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Wake me up when one of the companies begging for a bailout tries to issue stock and save themselves.
— Michael Lebowitz, CFA (@michaellebowitz) March 23, 2020
"After a 35% decline in the markets from the previous highs, a rally to the 38.2% Fibonacci retracement would encompass a 20% advance. Such an advance will “lure” investors back into the market, thinking the “bear market” is over."https://t.co/9rTSh0HcVGpic.twitter.com/UbFqF3QnPz
Good synopsis of the Fed's "Kitchen Sink" yesterday. If you don't really don't think we're in a #financialcrisis of rather mass proportions…then I really don't know what to tell you. This is more than just virus/economic issues. @SoberLookpic.twitter.com/Q27n1VIeqm
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.
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.)
Here is my only concern – this chart is everywhere over the last couple of days. Everyone seems to be convinced the #bearmarket is over already and can't wait to jump back in. Not typically how bear markets end. pic.twitter.com/4Y8lLXGft5
Here is the crazy part of this sell-off, stocks still aren't cheap to historical valuations. 1823 is fair value pic.twitter.com/CDNJtnXQ46
— Michael Lebowitz, CFA (@michaellebowitz) March 18, 2020
"I bought it for the dividend." "Muni's are super safe." "The packaging said high yield, nobody said it was all Califonia and Illinois bonds?" When things go wrong, they go wrong fast. pic.twitter.com/sBh86WcStq
Hey .@Delta you bought back almost $12 billion in stock over the last decade. How about selling that stock before asking tax payers for a handout. h/t @JackPScott
— Michael Lebowitz, CFA (@michaellebowitz) March 17, 2020
One day, we will find out exactly who "blew up," who got "bailed out," and which "Master of the Universe" was responsible. pic.twitter.com/kavDphjgBi
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.
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.
Buy and Hold ain't a process, despite what some cool cats on Twitter may tell you.
— Michael Lebowitz, CFA (@michaellebowitz) March 10, 2020
This is the flaw in the "I bought it for the dividends and dont care about the price" strategy. On Monday you lost 44% of the value and now you lost most of the dividend. This is not an investment strategy. https://t.co/iKhwpkHZii
— Michael Lebowitz, CFA (@michaellebowitz) March 11, 2020
After yesterday's "Black Swan Monday," it is not surprising we are getting a strong "reflexive rally" today. Just don't mistake it for a resumption of the #bullmarket. It could last for a few days, but lows will be retested, or new lows set, before the #bull returns. pic.twitter.com/6expqOZOKM
Don't be fooled by this nonsense. Stocks are NOT CHEAP on a FORWARD operating basis because #earnings have not be revised lower nearly enough yet to compensate for the supply chain impact. pic.twitter.com/F0exudWZJY
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.
Buy and hold is not a process… Buy and hold is a recipe to give back half or more of what you have earned over the last 5-10 years. Have a process and understand risk. You can make back money but not time.
— Michael Lebowitz, CFA (@michaellebowitz) March 5, 2020
Worst advice ever via @CNBC "Unless you’re selling investments, you’re not actually incurring a loss." NO – you just lost money and by the time you get back to even you lost something even more important – TIME!
The Fed cut 75bps for no reason at all in 2019. Think about that as you consider what they may do in the coming days.
— Michael Lebowitz, CFA (@michaellebowitz) March 2, 2020
From worst to best in one day. This is the "sellable rally" we discussed last week, be sure an use it as such. Rental trades will be sold and portfolios rebalanced to reduce "virus" exposures. pic.twitter.com/cMYP0oc8Ed
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.
I call B.S. This is equivalent to dating your sister and trying to convince people it's completely okay. (Unless you live in Kentucky)https://t.co/peyp3cSu1K
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.
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.
Why would I spend capital on an investment that will take years to recoup when buying back shares is a better way to boost my stock price NOW so I can sell my shares as an insider? pic.twitter.com/eXslRTBEzv
"The Fed has eliminated the risk of recession in the U.S. because of their interventions." Hmmm…..#Japan owns 80% of the ETF markets, runs QE roughly 3x the size of the U.S., and runs a massive #deficit and just reported a massive #GDP drop. pic.twitter.com/v2ywGJ2umS
Why would I pay off my loan when every Presidential candidate is promising to pay it of for me? Only stupid people responsibly pay their #debts, which would include me. ? https://t.co/xODWifWCZQ
“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.
Summary
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.
