Tag Archives: PCE

In The Fed We TRUST – Part 2: What is Money?

Part one of this article can be found HERE.

President Trump recently nominated Judy Shelton to fill an open seat on the Federal Reserve Board. She was recently quoted by the Washington Post as follows: “(I) would lower rates as fast, as efficiently, and as expeditiously as possible.” From a political perspective there is no doubting that Shelton is conservative.

Janet Yellen, a Ph.D. economist from Brooklyn, New York, appointed by President Barack Obama, was the most liberal Fed Chairman in the last thirty years.

Despite what appears to be polar opposite political views, Mrs. Shelton and Mrs. Yellen have nearly identical approaches regarding their philosophy in prescribing monetary policy. Simply put, they are uber-liberal when it comes to monetary policy, making them consistent with past chairmen such as Ben Bernanke and Alan Greenspan and current chairman Jay Powell.

In fact, it was Fed Chairman Paul Volcker (1979 to 1987), a Democrat appointed by President Jimmy Carter, who last demonstrated a conservative approach towards monetary policy. During his term, Volcker defied presidential “advice” on multiple occasions and raised interest rates aggressively to choke off inflation. In the short-term, he harmed the markets and cooled economic activity. In the long run, his actions arrested double-digit inflation that was crippling the nation and laid the foundation for a 20-year economic expansion.

Today, there are no conservative monetary policy makers at the Fed. Since Volcker, the Fed has been run by self-described liberals and conservatives preaching easy money from the same pulpit. Their extraordinary policies of the last 20 years are based almost entirely on creating more debt to support the debt of yesteryear as well as economic and market activity today. These economic leaders show little to no regard for tomorrow and the consequences that arise from their policies. They are clearly focused on political expediency.

Different Roads but the Same Path –Government

Bernie Sanders, Alexandria Ocasio-Cortez, Elizabeth Warren, and a host of others from the left-wing of the Democrat party are pushing for more social spending. To support their platform they promote an economic policy called Modern Monetary Theory (MMT). Read HERE and HERE for our thoughts on MMT. 

In general, MMT would authorize the Fed to print money to support government spending with the intention of boosting economic activity. The idealized outcome of this scheme is greater prosperity for all U.S. citizens. The critical part of MMT is that it would enable the government to spend well beyond tax revenue yet not owe a dime.   

President Trump blamed the Fed for employing conservative monetary policy and limiting economic growth when he opined, “Frankly, if we didn’t have somebody that would raise interest rates and do quantitative tightening (Powell), we would have been at over 4 instead of a 3.1.” 

Since President Trump took office, U.S government debt has risen by approximately $1 trillion per year. The remainder of the post-financial crisis period saw increases in U.S. government debt outstanding of less than half that amount. Despite what appears to be polar opposite views on just about everything, under both Republican and Democratic leadership, Congress has not done anything to slow spending or even consider the unsustainable fiscal path we are on. The last time the government ran such exorbitant deficits while the economy was at full employment and growing was during the Lyndon B. Johnson administration. The inflationary mess it created were those that Fed Chairman Volcker was charged with cleaning up.

From the top down, the U.S. government is and has been stacked with fiscal policymakers who, despite their political leanings, are far too undisciplined on the fiscal front.

We frequently assume that a candidate of a certain political party has views corresponding with those traditionally associated with their party. However, in the realm of fiscal and monetary policy, any such distinctions have long since been abandoned.

TRUST

Now consider the current stance of Democratic and Republican fiscal and monetary policy within the TRUST framework. Government leaders are pushing for unprecedented doses of economic stimulus. Their secondary goal is to maximize growth via debt-driven spending. Such policies are fully supported by the Fed who keeps interest rates well below what would be considered normal. The primary goal of these policies is to retain power.

To keep interest rates lower than a healthy market would prescribe, the Fed prints money. When policy consistently leans toward lower than normal rates, as has been the case, the money supply rises. In the wake of the described Fed-Government partnership lies a currency declining in value. As discussed in prior articles, inflation, which damages the value of a currency, is always the result of monetary policy decisions.

If the value of a currency rests on its limited supply, are we now entering a phase where the value of the dollar will begin to get questioned? We don’t have a definitive answer but we know with 100% certainty that the damage is already done and the damage proposed by both political parties increases the odds that the almighty dollar will lose value, and with that, TRUST will erode. Recall the graph of the dollar’s declining purchasing power that we showed in Part 1.

Data Courtesy St. Louis Federal Reserve

Got Money? 

If the value of the dollar and other fiat currencies are under liberal monetary and fiscal policy assault and at risk of losing the valued TRUST on which they are 100% dependent, we must consider protective measures for our hard-earned wealth.

With an underlying appreciation of the TRUST supporting our dollars, the definition of terms becomes critically important. What, precisely, is the difference between currency and money? 

Gold is defined as natural element number 79 on the periodic table, but what interests us is not its definition but its use. Although gold is and has been used for many things, its chief purpose throughout the 5,000-year history of civilization has been as money.

In testimony to Congress on December 18, 1912, J.P. Morgan stated: “Money is gold, and nothing else.” Notably, what he intentionally did not say was money is the dollar or the pound sterling. What his statement reveals, which has long since been forgotten, is that people are paid for their labor through a process that is the backbone of our capitalist society. “Money,” properly defined, is a store of labor and only gold is money.

In the same way that cut glass or cubic zirconium may be made to look like diamonds and offer the appearance of wealth, they are not diamonds and are not valued as such. What we commonly confuse for money today – dollars, yen, euro, pounds – are money-substitutes. Under an evolution of legal tender laws since 1933, global fiat currencies have displaced the use of gold as currency. Banker-generated currencies like the dollar and euro are not based on expended labor; they are based on credit. In other words, they do not rely on labor and time to produce anything. Unlike the efforts required to mine gold from the ground, currencies are nearly costless to produce and are purely backed by a promise to deliver value in exchange for labor.

Merchants and workers are willing to accept paper currency in exchange for their goods and services in part because they are required by law to do so. We must TRUST that we are being compensated in a paper currency that will be equally TRUSTed by others, domestically, and internationally. But, unlike money, credit includes the uncertainty of “value” and repayment.

Currency is a bank liability which explains why failing banks with large loan losses are not able to fully redeem the savings of those who have their currency deposited there. Gold does not have that risk as there is no intermediary between it and value (i.e., the U.S. government or the Japanese government). Gold is money and harbors none of these risks, while currency is credit. Said again for emphasis, only gold is money, currency is credit.

There is a reason gold has been the money of choice for the entirety of civilization. The last 90 years is the exception and not the rule.

