season reveals itself. The revisions to growth are likely to be confounding and broadly rationalized away by stock-friendly analysts. While monthly data has yet to give us any meaningful indications, we suspect personal consumption for the current quarter, and likely many ahead, will be weak.

Peak Hubris

In the past month, two well-known and highly respected money managers have made confident assertions about the markets. Their comments would lead one to believe that the future path of the market in the coming months is known. Sadly, many investors put blind faith in the words of high-profile, accomplished professionals and do little homework of their own. While we certainly respect the background, knowledge, and success of these and many other professionals, we take exception with their latest bit of advice.

Before the election In November 2016, were there investment professionals that claimed a Donald Trump victory would drive equity prices significantly higher? Although we are certain there were a (very) few, they certainly were not publicly discussing it, and the broad consensus was overwhelmingly negative.  In March of 2009, which professional investors were pounding the table claiming that the next decade would produce some of the greatest market returns in history? Again, while some may have thought valuations were fair at the time, few if any were raging bulls.

The two instances are not unique. More often than not, investor expectations fail to accurately anticipate the future reality. This is not solely about amateur individual investors, as it equally applies to the best and brightest. Despite the urge to heed the sage advice of the “pros”, we must always remain objective, especially when everyone seems so certain about what will happen next.

The Known Future

The current message from Wall Street analysts, media gurus and most investors is that stock prices will undoubtedly go up for the foreseeable future.  Unbridled optimism about corporate earnings offer one point of fundamental justification for such views, but in large part these forecasts are predominantly based on the simple extrapolation of prior price trends. In late January 2018, a few esteemed Wall Street analysists actually raised their year-end S&P 500 price forecast from what it was only weeks prior. Although rationalized by stronger estimates of earnings expectations and an improving economic prognosis, the fact that January’s market rally has the S&P 500 already approaching their year-end forecast also played a meaningful role.

Basing future expectations on the most recent price activity is a great method of forecasting returns, until the trend changes. Wall Street analysts are not the only ones convinced the recent trend will continue in the months ahead. The graph below shows that expectations for stock price increases are now higher than at any time since at least 1987.

This second table from Ronnie Stoeferle at Incrementum provides a broad gauge of the excessive bullishness in the markets.

While there are a slew of technical reasons to suspect the recent market dip may be a speed bump on the way to higher prices, there are some serious fundamental warnings along with geopolitical concerns that argue downside risks are being grossly ignored. We would avoid using the word certainty to describe a market or economic forecast, and given the juxtaposition of risks and excessive valuations, relying on the certainty of others is not a prudent way to build wealth.

Ray Dalio

The following quotes came from a recent interview with Ray Dalio:

  • “We are in this Goldilocks period right now. Inflation isn’t a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax ”
  • “There is a lot of cash on the sidelines. … We’re going to be inundated with cash,” … “If you’re holding cash, you’re going to feel pretty stupid.”
  • Finally, he said he expects to see “a market blow-off” despite the economy being in the last legs of the economic growth cycle.

What could go wrong? Ray Dalio, the billionaire founder of the world’s largest hedge fund, warns us that taking a conservative posture will make you “feel pretty stupid.”

There are four problems with these comments. First of all, does Ray Dalio really believes there is “cash on the sidelines”?  For every buyer there is a seller. The concept of “money on the sidelines” does not hold in a free market economy. This is one of Lance Robert’s 7 Myths of Investing.

7-Myths Of Investing

Second, neither he nor anyone else knows what the future holds and for every buyer there is a seller. Third, even if we presume him to be correct concerning the market, will he let you know when it’s time to sell stocks and hold cash?  Keep in mind that wealth is compounded most effectively by not chasing markets higher but by avoiding large losses. Finally, Mr. Dalio almost certainly has hedges in place so that, even if he is wrong, his portfolio will have some cushion. Again, although we respect his insight and he may well be correct, it is concerning to hear a person of such influence potentially mislead investors into thinking the future is certain and worse mocking those taking precautionary measures.

Jeremy Grantham

Mr. Grantham, also a very successful investment manager, has made similar comments as to how this bull market ends.

  • “I recognize on one hand that this is one of the highest-priced markets in U.S. history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull ”
  • “A melt-up or end-phase of a bubble within the next six months to two years is likely, i.e., over 50%.”

Mr. Grantham has a perfect track record this millennium of calling out the equity bubbles of 2000 and 2008 well in advance. Further, he has stated unequivocally that equity valuations are excessive and investors should expect flat to negative returns over the longer term. Currently, his firm GMO is forecasting annualized inflation-adjusted returns of -4.4% for U.S. large-cap stocks over the next seven years. Despite the prospects of negative returns and wealth losses, he feels confident influencing others to chase a “melt-up” bubble that may last from six months to two years.

Dalio/Grantham Wisdom

Both highly successful investors and thought leaders are telling the story of tenable market risks but then tempting investors with the possibility of a grand finale worth chasing.

No one knows how this current bull market will end. Dalio and Grantham may be correct, and it may end with a melt-up, blow-off rally for the ages.  On the other hand, it may have ended last week with the blow-off rally having occurred over the last year.

To put a historical perspective on how this market may top, the following charts compare the death of the NASDAQ 100 bull market in 2000 and the end to the S&P 500 bull market in 2007.

As shown, the topping of the last two bull markets took vastly different paths. Whether a blow-off rally as seen in the late 1990s, the one advocated by Grantham and Dalio, is the right call or a more frustrating rounded top of 2008 is the answer, we do not know. Left for consideration is whether the 37% rally since Trump’s election was the blow-off top and, if so, has it reached its apex?


While market geniuses in their right, Dalio and Grantham’s ideas about how this ends have zero certitude. If their minds change, we will almost assuredly be the last to know. Although a cynical premise, could they be propping the market up with talk of a magnificent rally so they can reduce their own risk? There is abundant evidence this occurred in 2007 as the mortgage meltdown progressed, albeit with different protagonists.  So, we think it is a fair question to ask in this instance.

Given current valuations, the risks are significant, and if history is any indication, we can be assured that this bull-run will end sooner rather than later. This is not a message encouraging you to ignore the thoughts of Dalio, Grantham or other successful investors. Rather we remind you that you are solely responsible for the risks you take. Being a good fiduciary and worthy steward of wealth mandates that we understand the risks as highlighted by Dalio and Grantham and avoid being influenced by the consensus groupthink that often has an ulterior motive. We all know how that ends.

We leave you with the S&P 500 price projections from Wall Street’s best and brightest in 2008.

The Next Maestro

The following article emphasizes that the perceived economic prosperity of recent decades is largely the result of political expediency. Those in charge of monetary policy have repetitively failed to act in the best interests of the public in an effort to either avoid criticism or preserve their individual status. While often ignored, this dynamic is crucial to understand to form longer term expectations for asset prices.

“I’m making records, my fans they can’t wait

They write me letters, tell me I’m great” – Joe Walsh

The modern day printing of digital dollars from thin air, literally from nothing, brings to mind a Latin phrase “ex nihilo, nihil fit” which means out of nothing, nothing comes. If that statement is true, and a moment of reflection surely produces the logical conclusion that it is true, then what do central bankers hope to accomplish by means of conjuring currency from, well, nothing? What does it further say about setting interest rates at less than nothing? If nothing can come from nothing then there is no solution in the idea that by printing dollars and inflating asset prices you can create something (a durable organic recovery). Although the net result for the economy will be nothing, the net result of those actions for individuals appears to be a redistribution of wealth in the economy. In the end, it becomes clear that the purpose of and reason for the exercise is not the good of the general public but rather advocacy of large financial institutions, political expediency and hubris. If that were not the case, then why would the Federal Reserve need to hire a veteran lobbyist (former Enron and Clinton administration employee) in navigating the use of their powers in the months following the financial crisis?

Hilltop Houses and Fifteen Cars

There is something god-like in the idea of creating something out of nothing – especially money – which fits with the progression of status among Federal Reserve (Fed) members. The idea that their stature and judgement is beyond reproach has been in play for some time.

Alan Greenspan: The absurd notion of central bankers as rock stars was popularized by Alan Greenspan. He achieved celebrity status by advancing in ways never before seen, the interventionism of the Federal Reserve. Some of his handiwork includes engineering a rapid recovery of the stock market following the Black Monday crash in 1987, the notoriety of uttering the term “irrational exuberance” in 1996, the front man on the cover of Time magazine as a member of “The Committee to Save the World”, having his name on a key market term – The Greenspan Put, and of course having a book published about him by the iconic Washington Post reporter and author Bob Woodward well before his tenure as Fed chief ended.  These are things now to which every Fed Chairman aspires – indeed, to which every central banker aspires.

Ben Bernanke: So desperate to follow suit after he stepped down as Fed Chairman in 2014, he could not wait for someone to write his story so he penned his own in the self-aggrandizing “Courage to Act”. In addition to well-paid fees for public appearances, his desperation for notoriety also extends to consulting for some of the most powerful hedge funds as well as blogging his perspectives from time-to-time. The legacy he is desperately trying to shape seems similar to the gilded stature Greenspan crafted for himself.