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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.
Summary
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.
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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.
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.
Reality
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:
that investors are extremely optimistic about the potential for revenue growth, or
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 Fifteenth Of August
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.
July 4th – June 6th – September 11th – August 15th
You likely associated the first three dates above with transformative events in U.S. history. August 15th, however, may have you scratching your head.
August 15, 1971 was the date that President Richard Nixon shocked the world when he closed the gold window, thus eliminating free convertibility of the U.S. dollar to gold. This infamous ‘new economic policy’, or “Nixon Shock”, thereby removed the requirement that the U.S. dollar be backed by gold reserves. From that fateful day forward, constraints were removed that previously hindered the Federal Reserve’s (Fed) ability to manage the U.S. money supply. Decades later, slowing economic growth, nonexistent wage growth, growing wealth disparity, deteriorating productivity growth and other economic ills lay in the wake of Nixon’s verdict.
The Transformation of the Federal Reserve and Alan Greenspan
With the stroke of President Nixon’s pen a new standard of economic policy was imposed upon the American people and with it came promises of increased economic growth, high levels of employment and general prosperity. What we know now, almost 50 years later, is that unshackling the U.S. monetary system from the discipline of a gold standard, allowed the Fed to play a leading role in replacing the Virtuous Cycle with an Un-Virtuous Cycle. Eliminating the risk of global redemption of U.S. dollars for gold also eliminated the discipline, the checks and balances, on deficit spending by the government and its citizens. As the debt accumulated, the requirement on the Fed to drive interest rates lower became mandatory to enable the economic system to service that debt.
In this new post-1971 era, the Fed approached monetary policy in a pre-emptive fashion with increasing aggression. In other words, the Fed, more often than not, forced interest rates below levels that would likely have been prevalent if determined by the free market. The strategy was to unnaturally mitigate even minor and healthy economic corrections and to encourage more public and private borrowing to drive consumption, indirectly discouraging savings. The purpose was to create more economic growth than there would otherwise have been.
This new and aggressive form of monetary policy is epitomized by the transformation of Federal Reserve Chairman Alan Greenspan. Greenspan came into office in 1987 as an Ayn Rand disciple, a vocal supporter of free-markets. Beginning with the October 19, 1987 “Black Monday” stock market crash, however, he began to fully appreciate his ability to control interest rates, the money supply and ultimately economic activity. He was able to stem the undesirable effects of various financial crises, and spur economic growth when he believed it to be warranted. Greenspan converted from a free market activist, preaching that markets should naturally set their own interest rates, to one promoting the Fed’s role in determining “appropriate” levels of interest rates and economic growth.
In 2006, after 18 years as Chairman of the Federal Reserve and nicknamed “The Maestro”, he retired and handed the baton to Ben Bernanke and Janet Yellen, both of whom have followed in his active and aggressive monetary policy ways.
Proof
The Fed’s powerful effect on interest rates made it cheaper for households and government to borrow and spend, and therefore debt was made more attractive to citizens and politicians. Personal consumption and government spending are the largest components of economic activity, accounting for approximately 70% and 20% of GDP respectively.
The following graph illustrates the degree to which interest rates across the maturity curve became progressively more appealing to borrowers over time. The graph below shows inflation-adjusted or “real” U.S. Treasury interest rates (yields) to provide a clear comparison of interest rates through various inflationary and economic periods. Since 2003, many of the data points in the graph are negative, creating an environment which outright penalizes savers and benefits borrowers.
The next graph tells the same story but in a different light. It compares the Federal Funds rate (the Fed controlled interest rate that banks charge each other for overnight borrowing) to the growth rate of economic output (GDP). This comparison is based on a theory proposed by Knut Wicksell, a 19th century economist. In the Theory of Interest (1898) he proposes that there is an optimal interest rate. Any interest rate other than that rate would have negative consequences for long term economic growth. When rates are too high and above the optimal rate, the economy would languish. Conversely, lower than optimal rates lead to over-borrowing, capital misallocation and speculation eventually resulting in economic hardships. To calculate the optimal rate, Wicksell used market rates of interest as compared to GDP.
In order to gauge the direct influence the Fed exerted on interest rates within Wicksell’s framework we compare the Fed Funds rate to GDP. Like the prior graph, notice the declining trend pointing to “easier” borrowing conditions. Additionally, note that since 2000 the spread between Fed Funds and GDP has largely been negative. As the spread declined, borrowers were further lead to speculation and misallocated capital, exactly what Wicksell theorized would occur with rates below the optimal level. The tech bubble, real-estate bubble and many other asset bubbles provide supporting evidence to his theory.