Despite their actions and words, the value of gold, and disTRUST of the dollar is not lost on Central Bankers. Since 2013, global central banks have bought $140 billion of gold and sold $130 billion of U.S. Treasury bonds. Might we say they are trading TRUST for surety?

Summary

To repeat, currency, whether dollars, pounds, or wampum, are based on nothing more than TRUST. Gold and its 5000 year history as money represents a dependable store of labor and real value; TRUST is not required to hold gold. No currency in the history of humankind, the almighty U.S. dollar included, can boast of the same track record.

TRUST hinges on decision makers who are people of character and integrity and willingness to do what is best for the nation, not the few. Currently, both political parties are taking actions that destroy TRUST to gain votes. While political party narratives are worlds apart, their actions are similar. Deficits do matter because as they accumulate, TRUST withers.

This article is not a call to action to trade all of your currency for gold, but we TRUST this article provokes you to think more about what money is.

Federal Reserve Headlines – Fact or Fiction?

When it becomes serious, you have to lie.” – Jean-Claude Juncker, former President of the Eurogroup of Eurozone finance ministers

On July 16, 2019, Chicago Federal Reserve President Charles Evans made a series of comments that were blasted across the financial news wires. In the headlines taken from his speech on the 16th and other statements over the past few weeks, Mr. Evans argues for the need to cut interest rates at the July 31st meeting and future meetings.

In this article, we look at his rationale and provide you with supporting graphs and comments that question his logic supporting the rate cuts. We pick on Charles Evans in this piece, but quite honestly, he is reiterating similar themes discussed by many other Fed members.

The issues raised here are important because the Fed continues to play an outsized role in influencing asset valuations that are historically high. As such, it is incumbent upon investors to understand when the Fed may be on the precipice of making a policy error. If asset prices rest on confidence in the Fed, what will happen when said confidence erodes?

The Fed’s Mandate

Before comparing reality with his recent headlines, it is important to clarify the Fed’s Congressional mandate as stated in the Federal Reserve Act. The entire Federal Reserve act can be found HERE. For this article, we focus on Section 2A- Monetary Policy Objectives as follows:

The stock market is at all-time highs, bond yields are well below “moderate,” unemployment stands at 50-year lows, and prices are stable. Based on the Fed’s objectives, there is certainly no reason to cut rates.

Evans Thoughts versus Reality

All of the headlines below in red are courtesy of Bloomberg News and the data is sourced from Bloomberg and the St. Louis Federal Reserve

There are a lot of risks out there, citing BREXIT

BREXIT, the UK withdrawal from the European Union (EU), passed in a public referendum over three years ago. Since then, lawmakers on both sides of the Channel have tried unsuccessfully to fulfill voters’ wishes. The exit was supposed to occur by March 29, 2019 but was extended to October 31, 2019. BREXIT is not a new risk. In fact, there was a high likelihood of a hard BREXIT in late March before the extension, and the Fed never mentioned it then as a reason to take action.  Further, the Bank of England (BOE) and the European Central Bank (ECB), not the Fed, are the parties that should be first in line to mitigate any financial/monetary risks associated with Europe and any repercussions coming from BREXIT. At some point Fed action may be warranted if a hard BREXIT occurs and rattles global economies. However, acting in advance on what might or might not happen is not the Fed’s job.

There are other risks, such as the ongoing trade war with China, the coming debt cap, and Iran to name a few. We ask you though, has there ever been a period where numerous concerns and risks did not exist?

Fed should not generate excess stimulus

The first graph quantifies the level of Fed Funds and the amount of QE, allowing us to compare monetary stimulus over the last 40 years. Clearly, the last ten years, including the current period, is excessive and if anything means the Fed should be removing “excess stimulus.”

For more details on this graph and other measures of excessive stimulus, please read our article Why the Fed’s Monetary Policy is Still Very Accommodative.

Other evidence also indicates that current monetary policy is excessive. For instance, the graph below, courtesy of Mr. Evans own Chicago Federal Reserve, shows that national financial conditions are near the easiest of any period in the last 50 years. Of the 2,531 weekly data points in the graph, only 60 weekly periods (2.3%) had easier financial conditions than today. Again, conditions are easy because monetary policy is very accommodative. Excess is an appropriate term to describe the state of monetary policy and it may actually be an understatement.

We need to do everything we can to get to 2% inflation

The Federal Reserve Act clearly says the Fed should promote stable prices. Stable prices do not axiomatically mean 2% inflation as they have interpreted it. The Act also makes no mention of persistent inflation that compounds over time.

The following graph shows the level of prices since the Revolutionary War. From 1775 to 1971 prices were relatively stable, except during times of war. Since 1971, when Nixon revoked the gold standard and allowed the Fed carte blanche to manipulate the money supply, higher annual prices have accumulated, resulting in massive price inflation.

The Fed’s 2% inflation target is a far cry from the price stability mandate to which they are supposed to adhere.

Says path of U.S. economy is toward trend growth

Mr. Evans uses language that suggests U.S. GDP has been running below trend but making progress toward trend growth. Based upon data supplied by the St. Louis Fed, real GDP has been running above trend for the last eight quarters as shown below.

Inflation situation alone calls for two 25 basis point cuts by year’s end

The following graphs show various measures of inflation and inflation expectations. It is hard to point to any recent inflation trends in these graphs that have meaningfully changed from the trends of the last few years. Given this broad set of data, why does the current inflation “situation” warrant even more aggressive monetary policy action?

Economic fundamentals are solid / U.S. economy is really quite solid

Mr. Evans is right. GDP was a little soft in the second quarter, but it was running above trend for the prior eight quarters. With Fed Funds still at dangerously low levels, the Fed’s balance sheet swollen beyond any historical precedent, and the economy “really quite solid,” his call for rate cuts does not reconcile with his own assessment of the economy.

Says he forecasts 50 basis points of accommodation to lift inflation

Using data going back to 1990, the graph below shows that there is no statistical relationship between the Fed’s (current) preferred measure of inflation (PCE) and the Fed Funds rate they manage. PCE measured a year forward to the current Fed Funds rate demonstrates even less of a relationship.

Based on data provided by the Fed, the idea that the Fed possess a magical joystick which enables them to control prices is fallacious. Evan’s statement lacks any statistical backing and is a complete guess at best. At worst, it is an intentional effort to influence public sentiment improperly.

Summary

The conclusions here suggest that Evans logic is flawed and misleading. Based on his arguments, the Fed has no basis to cut interest rates. Fed speakers that modify their language daily, as they have been doing over the prior month or two, to conjure support for rate cuts put their integrity and investor confidence in the Fed at risk.