Janet Yellen: In her time as the Chairman, Yellen was the beneficiary of much good fortune and did nothing to make waves (or right the ship). As the New York Times reports, given her tenure presiding over a “plummeting unemployment rate and consistently low inflation, Ms. Yellen became a pop culture phenomenon.” Such hyperbole used to lobby for Janet Yellen’s rock star status is derisory. The health of the organic economy is contrived by the over-use of debt. The disparity between the rich and poor has never been wider as Yellen assisted in hollowing out the middle class by adhering to a “saver-punishing” low-rate policy. Trickle down policy of boosting asset prices is surely benefitting the wealthy but to the detriment of society.  By myopically targeting traditional measures of inflation, she took latitude to continue crisis policies to print money and is complicit in the on-going accumulation of debt. The likelihood is that the failure to normalize monetary policy years ago has sown the seeds of the next crisis. Like Bernanke, how her role is cemented in history as one of those who are “great” among central bankers too will be determined by time and economic outcome.

Jerome Powell: Will the latest chairman of the Fed, Jerome Powell, have the courage to act? Vilified in the late 1970’s and early 1980’s for raising interest rates and temporarily choking off economic activity, Fed Chairman Paul Volcker had the character to sacrifice his own popularity and accept the short-term consequences in exchange for dramatic long-term economic benefits. He did it because arresting inflation was in the best interest of the country. Mr. Powell has a choice to make. He can do what’s best for the country or he too can aim to become a “pop culture phenomenon” and keep the charade going but he cannot do both.  Time will tell.

…Before the Fall

The modern day desire for individual notoriety and legacy among central bankers belies the purpose of the role they play in shaping the business cycle. Their influence on the trajectory of the economy should be so subtle as to scarcely be perceived. As was the case with McCabe, Martin and Burns, few should recognize their names. The incongruence of this passion among the power-elite who manage the printing presses of the world’s largest economies is akin to the contrast between pride and humility. Anyone who thinks themselves qualified to manage the monetary policy of the complex system of a major economy lacks requisite humility and is too deceived by pride to be thus qualified. A proud man is always looking down on things and people and, of course, as long as you are looking down, you cannot see that which is larger – the best interests of people or democracy

A Market Valuation That Defies Comparison

Comparing current equity valuations to prior valuation peaks such as those of 2008, 1999 or any other period is commonplace, but remains an essential way of assessing current market prospects and potential risks. Currently, seven of the eight traditional valuation techniques shown by Goldman Sachs below are in the upper strata of recent history.

The graph above, courtesy Goldman Sachs, is from August 2017. Since that time it is highly likely that all of those valuation levels have risen further.

In Second to None, published March 1, 2017, we opined that simply assessing valuation techniques, as shown above, is a great starting place for investors to gauge the present status of valuations. We added that it is equally important to normalize different periods of time to make their valuations comparable based on the level of economic growth which directly supports corporate profits. The result of our analysis shows that the current level of Cyclically Adjusted Price to Earnings (CAPE) is well above the levels of every other market peak, including 1999 and 1929. Essentially, investors are willing to pay more for each unit of economic growth today than at any time in modern history.

In this article, we update the data to reflect the current GDP adjusted CAPE and take it a step further to include the cyclical nature of corporate profit margins. When both adjustments are factored in, we gain a unique perspective that demonstrates the extent to which today’s valuations are, quite literally, off the charts.

GDP Trends

While the economy cycles from recession to growth and back, the long term economic growth trend, or secular GDP, has trended lower for the better part of the last 30 years. The graphs below show the cyclical short-term nature of economic growth (left) as well as the longer term trend (right).

Data Courtesy: St. Louis Federal Reserve (FRED)

There are a number of reasons for the long-term, downward growth trend about which we have written extensively. In a nutshell, the following are the three largest factors accounting for the deteriorating trend in growth:

  • Debt – The amount of federal, corporate and individual debt has consistently risen at a pace faster than economic growth. As such, many debtors are unable to borrow further to keep spending. Others are hampered by interest payments which crowd out spending. The Federal Reserve has used extraordinary policies to force interest rates to historic lows to counter the debt burden, but their actions have only bought time and incentivized even more debt. The debt problem, which we call the Lowest Common Denominator, has only worsened.
  • Demographics – Over the last 30 years, baby boomers provided a driving force for economic growth. As this outsized generation nears retirement, they will spend less and, in many instances, become a burden on the taxpayers that support them through social security and other entitlements. Additionally, slowing population growth and tightened restrictions on immigration are reducing the number of workers and consumers that can contribute to economic growth.
  • Productivity – Partially as a result of years of poor economic, fiscal and monetary policy that dis-incentivized long-term investment in favor of consumption, the rate of productivity growth, the lifeline of economic growth is nearing zero.

It is primarily these three reasons and their longer-term projections that make us nearly certain that secular economic growth will continue to weaken in the years ahead. That does not mean there will not be periods of stronger growth. However, given that few of our nation’s leaders truly understand what drives sustainable economic growth and even fewer have the courage required to reverse the trends, we see little reason to expect change.

Given our assumption that long-term economic trends are likely to persist, we believe it is necessary to use economic growth to normalize current equity valuations to compare them to prior periods.  The following graph is an updated version of the one shown in Second to None.  It plots CAPE divided by the trailing ten-year growth rate of nominal GDP.

Data Courtesy: St. Louis Federal Reserve (FRED) and Robert Shiller

Note that the graph above and all of the graphs normalizing CAPE in this article, unlike the one presented in Second to None, are scaled by multiples of the average on the y-axis instead of the calculated number. The rationale being that the purpose of the analysis is not to provide a concrete numerical data point, but a comparative measure that allows one to relate valuations over many different economic environments. As an example the current reading is 2.86, meaning market valuations using this measure are 2.86 times higher than the average since 1956.

The two potential arguments against this type of analysis are likely from those that disagree with our longer-term growth forecast or those that agree with us but believe that we should exclude data from the financial crisis of 2008 as it was far from the norm.

For those that think economic growth will be better than the trend of the last thirty years, you should be aware that a ten-year growth rate of 8.21% is required to bring the adjusted valuation to its long-term mean. Such a ten-year growth rate has not been witnessed since 1987 and is nearly 2% greater than the average over the last 70 years.

For those that think excluding 2008 is appropriate, we calculated a seven-year CAPE divided by seven-year growth. While the current level using this time frame is not as egregious, it is two times that of the average over the last 70 years and only slightly lower than the peak established in the year 2000.  We remind those in this camp that the current economic expansion has lasted 103 months, almost twice the average since 1945. The longest expansion during this period was 120 months. No one knows when a correction will come, but we are clearly in the later stages of the cycle unless one assumes that the laws of mean reversion have been permanently suspended for both valuations and economic cycles.

Margins are Cyclical

Corporate profit margins, or the difference between sales and net profits, are considered one of the most cyclical fundamental measures that exist. The reason is that, when margins are high in certain industries, new entrants are lured to those industries by the higher margins. Conversely, when margins are low, companies exit those industries and those remaining companies can increase margins. The graph below shows the cyclical nature of corporate margins since 1948.

Data Courtesy: St. Louis Federal Reserve (FRED)

When margins are higher or lower than average, it makes sense to assume they will revert to the mean over time. Therefore, the rationale and logic for normalizing CAPE based on current margins and its historical tendency, provides a valuation level, as shown below, that is comparable to other periods.

Data Courtesy: St. Louis Federal Reserve (FRED) and Robert Shiller

Note that in the first graph showing historical margins that margins over the last 70 years appear to have broken the cyclical pattern and have stayed well above the average for an extended period. Many stock promoters believe this is a reflection of a “new normal” and cheer such a feat. They may be correct, but you might also want to consider that if margins have risen to a new level and are not cyclical anymore, the age-old incentives that drive business decisions in a free market economy no longer exist.  If that is the case, we may also want to consider that capitalism may be broken. If capitalism is in fact eroding, do you really want to pay a high premium for stocks? To help answer that question, we suggest a quick review of the gross economic inefficiencies of those nations where capitalism is not employed.

Comparative CAPE

We believe that durable longer-term economic trends and profit margins should be used to normalize CAPE and again make it comparable to prior periods. The graph below presents CAPE adjusted for both.

Data Courtesy: St. Louis Federal Reserve (FRED) and Robert Shiller

The graph above highlights that valuations using this measure dwarf any prior valuation peak since at least the 1950’s. At over 350% above the mean, stock investors are currently paying significantly more for a unit of economic growth than at any time in the last 70 years. To extend the analysis, we estimated the adjusted CAPE level of 1929, as shown on the graph, and come to the same conclusion.


Most astute investors know that stock valuations are at or near historical highs. Even these investors, however, may be unaware that today’s valuations, when adjusted for the level of economic growth and heightened profit margins, defy comparison with any prior period since the Great Depression. The simple fact is that investors are paying over three times the average and almost twice as much as the prior peak for a dollar of economic growth. Furthermore, it is happening at a time when we are clearly late in the economic cycle and the outlook for growth, even if one is optimistic, is well below that required to justify such a level.  