The Smoking Gun
The graphs above make a good case that the Fed has been overly-aggressive in their use of interest rate policy to increase the desire to borrow and ultimately drive consumption. We fortify this claim by comparing the Fed’s monetary policy actions to their congressionally set mandate to erase any doubt you may still have. The following is the 1977 amended Federal Reserve Act stating the monetary objectives of the Fed. This is often referred to as the dual mandate.
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregatescommensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
To paraphrase – the Fed should allow the money supply and debt outstanding to grow at a rate matching the potential economic growth rate in order to help achieve their mandated goals.
Since 1977, the year the mandate was issued, the annualized growth rate of credit and the monetary base increased at over twice the rate of the economy’s potential growth rate (productivity + population growth). The two measures rose annually 42% and 65% respectively faster than actual economic growth.
Commensurateis not a word we would use to describe the relationships of those growth rates to that of the economy’s potential growth rate!
The Hangover
In a Virtuous Cycle, saving and investment lead to productivity gains, increased production growth and ultimately growing prosperity which then further perpetuates the cycle. In the Un-Virtuous Cycle, debt leads to consumption which leads to more debt and more consumption in a vicious self-fulfilling spiral. In the Un-Virtuous Cycle, savings, investment and productivity are neglected. Declining productivity growth causes a decline in the potential economic growth rate, thus requiring ever-greater levels of debt to maintain current levels of economic growth. This debt trap also requires ever lower interest rates to allow the growing mountain of debt to be serviced.
With almost 50 years of history there is sufficient data to judge the effects of the Fed’s monetary policy experiment. The first graph below highlights the exponential growth in debt (black line) which coincided with the decline in the personal savings rate (orange) and the Fed Funds rate (green).
As the savings rate slowed, investment naturally followed suit and, as the Virtuous Cycle dictates, productivity growth declined. The graph below highlights the decline in the productivity growth rate. The dotted black line allows one to compare the productivity growth rate prior to the removal of the gold standard to the period afterwards. The 10-year average growth rate (green) also highlights the stark difference in productivity growth rates before and after the early 1970’s. Please note, the green line denotes a ten-year average growth rate. Recent readings over the prior two years and other measures of productivity are very close to zero.
Over the long term, economic growth is largely a function of productivity growth. The graph below compares GDP to what it might have looked like had the productivity growth trend of pre-1971 continued. Clearly, the unrealized productive output would have gone a long way toward keeping today’s debt levels manageable, incomes more balanced across the population and the standard of living rising for the country as a whole.
The graphs below show the secular trend in economic growth and the lack of real income growth over the last 20 years.
A Feeble Rebuttal
Some may contend that debt was not only employed to satisfy immediate consumption needs but also used for investment purposes. While some debt was certainly allocated toward productive investment, the data clearly argues that a large majority of the debt was either used for consumptive purposes or was poorly invested in investments that were unsuccessful in increasing productivity. Had debt been employed successfully in productivity enhancing investments, GDP and productivity would have increased at a similar or greater pace than the rise in debt. In the 1970’s $1.66 of new debt created $1.00 of economic growth. Since that time, debt has grown at three times the rate of economic activity and it now takes $4.47 of new debt to create the same $1.00 of economic growth.
Summary
August 15, 2016 will mark the 45th anniversary of President Nixon’s decision to close the gold window. U.S. citizens and the government are now beholden to the consequences of years of accumulated debt and weak productivity growth that have occurred since that day. Now, seven years after the end of the financial crisis and recession, these consequences are in plain sight. The Fed finds themselves crippled under an imprudent zero interest rate policy and unable to raise interest rates due fear of stoking another crisis. Worse, other central banks, in a similar quest to keep prior debt serviceable and generate even more debt induced economic growth, have pushed beyond the realm of reality into negative interest rates. In fact, an astonishing $10 trillion worth of sovereign bonds now trade with a negative yield.
The evidence of these failed policies is apparent. However one must consider the basic facts and peer beyond the narrative being fed to the public by the central bankers, Wall Street, and politicians. There is nothing normal about any of this. It therefore goes without saying, but we will say it anyway – investment strategies based on historic norms should be carefully reconsidered.
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.
Summary
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.
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