The primary objective of Fed policy should be geared toward imperceptible adjustments to foster a well-functioning market-based economy. On the contrary, what we increasingly see is a market-economy increasingly jostled and cajoled by hair-on-fire day-traders posing as a monetary authority. By employing well publicized micro-management tactics, the Fed naturally increases the chances of a policy error. Indeed, the proper characterization of that risk is that the Fed increases the likelihood of further policy errors compounding the legacy issues already in play thanks to Powell’s predecessors.

Given the reliance of equity prices on the so-called “Fed Put” and the excessive valuations in many asset markets, we advise paying close attention as a policy error could quickly cause assets to re-price to properly reflect their inherent risks, and then some. Seldom do those adjustments stop at fair value.

In The Fed We Trust – Part 1

This article is the first part of a two-part article. Due to its length and importance, we split it to help readers’ better digest the information. The purpose of the article is to define money and currency and discuss their differences and risks. It is with this knowledge that we can better appreciate the path that massive deficits and monetary tomfoolery are putting us on and what we can do to protect ourselves.  

How often do you think about what the dollar bills in your wallet or the pixel dollar signs in your bank account are? The correct definitions of currency and money are crucial to our understanding of an economy, investing and just as importantly, the social fabric of a nation. It’s time we tackle the differences between currency and money and within that conversation break the news to you that deficits do matter, TRUST me.

At a basic level, currency can be anything that is broadly accepted as a medium of exchange that comes in standardized units. In current times, fiat currency is the currency of choice worldwide. Fiat currency is paper notes, coins, and digital 0s and 1s that are governed and regulated by central banks and/or governments. Note, we did not use the word guaranteed to describe the role of the central bank or government. The value and worth of a fiat currency rest solely on the TRUST of the receiver of the currency that it will retain its value and the TRUST that others will accept it in the future in exchange for goods and services.

Whether its yen, euros, wampum, bitcoin, dollars or any other currency, as long as society is accepting of such a unit of exchange, trade will occur. When TRUST in the value of a currency wanes, commerce becomes difficult, and the monetary and social prosperity of a nation falters. The history books overflow with such examples.

Maslow and Currency

Before diving into the value of a currency, it is worth considering the role it plays in society and how essential it is to our physical and mental well-being. This point is rarely appreciated, especially by those that push policies that debase the currency.

Maslow created his famous pyramid to depict what he deemed the hierarchy of human needs. The levels of his pyramid, shown below, represent the ordering of physiological and psychological needs that help describe human motivations. When these needs are met, humans thrive.

Humans move up the pyramid by addressing their basic, lowest level needs. The core needs, representing the base, are physiological needs including food, water, warmth and rest. Once these basic needs are met, one then seeks to attain security and safety. Without meeting these basic physiological and safety needs, our psychological and self-fulfillment needs, which are higher up the pyramid, are difficult to come by. Further, as we see in some third-world countries, the social fabric of the nation is torn to shreds when a large part of the population cannot satisfy their basic needs.

In modern society, except for a few who live “off-the-grid,” fiat currency is the only means of attaining these necessities. Possession of currency is a must if we are to survive and thrive. Take a look back to the opening paragraphs and let’s rephrase that last sentence: possession and TRUST of currency is a must if we are to survive and thrive.

It is this most foundational understanding of currency that keeps our economy humming, our physical prosperity growing and our society stable. The TRUST backing the dollar, euro, yen, etc. is essential to our financial, physical and psychological welfare.

Let’s explore why we should not assume that TRUST is a permanent condition.

Deficits Don’t Matter…. or Do They?

Having made the imperative connection between currency and TRUST and its linkage to trade and commerce along with our physical and mental well-being, we need to explore the current state of the United States government debt burden, monetary policy, and the growing belief that deficits don’t matter.

Treasury debt never matures, it is rolled over. Yes, a holder of a maturing Treasury bond is paid in full at maturity, however, to secure the funds to pay that holder, the government issues new debt by borrowing money from someone else. Over time, this scheme has allowed deficits to expand, swelling the amount of debt outstanding. Think of this arrangement as taking out a new credit card every month to pay off the old card.

The chart below shows U.S. government debt as a percentage of GDP. Since 1967 government debt has grown annually 2% more than GDP.

Data Courtesy: St. Louis Federal Reserve

Continually adding debt at a faster rate than economic growth (as shown above) is limited. To extend the ability to do this requires declining interest rates, inflation and a little bit of financial wizardry to make debt disappear. Fortunately, the U.S. government has a partner in crime, the Federal Reserve.

As you read about the Fed’s methods to help fund deficits, it is important to consider the actions they routinely take are at the expense of the value of the currency. This warrants repeating since the value of the currency is what supports TRUST in the currency and allows it to retain its functional purposes.

The Fed helps the government consistently run deficits and increase their debt load in three ways.

  1. The Fed stokes moderate inflation.
  2. The Fed manages interest rates lower than they should be.
  3. The Fed buys Treasury and mortgage securities (open market operations/QE) and, as we are now witnessing, monetizes the debt.

Inflation

Within the Fed’s charter, Congress has mandated the Fed promote stable prices. To you and me, stable prices would likely mean no inflation or deflation. Regardless of what you and I think, the Fed interprets the mandate as an annual 2% rate of inflation. Since the Fed was founded in 1913, the rate of inflation has averaged 3.11% annually. That rate may seem inconsequential, but it adds up. The chart below illustrates how the low but consistent rate of inflation has debased the purchasing power of the dollar.

Data Courtesy: St. Louis Federal Reserve

$1 borrowed in 1913 can essentially be paid off with .03 cents today. Inflation has certainly benefited debtors.

Interest Rate Management

For the better part of the last decade, the Fed has imposed price controls that kept interest rates below what should be considered normal. Normal, in a free market economy, is an interest rate that compensates a lender for credit risk and inflation. Since Treasury debt is considered “risk-free,” the predominant risk to Treasury investors is earning less than the rate of inflation. As far as “risk-free”, read our article: The Mind Blowing Concept of Risk-Free’ier.

If the yield on the bond is less than inflation, as has recently been the case, the purchasing power and wealth of the investor declines in the future.

The table below highlights how U.S. Treasury real rates (yields less CPI) have trended lower over the past forty years. In fact, over the last decade, negative real rates are the norm, not the exception. When investors are not properly compensated by the U.S. Treasury, the onus of government debt is partially being put upon investors. We have the Fed to thank for their Fed Funds (FF) policy of negative real rates.

Data Courtesy: St. Louis Federal Reserve

Fed Balance Sheet

The Fed uses its balance sheet to buy and sell U.S. Treasury securities to manage the money supply and thus enforce their interest rate stance. In 2008, their use of the balance sheet changed. From 2008 through 2013, the Fed purchased nearly $4 trillion of Treasury and mortgage-backed securities in what is called Quantitative Easing (QE). By reducing the supply of these securities, they freed up liquidity to move to other assets within the capital markets. The action propped up asset prices and helped keep interest rates lower than they otherwise would have been.