Fundamental valuations are a great means of understanding the potential value or lack thereof in a market or individual stock. However, it is a poor short-term trading tool. There is no doubt that, in time, valuations will revert to the norm. This can occur via sharp earnings increases or slower earnings growth accompanied by years of price stagnation. It can also transpire, as it has in the past, with a sharp drawdown in equity prices. Regardless of how you think this resolves itself, we hope this valuation technique provides another helpful tool for assessing the proper risk and reward tradeoff offered by markets currently.

Second To None – A Primer

Today’s equity market valuations have only been eclipsed by those of 1929, and 1999.”

In March of 2017, we examined traditional equity valuations in a new light to help better compare today’s valuations versus those of past business cycles. In particular, we adjusted the popular price-to-earnings (P/E) ratio for economic growth trends. The logic backing the analysis is that investors should be willing to pay a larger premium if economic growth is strong, and therefore corporate earnings are higher, and vice versa if economic growth is comparatively weak. The premise is similar to the popular price-to-earnings growth (PEG) ratio commonly used by equity investors. While P/E assesses the value of a stock on the basis of trailing earnings, PEG is more forward-looking using the expected growth of earnings. Essentially, the ratio tells us how much a current investor is willing to pay for a unit of expected earnings.

This re-publication of Second to None is intended to revisit a variety of key points as a base of understanding for an upcoming article. Given the extent to which markets have moved over the past several months, updating this analysis is timely. Further, the upcoming article will broaden the discussion to include a second important driver of corporate earnings and therefore provide fresh perspectives on valuations. We are confident you will find it compelling, so stay tuned.

Given the continuing equity market rally and multiple expansion, the quote above from prior articles, had to be modified slightly but meaningfully. As of today, the S&P 500 Cyclically Adjusted Price to Earnings ratio (CAPE) is on par with 1929. It has only been surpassed in the late 1990’s tech boom.

A simple comparison of P/E or other valuation metrics from one period to another is not necessarily reasonable as discussed in Great Expectations. That approach is too one-dimensional.   This article elaborates on that concept and is used to compare current valuations and those of 1999 to their respective fundamental factors.  The approach highlights that, even though current valuation measures are not as extreme as in 1999, today’s economic underpinnings are not as robust as they were then. Such perspective allows for a unique quantification, a comparison of valuations and economic activity, to show that today’s P/E ratio might be more overvalued than those observed in 1999.

Secular GDP Trends

Equity valuations are a mathematical reflection of a claim on the future cash flows of a corporation. When one evaluates a stock, earnings potential is compared to the price at which the stock is offered. In most cases, investors are willing to pay a multiple of a company’s future earnings stream. When the prospects for earnings growth are high, the multiple tends to be larger than when growth prospects are diminished.

To forecast earnings growth for a company, one needs to do an in-depth analysis of the corporation, the economy and the markets in which it operates. However, evaluating earnings growth for an index comprising many companies, such as the S&P 500, is a relatively straight-forward task.

Corporate earnings are a byproduct of economic activity. Earnings growth can differ from economic growth for periods of time, but in the long run aggregate earnings growth and GDP growth are highly correlated.  The two graphs below offer an illustration of the durability of this relationship. The graph on the left plots three-year average GDP growth and its trend since 1952, while the graph on the right highlights the correlation of GDP to corporate profits.

Data Courtesy: St. Louis Federal Reserve (FRED), Bureau of Economic Analysis (BEA) and Bloomberg

Given the declining trend of GDP and the correlation of earnings to GDP, it is fair to deduce that GDP and earnings growth trends were healthier in the late 1990’s than they are today. More specifically, the following table details key economic and financial data comparing the two periods.

Data Courtesy: St. Louis Federal Reserve (FRED), and Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

As shown, economic growth in the late 1990’s was more than double that of today, and the expected trend for economic growth was also more encouraging than today. Trailing three- five- and ten-year annual earnings growth rates contrast the current stagnant economic growth versus the robust growth of the 90’s. Additionally, various measures of debt have ballooned to levels that are constricting economic growth and productivity. Historically low interest rates are reflective of the current state of economic stagnation.

The graph below charts price-to-earnings (CAPE) divided by the secular GDP growth (ten-year average), allowing for a proper comparison of valuations to fundamentals.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

The current ratio of CAPE to GDP growth of 19.77 has far surpassed the 1999 peak and all points back to at least 1950. At the current level, it is over three times the average for the last 66 years.  Further, based on data going back to 1900, the only time today’s ratio was eclipsed was in 1933. Due to the Great Depression, GDP at that time for the preceding ten years was close to zero. So, despite a significantly deflated P/E multiple, the ratio of CAPE to GDP was extreme. Looking forward, if we assume a generous 3% GDP growth rate, CAPE needs to fall to 18.71 or 35% from current levels to reach its long term average versus GDP growth.


Equity valuations of 1999, as proven after the fact, were grossly elevated. However, when considered against a backdrop of economic factors, those valuations seem relatively tame versus today. Some will likely argue with this analysis and claim that Donald Trump’s pro-growth agenda will invigorate the outlook for the economy and corporate earnings. While that is a possibility, that argument is highly speculative as such policies face numerous headwinds along the path to implementation.

Economic, demographic and productivity trends all portend stagnation. The amount of debt that needs to be serviced stands at overwhelming levels and is growing by the day. Policies that rely on more debt to fuel economic growth are likely not the answer. Until the disciplines of the Virtuous Cycle are understood and followed, we hold little hope that substantial economic growth can be sustained for any meaningful period. Given such a stagnant economic outlook, there is little justification for paying such a historically steep premium for what could likely be feeble earnings growth for years to come.

For Your Consideration

Consider the following:

  1. The current U.S. economic expansion has lasted 103 months and counting. Based on data since 1945 covering 11 business cycles, the average is 58 months and the longest was 120 months (1991-2001).
  2. The unemployment rate is at 4.1%, the lowest level since January 2001.
  3. For the first time on record, the S&P 500 produced positive total returns in each month of last year.
  4. The S&P CoreLogic Case-Shiller 20-City Home Price Index is at 203.84, the highest level since December 2006 and less than 3 points shy of the all-time high seen at the peak of the housing bubble in July 2006.
  5. Small Business Optimism is at the highest level since September 1983 and the Michigan Current Consumer Sentiment gauge is at 17-year highs.
  6. Recent corporate earnings growth is strong at 9-10% and running above the historical average (6%).
  7. Tax reform legislation reduces taxes for corporations from a statutory rate of 39% to 21%.
  8. The current U.S. Consumer Price Index is 2.1% and 1.8% excluding-food and energy.
  9. The Federal Reserve is planning to adhere to a gradual series of rate hikes and balance sheet reduction over the coming year.
  10. The market currently expects 2 to 3, 25 basis point rate hikes in 2018, which would bring the Fed Funds rate to just over 2.00%.
  11. The Federal Reserve loses 44 years of policy-making experience with the departures of Yellen, Fischer, Dudley and Lockhart.
  12. Geopolitical risks are more extensive than any year in recent memory. Problems include instability in Sub-Saharan Africa, Southern Asia and the United Kingdom as well as friction between the U.S. and North Korea, Iran, Mexico and China.

After what we observed in 2017, another year of complacency measured by record low volatility and high valuations cannot be ruled out. That said, mean reversion remains part of the natural order and every day that elapses brings us another day closer to the eventuality of a regime shift. Changes in monetary policy, fiscal policy and Fed leadership have historically been quite volatile for markets, although the term of Janet Yellen was an exception. Also, according to Eurasia Group’s Ian Bremmer, “The markets don’t recognize it. They’re hitting records on a regular basis. The global economy feels pretty good, but geopolitically we are in the midst of a deep recession.” Heightened geopolitical risks have the potential to stir up the volatility pot and markets are not priced for any of those probabilities.

Markets have remained remarkably stable despite numerous geopolitical concerns throughout the past year. Based on the information provided above, it appears as though markets may be underpricing expectations for interest rate moves given the obvious dynamics between global growth, low rates, swollen balance sheets and market valuations. Yet the paradigm of the Fed as inflation fighters has long since passed, and the concern now remains defending against the evil windmills of deflation. The new Federal Open Market Committee (FOMC) will try to remain vigilant, but any unexpected uptick in inflation may spook them into moving back toward their natural inclination as inflation fighters. Given the shifting winds of Fed policy from easier to less easy, the markets’ failure to acknowledge the risks of a quicker tightening pace and the sensitivities of the debt-bloated economy to higher interest rates, our concerns remain in the arena of some difficult changes occurring sooner rather than later.

The same divergent dynamic exists on the geopolitical side of the equation. Often characterized as exogenous risks, they can be especially combustible when markets become as complacent as they apparently are today. The important message for investors is to remain vigilant about assessing risks and avoid being lulled into the groupthink trap. This is especially true as the consensus perspective becomes increasingly one-sided. Risks and consensus have both reached extremes and should be given proper consideration.