Since 2018, they have reversed these actions by reducing the size of their balance sheet in what is called Quantitative Tightening (QT). This reversal of prior action essentially makes the benefits of QE temporary. However, if they fail to reduce it back to levels that existed before QE was initiated, then the Fed permanently monetized government debt. In plain English, they printed money to extinguish debt.

As we write this article, the Fed is in the process of ending QT. Based on the Fed schedule as announced on March 20, 2019, the balance sheet will permanently end up $2.28 trillion larger than from when QE was initiated. To put that in context, the balance will have grown 269% since 2008, as compared to 48% economic growth.

Data Courtesy St. Louis Fed

The methods the Fed employs to manage policy as described above, all involve using their balance sheet to alter the money supply and help the Treasury manage its deficits. We can argue the merits of such a policy, but we cannot argue a basic economics law; when there is more of something, it is worth less. When something of value is created out of thin air, its value declines.

At what point is debt too onerous, deficits too large and the Fed too aggressive such that TRUST is harmed? No one knows the answer to that question, but given the importance of TRUST in a fiat currency regime, it would be wise to avoid actions that could raise doubt. Contrary to that guidance, current fiscal and monetary policy throws all TRUST to the wind.

Prelude to Part 2

As deficits grow and government debt becomes more onerous, the amount of Fed intervention must become greater.  To combat this growing problem, both political parties are downplaying deficits and pushing the Fed to do more. In part 2 we will explore emerging fiscal mindsets and what they might portend. We will then define money, and with this definition, show why the difference between currency and money is so important. 

Inflation: The Fed’s False Flag

Don’t piss down my back and tell me it’s raining” –Clint Eastwood/The Outlaw Josey Wales

On April 30, 2019, one day before the Federal Reserve’s FOMC policy-setting meeting, the Wall Street Journal published an article by Nick Timiraos and Paul Kiernan entitled Inflation Is Likely to Fuel Discussions as Fed Officials Meet. We quickly recognized this article was not the thoughts of the curious authors but more than likely indirect Fed messaging.

Similar to a trial balloon, conveyances like the one linked above allow the Fed to gauge market response to new ideas and prepare the markets and public for potential changes in policy.

Based on numerous articles published over the last two weeks, we are under growing suspicion that the Fed wants us to believe we need more inflation. For their part, the Fed in the May 1, 2019, FOMC policy statement changed language from the prior statement to highlight that inflation is not running at their 2% target but it is “running below” their goal. 

Is declining inflation a legitimate concern or a false flag meant to provide cover to lower rates?

Selling Deflation

The WSJ article published the day before the FOMC policy meeting has the Fed’s fingerprints all over it. The gist of the article is that inflation is running below the two percent goal and therefore needs to be addressed.

The following quotes come from that article:

  • Lower inflation remains the fly in the ointment.
  • Officials worry that the failure to hit the inflation target could undermine its credibility over time, which could cause consumers and businesses to expect lower inflation in the future, which in turn could cause price pressures to weaken further.
  • If officials grew concerned that the (inflation) shortfall was persistent, some could push for lowering rates.

Not to be outdone, Neil Irwin of the New York Times, in discussing how the Fed might fight the next recession, stated:

“In the near term, any changes are likely to tilt policy in the direction of having lower interest rates for longer periods, with the aim of getting inflation to more consistently average 2 percent (it has been consistently below that level for years).” 

These and a slew of comments from Fed officials, the media and market prognosticators lead us to believe the Fed is now using a lack of inflation to justify lowering interest rates.

First quarter 2019 GDP was just reported at 3.2% and has grown in each of the last 12 quarters, an unprecedented string of consecutive increases in GDP growth. The unemployment rate and jobless claims are at or near 50-year lows. Despite the solid economic growth and strong labor market, the amount of monetary and fiscal stimulus being employed is immense as we have documented on numerous occasions. Fed Funds at 2.5%, while off of the zero bound, is still well below rates of the prior 50 years. The Fed’s balance sheet, despite some run-off, is still four times larger than where it stood pre-financial crisis.

Since the economy and labor markets are strong and monetary policy very easy, inflation appears to be the only factor that the Fed could use to justify adopting an easier policy stance.

The Smoking Gun

Before considering inflation data, it’s worth reviewing the Fed’s thoughts about inflation as it relates to monetary policy. On October 2, 2018, Chairman Powell stated the following:

From the standpoint of contingency planning, our course is clear: Resolutely conduct policy consistent with the FOMC’s symmetric 2 percent inflation objective, and stand ready to act with authority if expectations drift materially up or down.

Given the statement above, is Inflation or inflation expectations materially changing? 

Below are six charts to help you decide if inflation or inflation expectations are moving materially lower. If not, is inflation the Trojan horse that allows the Fed to lower rates despite any reasonable rationale?  All of the data for the graphs below are sourced from Bloomberg.

Inflation Expectations

Standard Inflation Measurements

Fed’s Own Inflation Measures

The following two graphs are inflation indicators that the Fed created. They are designed to reduce temporary blips in the prices of all goods and services within the CPI and GDP reports. The Federal Reserve believes these measures present a more durable reading that is not as subject to transitory forces as other inflation measures.

Summary

Have inflation “expectations drift(ed) materially up or down?”

Looking at the ebbs and flows of inflation and inflation expectations of the last three years, we see no consistent change in the trend. As for the dreaded fear of deflation, the United States has not experienced it since the Great Depression in the 1930’s. In our opinion, this recent talk about lower inflation is a sad case of the Fed manufacturing a story to justify easier monetary policy.

We conclude with a message for the Federal Reserve- If you want to lower rates then lower rates, but please do not feign concern about inflation trends that are non-existent as cover for such moves. You preach transparency, so be transparent.

Quick Take: Bulls Attempt A “Jailbreak”

Yesterday, I discussed the “compression” of the market being akin to a “coiled spring” that when released could lead to a fairly decent move in one direction or another. To wit:

“As you can see in the ‘reddish triangle,’ prices have been continually compressed into an ever smaller trading range. This ‘compression’ is akin to coiling a spring. The more tightly the spring is wound, the more energy it has when it is released.”

As shown, the bulls are “attempting a jailbreak” of the “compression” that has pressured markets over the last two months. While the breakout is certainly encouraging, there isn’t much room before it runs into a more formidable resistance of the 100-day moving average. Furthermore, with interest rates closing in on 3% again, which has previously been a stumbling point for stock prices, it is too soon to significantly increase equity risk in portfolios.

This is just one day.

As I stated previously, as a portfolio manager I am not too concerned with what happens during the middle of the trading week, but rather where the market closes on Friday. This reduces the potential for “head fakes” as we saw last week with the break of the of the 200-dma on Thursday which was quickly reversed on Friday. The weekly close was one of the two outcomes as noted in our previous Quick-Take:

“If the market closes ABOVE the 200-dma by the close of the market on Friday, we will simply be retesting support at the 200-dma for the fourth time. This will continue to keep the market trend intact and is bullish for stocks.”

This breakout will provide a reasonable short-term trading opportunity for portfolios as I still think the most probable paths for the market currently are the #3a or #3b pathways shown above.

If we get a confirmed break out of this “compression range” we have been in, we will likely add some equity risk exposure to portfolios from a “trading” perspective. That means each position will carry both a very tight “stop price” where it will be sold if we are wrong as well as a “profit taking” objective if we are right.

Longer-term investments are made when there is more clarity about future returns. Currently, clarity is lacking as there are numerous “taxes” currently weighing on the markets which will eventually have to be paid.

  • Rising oil and gasoline prices (Tax on consumers)
  • Fed bent on hiking rates and reducing their balance sheet. (Tax on the markets)
  • Potential trade wars (Tax on manufacturers)
  • Geopolitical tensions with North Korea, Russia, China and Iran (Tax on sentiment)
  • Traders all stacked up on the “same side of the boat.” (Tax on positioning)

We continue to hold higher levels of cash, but have closed out most of our market hedges for now as we giving the markets a bit more room to operate.

With longer-term indicators at very high levels and turning lower, we remain cautious longer-term. However, in the short-term markets can “defy rationality” longer than anyone can imagine. But it is in that defiance that investors consistently make the mistake of thinking “this time is different.”

It’s not. Valuations matter and they matter a lot in the long-term. Valuations coupled with rising interest rates, inflationary pressures, and weak economic growth are a toxic brew to long-term returns. It is also why it is quite possible we have seen the peak of the market for this year.

I will update this “Quick Take” for the end of the week data in this coming weekend’s newsletter. (Subscribe at the website for email delivery on Saturday)

The Myth Of “Buy & Hold” – Why Starting Valuations Matter

If you repeat a myth often enough, it will eventually be believed to be the truth.

“Stop worrying about the market and just buy and hold stocks.”

Think about this for a moment. If it were true, then:

  • Why do major Wall Street firms have proprietary trading desks? (They aren’t buying and holding.)
  • Why are there professional hedge fund managers? (They aren’t buying and holding either)
  • Why is there volatility in the market? (If everyone just bought and held, prices would be stable.)
  • Why does Warren Buffett say “buy fear and sell greed?” (And why is he holding $115 billion in cash?)
  • Why are there financial channels like CNBC? (If everyone bought and held, there would be no viewers.)
  • Most importantly, why isn’t everyone wealthy from investing?

Because “buying and holding” stocks is a “myth.”

Wall Street is a business. A very big business which generates huge profits by creating products and selling it to their consumers – you. Just how big? Here are the sales and net income for some of the largest purveyors of investment products:

  • Goldman Sachs – Sales: $45 Billion / Income: $8.66 Billion
  • JP Morgan – Sales: $67 Billion / Income: $26.73 Billion
  • Bank Of America/Merrill Lynch – Sales: $59.47 Billion / Income: $20.71 Billion 
  • Schwab – Sales: $9.38 Billion / Income: $2.45 Billion
  • Blackrock – Sales: $13.25 Billion / Income: $4.02 Billion

There is nothing wrong with this, of course. It is simply “the business.”

It is just important to understand exactly which side of the transaction everyone is on. When you sell your home, there is you, the buyer and Realtor. It is clearly understood that when the transaction is completed the Realtor is going to be paid a commission for their services.

In the financial world the relationship isn’t quite as clear. Wall Street needs its customers to “sell” product to, which makes it less profitable to tell “you” to “sell” when they need you to “buy the shares they are selling for the institutional clients.”

Don’t believe me?  Here is a survey that was conducted on Wall Street firms previously.

“You” ranked “dead last” in importance.

Most importantly, as discussed previously, the math of “buy and hold” won’t get you to your financial goals either. (Yes, you will make money given a long enough time horizon, but you won’t reach your inflation-adjusted retirement goals.)

“But Lance, the market has historically returned 10% annually. Right?”

Correct. But again, it’s the math which is the problem.

  1. Historically, going back to 1900, using Robert Shiller’s historical data, the market has averaged, more or less, 10% annually on a total return basis. Of that 10%, roughly 6% came from capital appreciation and 4% from dividends.
  2. Average and Annual or two very different things. Investors may have AVERAGE 10% annually over the last 118 years, but there were many periods of low and negative returns along the way. 
  3. You won’t live 118 years unless you are a vampire.

The Entire Premise Is Flawed

If you really want to save and invest for retirement you need to understand how markets really work.

Markets are highly volatile over the long-term investment period. During any time horizon the biggest detractors from the achievement of financial goals come from five factors:

  • Lack of capital to invest.
  • Psychological and behavioral factors. (i.e. buy high/sell low)
  • Variable rates of return.
  • Time horizons, and;
  • Beginning valuation levels 

I have addressed the first two at length in “Dalbar 2017 Investors Suck At Investing” but the important points are these:

Despite your best intentions to “buy and hold” over the long-term, the reality is that you will unlikely achieve those promised returns.

While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology.

Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:

  • Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
  • Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
  • Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
  • Mental Accounting – Separating performance of investments mentally to justify success and failure.
  • Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
  • Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
  • Regret – Not performing a necessary action due to the regret of a previous failure.
  • Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
  • Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

The biggest of these problems for individuals is the “herding effect” and “loss aversion.”

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”

As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip” opportunity. As losses mount, anxiety increases until individuals seek to “avert further loss” by selling.

This is the basis of the “Buy High / Sell Low” syndrome that plagues investors over the long-term.

However, without understanding what drives market returns over the long term, you can’t understand the impact the market has on psychology and investor behavior.

Over any 30-year period the beginning valuation levels, the price you pay for your investments has a spectacular impact on future returns. I have highlighted return levels at 7-12x earnings and 18-22x earnings. We will use the average of 10x and 20x earnings for our savings analysis.

As you will notice, 30-year forward returns are significantly higher on average when investing at 10x earnings as opposed to 20x earnings or where we are currently near 25x.

For the purpose of this exercise, I went back through history and pulled the 4-periods where valuations were either above 20x earnings or below 10x earnings. I then ran a $1000 investment going forward for 30-years on a total-return, inflation-adjusted, basis.