Cause when life looks like easy street, there is danger at your door.”  – Grateful Dead

The Only Benchmark of Wealth

The New England Patriots are the winningest professional football team of the new millennia. While we could post a long list of reasons for their success, there is one that stands above the rest. In a recent interview, Patriots quarterback Tom Brady stated that they start each year with one goal; win the Super Bowl. Unlike many other teams, the Patriots do not settle for a better record than last year or improved statistics. Their single-minded goal is absolute and crystal clear to everyone on the team. It provides a framework and benchmark to help them coach, manage and play for success.

Interestingly, when most individuals, and many institutions for that matter, think about their investment goals, they have hopes of achieving Super Bowl like returns. Despite their well-intentioned ambitions, they manage their portfolios based on benchmarks that are not relevant to their goals. In this paper, we introduce a simple investment benchmark that simplifies the tracking process toward goals which if achieved, provide certitude that one’s long-term objectives will be met.

The S&P 500

Almost all investors benchmark their returns, manage their assets and ultimately measure their success based on the value of a stock, bond or blended index(s). The most common investor benchmark is the S&P 500, a measure of the return of 500 large-cap domestic stocks.

Our belief is that the performance of the S&P 500 and your retirement goals are unrelated. The typical counter-argument claims that the S&P 500 tends to be well correlated with economic growth and is a valid benchmark for individual portfolio performance and wealth. While that theory can be easily challenged over the past decade the question remains: Is economic growth a more valid benchmark than achieving a desired retirement goal?  Additionally, there are long periods like today where the divergence between stock prices and underlying economic fundamentals are grossly askew. These variances result in long periods when stock market performance can vary greatly from economic activity.

Even if we have a very long investment time frame and are willing to ignore the large variances between price and valuation, there is a much bigger problem to examine. Consider the following question: If you are promised a consistent annualized return of 10% from today until your retirement, will that allow you to meet your retirement goals?

Inflation and Purchasing Power

Regardless of your answer, we are willing to bet that most people perform a similar analysis. Compound current wealth by 10% annually to arrive at a future portfolio value and then determine if that is enough for the retirement need in mind. Simple enough, but this calculus fails to consider an issue of vital importance. What if inflation were to run at an 11% annual rate from today until your retirement date?  Your portfolio value will have increased nicely by retirement, but your wealth in real terms, measured by your purchasing power, will be less than it is today. Now, suppose you were offered annual returns equal to the annual rate of inflation (the consumer price index or CPI) plus 3%.

Based on 2017 CPI of approximately 2% for a total return of approximately 5% compared to almost 20% for the S&P 500, we venture to say that many readers would be reluctant to accept such an “unsexy” proposition. Whether a premium of 3% is the right number for you is up for debate, but what is not debatable is that a return based on inflation, regardless of the performance of popular indexes, is a much more effective determinant of future wealth and purchasing power.

To show why this concept is so important, consider the situation of an investor with plans to retire in 25 years. Our investor has $600,000 to invest and believes that he will need $1,500,000 based on today’s purchasing power, to allow him to live comfortably for the remainder of his life. To achieve this goal, he must seek an annualized return of at least 4.50%. As a point of reference, the total return of the S&P 500 is 6.60% over the past 100 years. At first blush our investor, given his relatively long time frame until retirement, might think the odds are good that the S&P 500 will allow him to achieve his retirement goal. However, his failure to factor in inflation causes his calculations to be incorrect. Since 1917, inflation has averaged 3.09%. The S&P 500 total return since 1917 including the effect of inflation is only 3.51%. The odds are not in his favor, and his oversight may ultimately leave him in a difficult situation.

The graph below shows the resulting 25 year total returns based on each monthly starting point since 1917. The red line shows our investor’s goal of 4.50%. Keep in mind that since the graph requires 25 years of data, the last data point on the graph is December 1992.

Over the time frame illustrated, the investor was subjected to anxiety-inducing random high and lows relative to his target return. His portfolio performance is a flag in the wind at the mercy of the volatility of the equity markets.

Instead of rolling the dice like an investor managing and benchmarking towards the S&P 500, why not manage your portfolio based on an index that will properly target a dollar amount of purchasing power in the future? In our prior example, achieving a benchmark of the annual rate of CPI plus 4.50% would allow our investor to retire with at least $1,500,000 in today’s purchasing power.

Inflation based indexing

Unlike benchmarking to a popularly traded equity or bond index using ETFs and mutual funds, managing to an inflation-linked benchmark is more difficult. It requires an outcome-oriented approach that considers fundamentals and technical analysis across a wide range of asset classes. At times, alternative strategies might be necessary or prudent. Further, and maybe most importantly, one must check one’s ego at the door, as returns can vary widely from those of one’s neighbors. The challenge of this approach explains why most individuals and investment professionals do not subscribe to it. It is far easier to succeed or fail with the crowd than to take an unconventional path that demands rigor.

The reward for using the proper index and successfully matching or exceeding it is certitude. The CPI-plus benchmark approach described here is far more honest and durable in its ability to compound wealth and show definitive progress. It is deliberate and does not hand over control of the outcome to the whim of the market. It also requires an investor to avoid the hype and distractions that continually surround the day-to-day movements of the stock market.


We understand the difficulty in achieving one’s financial goals, especially in today’s unique environment of low-interest rates and high stock market valuations. Why compound the difficulty by managing your wealth to the random volatility of an index or benchmark that is different from your goals? Matching the performance of the S&P 500 is cheap and easy for a reason. It is also irrelevant to compounding wealth as it ignores important aspects of the wealth management process such as avoiding large and wealth-debilitating drawdowns.

Meeting your goals requires a logical and deliberate strategy guided by a set of rules that few investors understand. There is a reason many investors and retirees are failing to meet their goals. Using a reliable but different approach will help ensure that you don’t end up as one of them.

Investment Outlook 2018

The following outlook provides our investment thoughts for the coming year. We did not include specific recommended asset allocation weightings for the major asset classes, as they will be part of Real Investment Advice premium services.  If you would like to receive pre-launch information on our new services just send us your email address.

Market Fundamentals

The confluence of improving synchronous economic global growth and hyper-inflating asset markets is urging central bankers to pause extraordinary policies and, in many cases, begin reversing them. While not obvious to most, monetary policy error has been in play since quantitative easing commenced in 2009, but the consequences will not appear until future central bank actions to raise interest rates and reduce their balance sheets affects commerce. The yield curve, credit spreads, and financial conditions can provide indications of when this may occur.

Market Fundamentals Commentary

Record highs in stocks, near-record lows in bond yields and historically tight credit spreads present significant challenges for investors. Economic data has improved, but many fundamental economic gauges remain soft relative to pre-crisis averages and inconsistent with asset price levels and valuations. Most investors do not seem at all concerned as money continues to move into risky asset classes, a classic sign of a bubble. While a defensive posture seems prudent, the technical picture remains supportive of further gains. One should respect the momentum behind these moves for the foreseeable future but be mindful that liquidity can evaporate quickly.

The primary investment theme remains “buy the dip.” That approach has worked amazingly well, a testament to the sustained strength of markets. Thanks in no small part to gradualism from the Fed on interest rate and balance sheet normalization, the blind assumption is that the favorable trajectory of risk assets can be endlessly extrapolated into the future.

There is a distinct difference between taking a defensive posture and a negative one. Remaining full-bore aggressively long at this juncture is a speculative endeavor akin to letting our kids play in the median of a busy highway. Proper care and stewardship of wealth means being protective and forward-looking to avoid large losses.

“The peer pressure and career risk of bolstering one’s defenses in a Pamplona-style bull run are palatable, but wealth is most effectively compounded by avoiding large losses not chasing returns with the irrationally exuberant. Many investors and others are stumbling confidently forward playing the role of the genius in a bull market.  The prudent manager worries about the trifles of liquidity at a time when it is so plentiful it seems unreasonable to worry.  Liquidity comes at a cost, but excess liquidity in times of crisis offers both priceless protection and clear-headed decision-making opportunities that are rare indeed.” –Liquidity Defined 12/14/2017 –The Unseen

Outlier scenario – The market is far more sensitive to changes in interest rates than currently perceived. If the Fed continues to increase the Fed Funds rate and reduce their balance sheet in response to low unemployment and moderate levels of inflation, economic activity will decline. The result is a recession that initiates the unwinding of leverage accumulated in the system compounded by and revealing many layers of hidden risks.

Federal Reserve Outlook

The Fed gets new leadership early in the year in Jerome Powell, but he appears to be using the same playbook as Janet Yellen.

  • Yield curve flattening
  • Financial conditions will eventually become less favorable
  • U.S. dollar stable at the low end of a 3-year range and supportive of future Fed policy

Federal Reserve Commentary

Given his time as a Fed board member and non-controversial positions on policy, Fed Chair nominee Jerome Powell should have no trouble being confirmed. He echoes many of Janet Yellen’s perspectives, and his demonstrated comportment is similar to that of the post-GFC era Chairmen. In the near-term, such a status quo transition is constructive for risk markets. However, the lengthy duration of the current economic cycle and the lofty valuations present when Powell assumes command make it hard to argue that the current environment is stable.