At 10x earnings, the worst performing period started in 1918 and only saw $1000 grow to a bit more than $6000. The best performing period was not the screaming bull market that started in 1980 because the last 10-years of that particular cycle caught the “dot.com” crash. It was the post-WWII bull market than ran from 1942 through 1972 that was the winner. Of course, the crash of 1974, just two years later, extracted a good bit of those returns.

Conversely, at 20x earnings, the best performing period started in 1900 which caught the rise of the market to its peak in 1929. Unfortunately, the next 4-years wiped out roughly 85% of those gains. However, outside of that one period, all of the other periods fared worse than investing at lower valuations. (Note: 1993 is still currently running as its 30-year period will end in 2023.)

The point to be made here is simple and was precisely summed up by Warren Buffett:

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

This is shown in the chart below. I have averaged each of the 4-periods above into a single total return, inflation-adjusted, index, Clearly, investing at 10x earnings yields substantially better results.

So, with this understanding let me return once again to those that continue to insist the “buy and hold” is the only way to invest. The chart below shows $3000 invested annually into the S&P 500 inflation-adjusted, total return index at 10% compounded annually and both 10x and 20x valuation starting levels. I have also shown $3000 saved annually in a mattress.

The red line is 10% compounded annually. You won’t get that, but it is there so you can compare it to the real returns received over the 30-year investment horizon starting at 10x and 20x valuation levels. The shortfall between the promised 10% annual rates of return and actual returns are shown in the two shaded areas. In other words, if you are banking on some advisors promise of 10% annual returns for retirement, you aren’t going to make it.

I want you to take note of the following.

When investing your money at valuations above 20x earnings, it takes 22-years before it has grown more than money stuffed in a mattress. 

Why 22 years? 

Take a look at the chart below.

Historically, it has taken roughly 22-years to resolve a period of over-valuation. Given the last major over-valuation period started in 1999, history suggests another major market downturn will mean revert valuations by 2021.

The point here is obvious, but difficult to grasp from a mainstream media that is continually enticing young Millennial investors to mistakenly invest their savings into an overvalued market. Saving your money, and waiting for a valuation based opportunity to invest those savings in the market, is the best, safest way, to invest for your financial future. 

Of course, Wall Street won’t like this much because they can’t charge you a fee if you are sitting on a mountain of cash awaiting the opportunity to “buy” their next misfortune.

But isn’t that what Baron Rothschild meant when quipped:

“The time to buy is when there’s blood in the streets.”

Quick Take: Market Breaks Important Support

I have often discussed that as a portfolio manager I am not too concerned with what happens during the middle of the trading week. The reason is daily price volatility can lead to many false indications about the direction of the market. These false indications are why so many investors suggest that technical analysis is nothing more than “voo doo.”

For me, price analysis is more about understanding the “trend” of the market and the path of least resistance for prices in the short and intermediate-term. This analysis allows for portfolio positioning to manage risk.

Over the last several weeks, I have been mapping out the ongoing correction in the market and have noted the important support that has been provided by the running 200-day moving average. The chart below is updated through this morning.

The break of the 200-dma today is not a good sign. Consolidation processes are much akin to the “coiling of a spring.”  As prices become compressed, when those prices break out there is a “release of energy” from that compression which tends to lead to rather sharp moves in the direction of the breakout.

Importantly, the break of support today is NOT a signal to run out and sell everything.  It is, however, a worrisome warning that should not be entirely dismissed.

As stated, nothing matters for me until we see where the market closes on Friday.

Here is what we are wanting to see:

  • If the market closes ABOVE the 200-dma by the close of the market on Friday, we will simply be retesting support at the 200-dma for the fourth time. This will continue to keep the market trend intact and is bullish for stocks. 
  • If the market closes BELOW the 200-dma on Friday, the break of support will be confirmed, suggesting a downside failure of the consolidation pattern over the last couple of months. This break is bearish for the market and suggests higher levels of caution. Such will lead to two other options:
    • With the market oversold on a short-term basis, any rally that fails at the 200-dma will further confirm the downside break of the consolidation. This would suggest lower prices over the next month or so.
    • If the market recovers by early next week, above the 200-dma, positioning will remain on hold.

I am often asked why I don’t just take ONE position and make a call.

Because we can not predict the future. We can only react to it.

After having raised cash over the last couple of months on rallies, there isn’t much we need to do at the moment.

However, the weakness in the market, combined with longer-term sell signals as discussed on Tuesday, is suggesting the market has likely put in its top for the year.

We remain cautious and suggest the time to “buy” has not arrived yet.

Bull Markets Actually Do Die Of “Old Age”

David Ranson recently endeavored in a long research report to simply declare that “bull markets do not die of old age.”

“The life expectancy of bull markets can be inferred from history. Fourteen bull markets in U.S. stocks have come and gone since 1927, and their mean lifetime is 55 months. But this calculation can be taken further. From the age of one year to the age of eight years, there’s no overall tendency for life expectancy to decline as a market advance gets older. The present stock market advance, which began 105 months ago, is no more likely to end within the next twelve months than it was when it was only twelve months old. Bull markets do not die of old age.”

Think about this for a moment.

This is the equivalent of suggesting that since the average male dies at 88-years of age if he lives to be 100, he has no more chance of dying in the next 12-months than he did when he was 40-years old. 

While a 100-year old male will likely expire within a relatively short time frame, it will not just “being old” that leads to death. It is the onset of some outside influence such as pneumonia, infection, organ failure, etc. that leads to the eventual death as the body is simply to weak to defend itself. While we attribute the death to “old age,” it was not just “old age” that killed the host.

This was a point that my friend David Rosenberg made in 2015 before the first rate hike:

“Equity bull markets never die simply of old age. They die of excessive Fed monetary restraint.

First, averages and medians are great for general analysis but obfuscate the variables of individual cycles. To be sure the last three business cycles (80’s, 90’s and 2000) were extremely long and supported by a massive shift in a financial engineering and credit leveraging cycle. The post-Depression recovery and WWII drove the long economic expansion in the 40’s, and the “space race” supported the 60’s.

But each of those economic expansions did indeed come to an end. The table below shows each expansion with the subsequent decline in markets.

Think about it this way.

  • At 104 months of economic expansion in 1960, no one assumed the expansion would end at 105 months.
  • At 118 months no one assumed the end of the “dot.com mania” was coming in the next month. 
  • In December of 2007, no one believed the worst recession since the “Great Depression” had already begun. 

The problem for investors, and the suggestion that “bull markets don’t die of old-age,” is that economic data is always negatively revised in arrears. The chart below shows the recession pronouncements by the National Bureau Of Economic Research (NBER) and when they actually began.