Outlier scenario – The inability of the Fed to effectively respond to a weaker economy due to elevated levels of inflation and/or a dramatically weaker U.S. dollar alters market expectations about the Fed “put” that has been in place for the past 30 years.

Bond Markets

Yield curve flatter as Fed interest rate hikes continue but inflation remains tame/below target

  • Debt levels continue to weigh on economic growth and inflation dynamics
  • Growing debt due to fiscal policy/tax cuts heightens concerns
  • Shortage of quality collateral and rate differential keeps long-term interest rates low

Bond Markets Commentary

U.S. Treasury yields are bi-polar. Short maturity yields are rising with Fed rate hikes while long-maturity yields are stable to lower. This dynamic produces a flattening of the yield curve revealing short-term optimism and long-term doubt. On an absolute basis, yields remain very low. The 2-year Treasury yield is 1.82% while the 10-year yield is 2.40%. The 2s-10s yield curve spread resides at the lowest level (0.58%) since the financial crisis of 2008.

Investors looking for income in the safety of the Treasury market will die of thirst long before achieving their targets. Accordingly, many investors are reaching for additional yield in riskier categories, namely high yield credit and dividend-paying stocks. This game has been going on for a long time. Despite the relative yield enhancement those alternatives offer, the question of whether or not an investor is appropriately rewarded for taking that risk still exists.

Non-investment grade, or “junk” bond, yields range from 4% to 10%, depending on the company and sector, with the overall average yield at about 5.75%. A bond is relegated to junk status precisely because of the elevated risk of default. At current market yields, junk bonds pose an inordinate threat of record low recovery value and terminal realized yield. Using the average yield for junk bonds of 5.75%, an average default rate of 5% and a generous recovery rate of 50%, a high yield debt portfolio is mathematically identical to a risk-free asset with a yield of 3.25%. That amounts to a risk-adjusted premium of only 0.85% over 10-year Treasuries (3.25 – 2.40). A yield pickup of less than 1% is hardly compelling, especially when one considers the downside from current valuation levels is immense.

Investors who think they get a nice yield boost from owning high yield debt are not considering the risk-adjusted outcomes. The risk-adjusted premium over Treasuries should be at least 200 to 300 basis points. Fixed income portfolio allocations should reside predominantly in the defensive havens of high-quality sovereign, well selected municipal and investment-grade corporate bonds. We recommend no allocation to junk.

Outlier scenario – Rising debt levels, inflation and global concerns over future monetary policy causes interest rates to rise as marginal buyers (Japan, China, Saudi Arabia, etc.) turn to sellers to reduce U.S. debt and U.S. dollar exposure. A disorderly rise in interest rates creates sudden distress and defaults in credit markets.

Stock markets

Markets remain supported as financial conditions are historically ultra-easy, despite the recent interest rate hikes

  • Valuations are stretched to extremes
  • Investors are conditioned to such valuations and insensitive to history
  • Momentum and lack of viable investment options helps the market retain a bid
  • Problems emerge when higher short-term rates have a constricting economic effect

Stock Market Commentary

There are several measures used to justify current valuations, but they sound similar to those used in the dot-com Tech bubble. The relationships between valuation and fundamentals, on which cash flows are ultimately based, are grossly dislocated. Markets may well move higher, but to advocate a full allocation to equities under current circumstances ignores warnings of bubbles past. Stock market cap-to-GDP, price-to-sales, margin balances, cyclically-adjusted price-to-earnings ratios (CAPE), and others argue convincingly that the stock market is either near historic valuations or well through them. Owning well-selected, single-name companies because they are fundamentally cheap, not relatively cheap, makes sense.  Otherwise, limiting general equity allocation exposures is prudent until reasonable opportunities return. We suggest setting stop losses and/or options strategies to help limit downside risk and retain any additional upside.

Outlier scenario – Realization and acknowledgment that valuations are high and concern over future returns sparks initial selling as the market begins to collapse under its own weight. This sets off a broad exodus out of risky assets for similar reasons.


Currencies remain the pressure release valve for money printing and monetary malfeasance.

  • GBP at risk to weaken further as Brexit talks continue to languish
  • Growth in Europe, slow policy response by ECB and political turmoil in Germany point to a weaker Euro
  • US dollar stable/stronger in response to GBP and EUR

FX Commentary

The precedent set since the financial crisis suggests one wants to steer away from currencies likely to be devalued for purposes of supporting and manipulating asset prices. The problem with that plan is that all developed world economies are guilty of money-printing schemes. Further, it seems inevitable that they will most likely take this short cut once again should problems re-emerge. The most dominant and liquid currencies are those most susceptible to active and intentional devaluation.

Europe’s banking system, though improving, still has significant exposures to possible defaults and therefore the potential for bank failures and government bailouts. Australia and Canada have rather large housing market bubbles that probably will not escape punishment in the next downturn. China remains both a communist regime and a pretender on the stage of free markets. The United States has somehow developed a sick pride in unconventional monetary policies and, given the U.S. dollar’s reserve currency status, will be called upon to conjure liquidity in times of distress. Given that the safest currencies tend to reside in stable nations with strong economies, it is not difficult to see why the U.S. dollar has historically been a safe-haven currency.  While muscle-memory argues that the dollar retains safe-haven status in the next crisis, other factors may come in to play and upend much of what has historically held true. Other durable alternatives include the Singapore dollar, the Norwegian krone and the Polish zloty.  Finally, the immutable status of gold as money is indisputable, despite decades of efforts from central bankers to discredit its durability. Warren Buffet was wrong to classify gold as an asset as it is the ultimate alternate currency. Given the proclivity of central bankers to print digital dollars, insurance in the form of gold and gold miners warrants consideration in a portfolio.

The Bitcoin hype is a speculative phenomenon but one well-timed as it further reflects the lack of trust in central bankers. We do not consider Bitcoin or any other crypto-currency as a replacement for gold, but we are not averse to reasonable alternatives to traditional fiat currencies.

Outlier scenario – The Federal Reserve’s willingness to print money to bailout banks following the last financial crisis raises concerns going forward about U.S. dollar stability. Those reservations cause traditional sponsors of the U.S. dollar financed economy (China, Japan, Saudi Arabia) to reduce their dollar holdings thus inciting volatility and resulting in a precipitous decline in the world’s reserve currency.


Comparative weakness in commodities and strength in equities is signaling a rare long-term buying opportunity.

  • Gold, crude oil, and copper among other key hard and soft commodities that have been relatively cheap for some time
  • Natural resources not only reflect value but act as a sound hedge against central bank interventionism
  • China’s debt growth, excess capacity, and property bubble raise concerns, putting pressure on Australia, Latin America, and Near-term commodity upside limited

Commodities Commentary

The extent to which crude oil and energy companies have languished since the 2014 peak in crude prices suggests there are opportunities in the stocks and/or bonds of those companies. That said, there is no way around doing the appropriate work to find those opportunities. Energy-related Exchange-Traded Funds (ETFs) tend to include a lot of speculative companies unfit for a defensive stance, which makes it difficult to take a generalized ETF approach. If the Fed does what they do best (print money), then natural resource companies now trading at a relative discount to other sectors of the economy stand to be terrific value plays into the future. There is certainly a risk, but the downside should be limited for the equities and bonds of good, undervalued companies.

Broadly, commodities are currently at a unique value point relative to stocks. A portfolio allocation overweight in resource companies may present some volatility but should be a good long-term position to have and add to as the economic cycle progresses.

Further, commodities provide a hedge against inflation. While not on the horizon, inflation could force central banks to halt money printing policies with severe effects for asset markets driven by those same policies. Investments in the resource/commodity sector can take the form of good equity selections or, even better, discounted bonds of companies offering above average yields to reinforce durable contracted cash flow returns.

Outlier scenario – Similar to gold, in the event of a suddenly unfolding crisis, the demand for natural resources surges as uncertainty about financial assets and central bank responses cause many to use hard and soft commodities as an alternative source of safe haven.

Emerging Markets (EM)

Dependent on trade-based commerce, EMs benefiting from synchronous global growth.

  • Durability of export-led growth key to outlook
  • EM countries are hurt by US dollar strength
  • Rising short-term interest rates in the US and issues emanating from China will begin to expose a variety of EM imbalances

Emerging Markets Commentary:

Emerging market economies tend to be inherently volatile, unstable and marred by crises. Although those risks remain in play, select emerging market countries may offer comparative stability and excellent return opportunities in the next year. An improving trend in emerging market performance fully developed in 2017, and a continuation of this trend has sound historical precedence. That said, there is still plenty of risk and uncertainty especially within the context of a broad global destabilization. A portfolio allocation to EM stocks through funds tracking the MSCI Emerging Markets Index should offer a return boost if we are to have another year of low volatility. On the other hand, if 2018 proves to be turbulent, this exposure will certainly detract from returns. Dollar strength tends to play a big role in EM returns. Any sustained U.S. dollar strength, especially if accompanied by a global economic downturn, is a strong signal to exit these positions. Portfolio weighting is important, and accordingly, a modest level properly sizes the exposure relative to uncertainties.

Outlier scenario – With developed stock and bond markets fully valued due to central bank intervention, the emerging markets become a value option not found in many other categories. Fundamentals and momentum align to spur a historic rally relative to developed markets, but vigilance is important.

The Risk Spectrum

Cause when life looks like Easy Street, there is danger at your door – Grateful Dead

On numerous occasions, we have posited that equity investors appear to be blinded by consistently rising stock prices and the allure of minimal risks as portrayed by record low volatility. It is quite possible these investors are falling for what behavioral scientists diagnose as “recency bias”. This condition, in which one believes that the future will be similar to the past, distorts rational perspective. If an investor believes that tomorrow will be like yesterday, a prolonged market rally actually leads to a perception of lower risk which is then reinforced over time. In reality, risk rises with rapidly rising prices and valuations. When investors’ judgement becomes clouded by recent events, instead of becoming more cautious, they actually become more aggressive in their risk-taking.

In our premier issue of The Unseen, 720Global’s premium subscription service, we quantified how much riskier financial assets are than most investors suspect. The message in, The Fat Tail Wagging the Dog, is that extreme historical price changes occur with more frequency than a normal distribution predicts. Reliance upon faulty theories laced with flawed assumptions can lead investors to take substantial risks despite paltry expected returns.

In this article, we further expand on those concepts and present a simple framework to help readers understand the spectrum of risks that equity holders are currently taking.

Risk Spectrum

When one assesses risk and return, the most important question to ask is “Do my expectations for a return on this investment properly compensate me for the risk of loss?” For many of the best investors, the main concern is not the potential return but the probability and size of a loss.  A key factor to consider when calculating risk and return is the historical reference period. For example, if one is to estimate the risk of severe thunderstorms occurring in July in New York City, they are best served looking at many years of summer meteorological data for New York City as their reference period. Data from the last few weeks or months would provide a vastly different estimate. Likewise, if one is looking at the past few months of market activity to gauge the potential draw down risk of the stock market, they would end up with a different result than had they used data which included 2008 and 2009.

No one has a crystal ball that allows them to see into the future. As such the best tools we have are those which allow for common sense and analytical rigor applied to historical data. Due to the wide range of potential outcomes, studying numerous historical periods is advisable to gain an appreciation for the spectrum of risk to which an investor may be exposed. This approach does not assume the past will conform to a specific period such as the last month, the past few years or even the past few decades. It does, however, reveal durable patterns of risk and reward based upon valuations, economic conditions and geopolitical dynamics. Armed with an appreciation for how risk evolves, investors can then give appropriate consideration to the probability of potential loss.

Measuring Risk

The graph below plots the percentage price change of the S&P 500 that one would expect at each respective date given a 3-standard deviation price change. The data is computed based on price changes from the preceding six months. Essentially, the graph depicts expected outcomes for those solely relying on recency biased risk management approaches.  (On a side note, a 3-standard deviation price change should have occurred 14 times over the 17 year period based on a normal distribution. In reality, it happened 249 times!)

Data Courtesy: Bloomberg

Currently, if one is basing their risk forecast on the last six months of price data, they should anticipate that a “rare” 3-standard deviation change will result in a price change of 7.11% (green line). Accordingly, the table below applies a range of readings from the graph above to create an array of potential draw downs. The historical data is applied to the current S&P 500 price to provide current context.

We caution you, major draw downs are frequently much greater than a 3-standard deviation event.


As mentioned earlier, the best investment managers obsess not about what they hope to make on an investment but what they fear they could lose. At this juncture, current market dynamics offer a lot of reasons one should be concerned. For those who rest assured that the future will be representative of the immediate past, you likely already stopped reading this article. For those who recognize that regime shifts to higher volatility tend to follow periods when risk is under-appreciated, valuations are high and economic growth feeble, this framework should be a beneficial guide to better risk management. Although the timing is uncertain, we are confident that it will pay handsome dividends at some point in the future.





The Lowest Common Denominator

The Lowest Common Denominator: Debt

At a recent investment conference, hedge fund billionaire Stanley Druckenmiller predicted that interest rates would continue rising. Specifically, he suggested that, consistent with the prospects for economic growth, the 10-year U.S. Treasury yield could reach 6.00% over the next couple of years. Druckenmiller’s track record lends credence to his economic perspectives.  While we would very much like to share his optimism, we find it difficult given the record levels of public and private debt.

Druckenmiller’s comments appear to be based largely on enthusiasm for the new administration’s proposals for increased infrastructure and military spending along with tax cuts and deregulation. This is consistent with the outlook of most investors today.  Although proposals of this nature have stimulated economic growth in the past, today’s economic environment is dramatically different from prior periods. Investors and the market as a whole are failing to consider the importance of the confluence of the highest debt levels (outright and as a % of GDP) and the lowest interest rates (real and nominal) in the nation’s history.  Because of the magnitude and extreme nature of these two factors, the economic sensitivity to interest rates is greater and more asymmetric now than it has ever been.  Additionally, due the manner in which debt and interest rates have evolved over time, the amount of interest rate risk held by fixed income and equity investors poses unparalleled risks and remains, for the moment, grossly under-appreciated.

Proper assessment of future investment and economic conditions must carefully consider changes in the debt load and the interest rates at which new and existing debt will be serviced.

A 45-year Trend

For more than a generation, there has been a dramatic change in the landscape of interest rates as illustrated in the graph below.  Despite the recent rise in yields (red arrow), interest rates in the United States are still near record-low levels.

Data Courtesy: Bloomberg

Declining interest rates have been a dominant factor driving the U.S. economy since 1981. Since that time, there have been brief periods of higher interest rates, as we see today, but the predictable trend has been one of progressively lower highs and lower lows.

Since the Great Financial Crisis in 2008, interest rates have been further nudged lower in part by the Federal Reserve’s (Fed) engagement in a zero-interest rate policy, quantitative easing and other schemes.  Their over-arching objective has been three-fold:

  • Lower interest rates to encourage more borrowing and thus more consumption (“How do you make poor people feel wealthy? You give them cheap loans.” –The Big Short)
  • Lower interest rates to allow borrowers to reduce payments on existing debt thus making their balance sheet more manageable and freeing up capacity for even more borrowing
  • Maintain a prolonged period of low interest rates “forcing” investors out of safe-haven assets like Treasuries and money market funds and into riskier asset classes like junk bonds and stocks with the aim of manufacturing a durable wealth effect that might eventually lift all boats

In hindsight, lower interest rates were successful in accomplishing some of these objectives and failed on others. What is getting lost in this experiment, however, is that the marginal benefits of decreasing interest rates are significantly contracting while the marginal consequences are growing rapidly.

Interest Rates and Duration

What are the implications of historically low interest rates for a prolonged period of time?  What is “seen” and touted by policy makers are the marginal benefits of declining interest rates on housing, auto lending, commercial real estate and corporate funding to name just a few beneficiaries. What is “unseen” are the layers of accumulating risks that are embedded in a system which discourages savings and therefore eschews productivity growth. Companies that should be forced into bankruptcy or reorganization remain viable, and thus drain valuable economic resources from other productive uses of capital.

In other words, capital is being misallocated on a vast scale and Ponzi finance is flourishing.

In an eerie parallel to the years leading up to the crisis of 2008, hundreds of billions of dollars of investors’ capital is being jack-hammered into high-risk, fixed-income bonds and dividend-paying stocks in a desperate search for additional yield. The prices paid for these investments are at unprecedented valuations and razor thin yields, resulting in a tiny margin of safety. The combination of high valuations and low coupon payments leave investors highly vulnerable. Because of the many layers of risk across global asset markets that depend upon the valuations observed in the U.S. Treasury markets, deeper analysis is certainly a worthy cause.

At the most basic level, it is important to appreciate how bond prices change as interest rates rise and fall.  The technical term for this is duration. Since that price/interest rate relationship is the primary determinant of a bond’s profit and loss, this analysis will begin to reveal the potential risk bond investors face. Duration is defined as the sensitivity of a bond’s price to changes in interest rates. For example, a 10-year U.S. Treasury note priced at par with a 6.50% coupon (the long term average coupon on U.S. Treasury 10-year notes) has a duration of 7.50. In other words, if interest rates rise by 1.00%, the price of that bond would decline approximately 7.50%.  An investor who purchased $100,000 of that bond at par and subsequently saw rates rise from 6.50% to 7.50%, would own a bond worth approximately $92,500.

By comparison, the 10-year Treasury note auctioned in August 2016 has a coupon of 1.50% and a duration of 9.30. Due to the lower semi-annual coupon payments compared to the 6.50% Treasury note, its duration, which also is a measure of the timing of a bonds cash flows, is higher. Consequently, a 1.00% rise in interest rates would cause the price of that bond to drop by approximately 9.30%. The investor who bought $100,000 of this bond at par would lose $9,300 as the bond would now have a price of $90.70 and a value of $90,700.

A second matter of importance is that the coupon payments, to varying degrees, mitigate the losses described above. In the first example, the annual coupon payments of $6,500 (6.50% times the $100,000 investment) soften the blow of the $7,500 loss covering 86% of the drop in price. In the second example, the annual coupon payments of $1,500 are a much smaller fraction (16%) of the $9,300 price change caused by the same 1.00% rise in rates and therefore provide much less cushion against price declines.