The point here is simple, by the time the economic data is revised to reveal a recession, it will be far too late to do anything about it from an investment perspective. However, the financial market has tended to “sniff” out trouble

The Infections That Kill Old Bull Markets

Infection #1: Interest Rates

As noted by David Rosenberg, with the Fed continuing to hike rates in the U.S., tightening monetary conditions, the previous 3-year time horizon is now substantially shorter. More importantly, the “average” time frame between an initial rate hike and recession was based on economic growth rates which were substantially higher than they are currently.

Furthermore, as interest rates rise, so does the cost of capital. In a heavily leveraged economy, the change in interest expense has been a good predictor of economic weakness. As recently noted by Donald Swain, CFA:

“What if marginal interest expense pressures are the true recession signal (cause of economic weakness) and the yield curve is just a correlated input to that process? If so, for the first time, the Fed is hiking into what is already the most hostile refit period in 35-years.”

The point is that in the short-term the economy and the markets (due to momentum) can SEEM TO DEFY the laws of gravity as interest rates begin to rise. However, as rates continue to rise they ultimately act as a “brake” on economic activity. Think about the all of the areas that are NEGATIVELY impacted by rising interest rates:

  1. Debt servicing requirements reduce future productive investment.
  2. The housing market. People buy payments, not houses, and rising rates mean higher payments. 
  3. Higher borrowing costs which lead to lower profit margins for corporations.
  4. Stocks are cheap based on low-interest rates. When rates rise, markets become overvalued very quickly.
  5. The economic recovery to date has been based on suppressing interest rates to spur growth.
  6. Variable rate interest payments for consumers
  7. Corporate share buyback plans, a major driver of asset prices, and dividend issuances have been done through the use of cheap debt.
  8. Corporate capital expenditures are dependent on borrowing costs.

Infection #2: Spiking Input Costs

When rate hikes are combined with a surge in oil prices, which is a double whammy to consumers, there has been a negative outcome as noted by Peter Cook, CFA last week.

“A better record of predicting recessions is achieved when Fed has hiked rates by 2.00%-2.50%, AND oil prices have at least doubled. The price of money and energy are major financial inputs to financial planning, so when they simultaneously rise sharply, consumers and businesses are forced to retrench. Based on the Fed’s well-communicated strategy, it plans to raise rates another 0.75% during 2018 on top of the previous 1.50% over the past few years. If crude oil stays above $50-60, both conditions for a recession would be met in the second half of 2018.

Yet neither the Fed, or any high-profile economist, is predicting the beginning of a recession during 2019, let alone 2018. Answering the inflation/deflation question correctly is the most important issue of the day for investment portfolios. If recession/deflation arrives before growth/inflation, a major adjustment in expectations, and capital market prices, is coming within the next year.” 

This shouldn’t be surprising.

In the past, when Americans wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates, and lax lending standards, put excess credit in the hands of every American. Such is why, during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth slowed along with incomes.

As I recently discussed with Shawn Langlois at MarketWatch:

“With a deficit between the current standard of living and what incomes, savings and debt increases can support, expectations of sustained rates of stronger economic growth, beyond population growth, becomes problematic.

For investors, that poses huge risks in the market.

While accounting gimmicks, wage suppression, tax cuts and stock buybacks may support prices in the short-term, in the long-term the market is a reflection of the strength of the economy. Since the economy is 70% driven by consumption, consumer indebtedness could become problematic.”

Infection #3 – Valuations

Lastly, it isn’t an economic recession that is truly problematic for investors.

If asset prices rose equally with increases in earnings, in other words the price-to-earnings ratio remained flat, then theoretically “bull markets” would last forever.

Unfortunately, since asset prices are a reflection of investor psychology, or “greed,” it is not surprising that economic recessions reveal the mispricing between the premium investors pay for a stream of earnings versus what they are really worth.  As I noted just recently:

“Bull markets are born on pessimism, grow on skepticism, and die on euphoria.” -Sir John Templeton

Take a look at the chart below which is Robert Shiller’s monthly data back to 1871. The “yellow” triangles show periods of extreme undervaluation while the “red” triangles denote periods of excess valuation.

Not surprisingly, 1901, 1929, 1965, 1999, and 2007 were periods of extreme “euphoria” where “this time is different” was a commonly uttered phrase.

Conclusion

What the majority of mainstream analysis fails to address is the “full-cycle” of markets. While it may appear that “bull markets do not die of old age,” in reality, it is “old age that leaves the bull defenseless against infections.”

It is the impact of an exogenous event on an over-leveraged, extended and over-valued market that eventually leads to its death. Ignoring the “infections,” and opting for “hope,” has always led to emotionally driven mistakes which account for 50% of investor’s under-performance over a 20-year cycle.

With expectations rising the Fed will further tighten monetary policy, the vulnerabilities of an “aged bull market” will be an issue for investors in the future.

“In investing, the man who wins is the man who loses the least.” – Dick Russell

Analysts’ Estimates Go Parabolic – Is The Market Next?

At the end of February, I discussed the impact of the tax cut and reform legislation as it related to corporate profits.

“In October of 2017, the estimates for REPORTED earnings for Q4, 2017 and Q1, 2018 were $116.50 and $119.76. As of February 15th, the numbers are $106.84 and $112.61 or a difference of -$9.66 and -7.15 respectively. 

First, while asset prices have surged to record highs, reported earnings estimates through Q3-2018 have already been ratcheted back to a level only slightly above where 2017 was expected to end in 2016. As shown by the red horizontal bars – estimates through Q3 are at the same level they were in January 2017.  (Of course, “hope springs eternal that Q4 of this year will see one of the sharpest ramps in earnings in S&P history.)”

That was so yesterday.

Despite a recent surge in market volatility, combined with the drop in equity prices, analysts have “sharpened their pencils” and ratcheted UP their estimates for the end of 2018 and 2019. Earnings are NOW expected to grow at 26.7% annually over the next two years.

The chart below shows the changes a bit more clearly. It compares where estimates were on January 1st versus March and April. “Optimism” is, well, “exceedingly optimistic” for the end of 2019.

The surge in earnings estimates gives cover for Wall Street analysts to predict surging asset prices. Buy now before you miss out!

“While earnings season has only just gotten started (only 10% of the S&P 500 companies have reported so far), a whopping 84.6% have beaten their earnings estimates, and 78.8% have beaten their revenue estimates. Those are impressive stats. And this earnings season looks like it could be even better than the lofty expectations going into it. This sets the market up for all-time highs just ahead.” 

Sure, that could well be the case as a momentum-driven market is a very tough thing to kill. Despite the recent “hiccup” over the last month or so, the market remains above it’s 200-day moving average and there are few signs of investor panic currently.

However, there are two major concerns with the current trajectory of earnings estimates.

The first is that Wall Street has historically over-estimated earnings by about 33% on average.