In the following graph, the changing sensitivity of price to interest rate (duration- blue) is highlighted and compared to the amount of coupon cushion (red), or the amount that yield can change over the course of a year before a bondholder incurs a loss.

The coupon on the 10-year U.S. Treasury note used in our example only allows for a 16 basis point (0.16%) increase in interest rates, over the course of a year, before the bondholder posts a total return loss. In 1981, the bondholder could withstand a 287 basis point (2.87%) increase in interest rates before a loss was incurred.

Debt Outstanding

While the increasing interest rate risk and price sensitivity coupled with a decreasing margin of safety (lower coupon payments) of outstanding debt is alarming, the story is incomplete. To fully appreciate the magnitude of this issue, one must overlay those risks with the amount of debt outstanding.

Since 1982, the duration (price risk) of nominal U.S. Treasury securities has risen 70% while the average coupon, or margin of safety, has dropped 85%. Meanwhile, the total amount of U.S. public federal debt has exploded higher by 1,600% and total U.S. credit market debt, as last reported by the Federal Reserve in 2015, has increased over 1,000% standing at $63.4 trillion. When contrasted with nominal GDP ($18.6 trillion) as graphed below, one begins to gain a sense for how radically out of balance the accumulation of debt has been relative to the size of the economy required to support and service that debt.  In other words, were it not for the steady long-term decline in interest rates, this arrangement likely would have collapsed under its own weight long ago.

Data Courtesy: St. Louis Federal Reserve (FRED)

To provide a slightly different perspective, consider the three tables below, which highlight the magnitude of government and personal debt burdens on an absolute basis as well as per household and as a percentage of median household income.

Data Courtesy St. Louis Federal Reserve (FRED) and USdebtclock.org

If every U.S. household allocated 100% of their income to paying off the nation’s total personal and governmental debt burden, it would take approximately six years to accomplish the feat (this calculation uses aggregated median household incomes). Keep in mind, this assumes no expenditures on income taxes, rent, mortgages, food, or other necessities. Equally concerning, the trajectory of the growth rate of this debt is parabolic.

As the tables above reflect, for over a generation, households, and the U.S. government have become increasingly dependent upon falling interest rates to fuel consumption, refinance existing debt and pay for expanded social and military obligations. The muscle memory of a growing addiction to debt is powerful, and it has created a false reality that it can go on indefinitely. Although no rational individual, CEO or policy-maker would admit to such a false reality, their behavior argues otherwise.

Investors Take Note

This article was written largely for investors who own securities with embedded interest rate risks such as those described above. Although we use U.S. Treasury Notes to illustrate, duration is a component of all bonds. The heightened sensitivities of price changes coupled with historically low offsetting coupons, in almost all cases, leaves investors in a more precarious position today than at any other time in U.S. history. In other words, investors, whether knowingly or unknowingly, have been encouraged by Fed policies to take these and other risks and are now subject to larger losses than at any time in the past.

This situation was beautifully illustrated by BlackRock’s CIO Rick Rieder in a presentation he gave this fall. In it he compared the asset allocation required for a portfolio to achieve a 7.50% target return in the years 1995, 2005 and 2015. He further contrasts those specific asset allocations against the volatility (risk) that had to be incurred given that allocation in each respective year. His takeaway was that investors must take on four times the risk today to achieve a return similar to that of 1995.


We generally agree with Stanley Druckenmiller. If enacted correctly, there are economic benefits to deregulation, tax reform and fiscal stimulus policies. However, we struggle to understand how higher interest rates for an economy so dependent upon ever-increasing amounts of leverage is not a major impediment to growth under any scenario. Also, consider that we have not mentioned additional structural forces such as demographics and stagnating productivity that will provide an increasingly brisk headwind to economic growth. Basing an investment thesis on campaign rhetoric without consideration for these structural obstacles is fraught with risk.

The size of the debt overhang and dependency of economic growth on low interest rates means that policy will not work going forward as it has in the past. Although it has been revealed to otherwise intelligent human beings on many historical occasions, we retain a false belief that the future will be like the past. If the Great Recession and post-financial crisis era taught us nothing else, it should be that the cost of too much debt is far higher than we believe.  More debt and less discipline is not the solution to a pre-existing condition characterized by the same. The price tag for failing to acknowledge and address that reality rises exponentially over time.





Price To Sales Ratio – Another Nail In The Coffin?


Editor Note: Michael Lebowitz of 720 Global Research is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  He is a regular contributor to Real Investment Advice.

720 Global has repeatedly warned that U.S. equity valuations are historically high and, of equal concern, not properly reflective of the nation’s weak economic growth potential. In this article we provide further support for that opinion by examining the ratio of equity prices to corporate revenue also known as the price to sales ratio (P/S). At its current record level, the P/S ratio leads us to one of two conclusions: 1) Investors are extremely optimistic about future economic and earnings growth or 2) Investors are once again caught up in the frenzy of an equity bubble and willing to invest at valuations well above the norm.

Either way, the sustainability or extension of the current P/S ratio to even higher levels would be remarkable. What follows here is an exercise in logic aimed at providing clarity on the topic.

Before showing you the current P/S ratio in relation to prior market environments, it is important to first consider two related concepts that frame the message the market is sending us.

Concept #1 – Investors should accept higher than normal valuation premiums when potential revenue growth is higher than normal and require lower than average premiums when potential revenue growth is lower than normal.

Consider someone who is evaluating the purchase of one of two dry cleaning stores (A and B). The two businesses are alike with similar sales, pricing, and locations. However, based on the buyers’ analysis, store A’s future revenue is limited to its historical 2% growth rate. Conversely, the potential buyer believes that store B, despite 2% growth in the past, has a few advantages that are underutilized which the buyer believes can potentially produce a revenue growth rate of 10%. If stores A and B are offered at the same price the buyer would most likely opt to purchase store B. It is also probable the buyer would be willing to pay a higher price for store B versus store A. Therefore highlighting that revenue growth potential is a key factor when deciding how much to pay for a business.

Purchasing a mutual fund, ETF or an equity security is essentially buying a claim on a potential future stream of earnings cash flows, just like the dry cleaning business from the prior example. The odds, therefore, of a rewarding investment are substantially increased when a company, or index for that matter, offering substantial market growth potential is purchased at a lower than average P/S ratio. Value investors actively seek such situations.

Logically one would correctly deduce that P/S ratios should tend to follow a similar directional path as expected revenues.

Concept #2 – Corporate earnings growth = economic growth

Corporate earnings growth rates and economic growth rates are nearly identical over long periods. While many investors may argue that corporate earnings growth varies from the level of domestic economic activity due to the globalization of the economy, productivity enhancements that lower expenses for corporations, interest rates and a host of other factors, history proves otherwise.

Since 1947, real GDP grew at an annualized rate of 6.43%. Over the same period, corporate earnings grew at a nearly identical annualized rate of 6.46%. Thus, expectations for future corporate earnings over the longer term should be on par with expected economic growth although short term differences can arise.

The graph below shows the running three-year annualized growth rate of U.S. real GDP since 1950.  While there have been significant ebbs and flows in the rate of growth over time, the trend as shown by the red dotted regression line is lower. The trend line forecasts average GDP growth for the next 10 years (green line) of 1.85%, a level that is historically recessionary.


As we have shared before, the combination of negligible productivity growth, heavy debt loads, short-termism and demographic changes will continue to produce headwinds that extract a heavy price on economic growth in the years ahead.  Barring major changes in the way the economy is being managed or a globally transformative breakthrough, there is little reason to expect a more optimistic outcome. Given this expectation, the outlook for corporate earnings is equally dismal and likely to produce similar negligible growth rates.


The graphs below chart the S&P 500 (blue line/top graph) and the median S&P 500 P/S ratio (red line/ bottom graph) since 1964. As shown in the bottom graph, the P/S ratio is now 2.50 standard deviations from the median and well above the prior levels preceding the significant bear markets of 2000-2002 and 2007-2009.


Based on the fact that the P/S ratio has been steadily rising and has eclipsed prior peaks, we are left to select from one of two conclusions as we mentioned previously:

  1. that investors are extremely optimistic about the potential for revenue growth, or
  2. investors are once again caught in the grasp of bubble mentality and willing to pay huge premiums to avoid missing out on further gains.

After further deliberation, however, there is a very plausible third possibility. Perhaps the lack of viable options for investors to generate acceptable returns, has them reluctantly ignoring the risks they must assume in those efforts.  If that is indeed the case, then one should also consider the possibility that the next correction will extract more than a pound of flesh in damage.

We remain confident that extravagant earnings and economic growth are not in the cards, and it is very likely monetary policy is fueling a new form of bubble logic. Invest with caution!

Michael Lebowitz, 720 Global Research

RIA Contributing Partner

Follow Michael on Twitter or go to 720global.com for more research and analysis.

The Death Of A Virtuous Cycle

Editor Note: Michael Lebowitz of 720 Global Research is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  He is a regular contributor to Real Investment Advice.



Despite many promises, there has been no sustainable economic recovery. The United States, and the developed world for that matter, have made repetitive attempts over the last 16 years to return economic growth to the pace of years long past. These nations are stuck in a cycle in which hopes for economic “escape velocity” get crushed by economic recession and asset price collapse. Following each failure is an increasingly anemic pattern of economic growth accompanied by rising mountains of debt, which ultimately lead to another failure. The perpetual excuse from the central bankers is that not enough was done to foster “lift-off”. In their view, lower interest rates, more fiscal spending and additional quantitative easing will eventually provide the needed spark that will cause the economic engine to fire on all cylinders. In the profound words of Mark Twain:

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

What follows in this article is evidence that current economic policy is not simply flawed in its logic and application but actually destructive. As should be evident to all by now, these experimental monetary and fiscal policies provide short term economic relief but only serve to exaggerate the problems they claim to solve. The elegant Virtuous Cycle that propelled western economies to prosperity has been quietly dismantled and replaced with an unproductive imitation. This new, Un-Virtuous Cycle euthanizes discipline and prudence in exchange for the immediate gratification of debt-fueled consumption.

The Virtuous Cycle


One of the primary differentiating characteristics between rich and poor countries is the presence or absence of physical capital in the form of abundant sophisticated machinery and equipment. These productive assets are accumulated through savings (individual or institutional) which is converted to investment in physical capital. In the natural order, there is a sequence of events properly characterized as The Virtuous Cycle (illustrated below). It is an identity associated with sustainable productive output and growth.


Saving, or simply the discipline of consuming less than one earns, is a prerequisite for capital accumulation and the chief requirement in the Virtuous Cycle. The amount of saving determines how much investment will take place. Investment in new property, plant and equipment – better tools – fuels new and improved forms of production and leads to increased productivity and enhanced income. Higher incomes increase consumption and produce higher levels of savings, so economic prosperity continually grows. This cycle enables us to produce things of greater complexity than we otherwise could, and thus advance productivity, income and prosperity.
It is logical therefore that government and central bank policies should focus on promoting a healthy savings rate. However, over the last several decades we have seen the exact opposite. Central bank policy dismembers the Virtuous Cycle by punishing savers.

Two Primary Factors of Economic Growth


The impact of misguided economic policy is best understood through an evaluation of the two key components of economic growth.

1.) Demographics – the size of the working population
2.) Productivity – the amount of goods and services that can be produced in a unit of time

The working age population in the United States and most developed nations has become stagnant with the recent on-set of the baby boomers retiring. There is little a country can do to influence this variable outside of a dramatic relaxation of immigration policies which clearly runs counter to the current trend. Productivity, on the other hand, is more readily influenced by policy. Economic policy however, has incentivized a preference for consumption fueled by debt instead of saving which feeds and encourages productivity. Productivity growth is experiencing a multi-year decline as a direct result of these policy errors. As demographic and productivity trends worsen, it should be no surprise that economic growth remains anemic and the outlook will deteriorate further.

Despite the fact that in the long-run it is the primary determinant of a country’s future standard of living and affluence, the importance of productivity is not well understood by many outside the economics profession. As a clinical economic measure, productivity tells us how much an individual is able to produce in one hour of labor. If productivity is growing, then workers are incrementally able to produce more in an hour of work than they were previously. Although productivity can improve for a variety of reasons, it generally occurs because the tools employed make workers more efficient.

In the United States, we are currently experiencing a secular decline in productivity growth and this has troubling implications for the future. As shown below, productivity growth trends in the U.S. and 9 other leading economies are currently measured at their lowest levels since at least the year 2000.


While this fact may seem counter-intuitive given how much technological advancement there appears to have been, Total Factor Productivity and Labor Productivity data clearly point this out. Further supporting this analytical evidence is the consistently poor rate of economic growth, stagnant wage levels and the widening gap of wealth disparity.

Why is Productivity Falling?


The question of why U.S. productivity growth is so weak has been a topic of much debate. Explanations include employer and worker behavior patterns, the influence of a rising service sector economy and the most commonly cited excuse, measurement error. The disparity of explanations implies that most economists do not have a sound diagnosis for this “economic mystery” as Neil Irwin of The New York Times recently called it. One thing is certain to economists – to the extent that productivity is in fact weak and even potentially in decline, a continuation of this trend will have important implications for U.S. and developed world economic growth and, of course, asset prices whose returns are predicated on growth.

No Economic Mystery


Dear experts,

The solution to the mystery is straight-forward. Rising productivity depends upon the perpetuation of evolving complex production which hinges upon saving, otherwise known as consumption deferred. The accumulation of, and refinements to, physical capital through savings and investment provides the cornerstone for the advancement of labor and technology. In other words, productivity requires savings to feed the Virtuous Cycle.

That is, simply enough, the answer to this great economic mystery.

The Un-Virtuous Cycle


Since the financial crisis, a growing number of people are beginning to question the foundation upon which our economic prosperity rests. Our ability and willingness to transact does not appear to have changed but we seem to harbor more doubts. Stagnant growth and incomes aggravate this view. Inflation is reported as worryingly low but the cost of many high expense items such as healthcare, tuition and rents are rising significantly faster than wages. A dwindling middle class is most acutely suffering the consequences resulting from this squeeze.

Maybe the success of Bernie Sanders and Donald Trump are reflective of the erosion in confidence and trust. Perhaps current generations have realized they are not likely to be wealthier than their parents. Certainly the secular decline in our economic and productivity growth offers clues. Whatever the reasons, the system on which our affluence was built has been quietly dismantled. The doubts and frustrations reflected in all various forms by the general population are among its manifestations. Finding a culprit is also part of the problem because it appears no one can quite put their finger on how we got here. Equity and housing market bubbles are often-cited villains but those and other financial irregularities are the symptoms not the causes.

In a world where governments and central banks of the most affluent countries are manipulating interest rates to zero or even negative yields, the Virtuous Cycle, which depends upon saving and investment, is conspicuously neglected. In its place, the natural order of economic output has been rearranged for political expediency and at times as a reaction to numerous financial crises. A durable, time-tested model of prosperity, Savings-Investment-Production-Income, has been hi-jacked by a model focused solely on consumption, requiring ever increasing levels of debt to grow. It is an impatient, undisciplined model. Not only is such a model unsustainable, it is destructive.


In their textbook Macroeconomics, Rudiger Dornbusch and current Federal Reserve Vice-Chairman Stanley Fischer state:

“When the return on savings becomes negative, one of three things happens: Households sharply reduce their saving or they shift their saving abroad (which we call capital flight) or they accumulate their saving in unproductive assets, such as gold. One way or another, the financial environment for saving is an important factor in mobilizing resources for capital formation and in channeling them from households, via financial intermediaries, to investing firms.”

To paraphrase their point: When the financial environment discourages savings, the investment and production components of the virtuous cycle suffer which also negatively affects productivity and income. That is precisely what we are seeing.

Some may argue that the recent rise in the national savings rate invalidates this perspective. On the contrary, policies that incentivize consumption over savings have been in effect for decades. It is myopic to observe the savings rate over the last few months in an effort to invalidate what is best described as a secular, policy-driven change. The cumulative effects of these policies are quietly corrosive. The savings rate (expressed as a percentage of disposable income) as shown below, averaged 8.9% from 1976 to 1996. Over the most recent 20 years the average is 4.9%.



The subordination of saving to consumption was born in earnest in 1971 when President Nixon closed the gold window and eliminated any form of discipline imposed on the value of our currency. It was further advanced in the Greenspan, Bernanke, and Yellen eras at the Federal Reserve through so-called “pre-emptive” monetary policy and more recently quantitative easing. Those efforts allowed citizens and lawmakers to shirk their fiscal responsibilities and as a result, the size of the national debt is now seen as a major security risk.

Further proof of this behavior can be seen in the record low yields, and rash of negative yields in the global bond markets. As evidenced by the bond yields in the table below, the incentive to save and fuel the Virtuous Cycle is nil.





The organic economic structure that made western economies uniquely successful and prosperous has been altered. The virtues of discipline, patience and work ethic have been mortgaged away, traded in for quick growth schemes that yield far less than promised. The Virtuous Cycle of savings, investment, production and income which delivered unparalleled prosperity and opportunity for centuries has been tossed aside by those charged with shepherding this durable but fragile gift.

The nation’s economic illness and her citizens’ growing intolerance is testimony. The developmental effects of this economic subversion has taken decades to emerge. The economy is sick but leaders refuse to acknowledge it, offering only weak reassurances because the implications are deeply troubling. The fact that the Fed and other central bankers were blindsided by asset bubbles and have so wrongly predicted economic activity highlights their lack of understanding of the principles of the Virtuous Cycle.

Unfortunately, ignoring or not understanding the facts does not change them, and if repairable at this late stage, fixing the problem will be very painful. At the same time, and even more importantly, repairing America’s economic foundation first requires proper diagnosis and understanding of the cause as has been presented here.

Michael Lebowitz, 720 Global Research

RIA Contributing Partner

Follow Michael on Twitter or go to 720global.com for more research and analysis.