Yes, 84% of companies have beaten estimates so far, which is literally ALWAYS the case, because analysts are never held to their original estimates. If they were, 100% of companies would be missing estimates currently. 

At the beginning of January, analysts overestimated earnings by more than $6/share, reported, versus where they are currently. It’s not surprising volatility has picked up as markets try to reconcile valuations to actual earnings.

Furthermore, the overestimation provides a significant amount of headroom for Wall Street to be disappointed in future, particularly once you factor in the impacts of higher interest rates and slower economic growth. 

But economic growth is set to explode. Right?

Most likely not.

As I discussed last week, the short-term boost to economic growth in the U.S., driven by a wave of natural disasters, is now beginning to fade. However, the same is seen on a global scale as well. To wit:

“The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”

Furthermore, the economy is sensitive to changes in interest rates. This is particularly the case when the consumer, which comprises about 70% of the GDP calculation, is already heavily leveraged. Furthermore, with corporations more highly levered than at any other point n history, and dependent on bond issuance for dividend payments and share buybacks, higher interest rates will quickly stem that source of liquidity. Notice that each previous peak was lower.

With economic growth running at lower levels of annualized growth rates, the “bang point” for the Fed’s rate hiking campaign is likely substantially lower as well. History suggests this will likely be the case. At every point in history where the Fed has embarked upon a rate hiking campaign since 1980, the “crisis point” has come at steadily lower levels.

But even if we give Wall Street the benefit of the doubt, and assume their predictions will be correct for the first time in human history, stock prices have already priced in twice the rate of EPS growth.

There are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until a recession occurs and earnings fall in tandem.

More importantly, the expectation for a profits-driven surge in asset prices fails to conflate with the reality that valuations have been the most important driver of higher stock prices throughout history. Currently, despite surging earnings expectations, market participants are already revaluing equity and high-yield investments.

In our opinion, the biggest mistake that Wall Street is potentially making in their estimates is the differential between “statutory” and “effective” rates. As we addressed previously:

From 1947 to 1986 the statutory corporate tax rate was 49% and the effective tax rate averaged 36.4% for a difference of 12.6%. From 1987 to present, after the statutory tax rate was reduced to 39%, the effective rate has averaged 28.1%, 10.9% lower than the statutory rate.

In reality, a company that earned $5.00 pretax only paid $1.41 in taxes in 2017 on average, leaving an after-tax profit of $3.59, and not $3.25. Under the new tax law that after-tax profit would come in at the $3.95 as stated in the article and the gain would be 10%, or half, of the gain Wall Street expects.”

There is virtually no “bullish” argument that will currently withstand real scrutiny.

  • Yields are rising which deflates equity risk premium analysis,
  • Valuations are not cheap,
  • The Fed is extracting liquidity, along with other Central Banks slowing bond purchases, and;
  • Further increases in interest rates will only act as a further brake on economic growth.

However, because optimistic analysis supports our underlying psychological “greed”, all real scrutiny to the contrary tends to be dismissed. Unfortunately, it is this “willful blindness” that eventually leads to a dislocation in the markets.

Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.

This time will likely be no different.

Will tax reform accrue to the bottom lines of corporations? Most assuredly.

However, the bump in earnings growth will only last for one year. Then corporations will be back to year-over-year comparisons and will once again rely on cost-cutting, wage suppression, and stock buybacks to boost earnings to meet Wall Street’s expectations.

Are stocks ready to go parabolic?

Anything is possible, but the risk of disappointment is extremely high.

Tax Cuts & The Failure To Change The Economic Balance

As we approach “tax day” in the U.S., I wanted to take a moment to revisit the issue of taxes, who pays what, and why the “Tax Cut and Jobs Act” will likely have limited impact on economic growth.

This week, Laura Saunders penned for the WSJ an analysis of “who pays what” under the U.S. progressive tax system. The data she used was from the Tax Policy center which divided about 175 million American households into five income tiers of roughly 65 million people each. This article was widely discussed on radio shows across the country as “clear evidence” recent tax reform was having a “huge effect” on average households and a clear step in “Making America Great Again.”

The reality, however, is far different than the politically driven spin.

First, the data.

“The results show how steeply progressive the U.S. income tax remains. For 2018, households in the top 20% will have income of about $150,000 or more and 52% of total income, about the same as in 2017. But they will pay about 87% of income taxes, up from about 84% last year.”

See, the “rich” are clearly paying more. 

Not really, percentages are very deceiving. If the total amount of revenue being collected is reduced, the purpose of a tax cut, the top 20% can pay LESS in actual dollars, but MORE in terms of percentage. For example:

  • Year 1: Top 20% pays $84 of $100 collected = 84%
  • Year 2: Top 20% pays $78 of $90 collected = 87%

This is how “less” equals “more.” 

So, where is the “less?”

“By contrast, the lower 60% of households, who have income up to about $86,000, receive about 27% of income. As a group, this tier will pay no net federal income tax in 2018 vs. 2% of it last year.”

“Roughly one million households in the top 1% will pay for 43% of income tax, up from 38% in 2017. These filers earn above about $730,000.”

While the “percentage or share” of the total will rise for the top 5%, the total amount of taxes estimated to be collected will fall by more than $1 Trillion for 2018. As Roberton Williams, an income-tax specialist with the Tax Policy Center, noted while the share of taxes paid by the top 5% will rise, the people in the top 5% were the largest beneficiaries of the overhaul’s tax cut, both in dollars and percentages.

Not surprisingly, as I noted previously, income taxes for the bottom 2-tiers of income earners, or roughly 77-million households, will have a negative income tax rate. Why? Because, despite the fact they pay ZERO in income taxes, Congress has chosen to funnel benefits for lower earners through the income tax rather than other channels such as federal programs. Since the recent tax legislation nearly doubled the standard deduction and expanded tax credits, it further lowered the share of income tax for people in those tiers.

The 80/20 Rule

In order for tax cuts to truly be effective, given roughly 70% of the economy is driven by personal consumption, the amount of disposable incomes available to individuals must increase to expand consumption further.

Since more than 80% of income taxes are paid by the top 20%, the reality is tax cuts only have a limited impact on consumption for those individuals as they are already consuming at a level with which they are satisfied.

The real problem is the bottom 80% that pay 20% of the taxes. As I have detailed previously, the vast majority of Americans are living paycheck to paycheck. According to CNN, almost six out of every ten Americans do not have enough money saved to even cover a $500 emergency expense. That lack of savings can be directly attributed to the lack of income growth for those in the bottom 80% of income earners.

So, with 80% of Americans living paycheck-to-paycheck, the need to supplant debt to maintain the standard of living has led to interest payments consuming a bulk of actual disposable income. The chart below shows that beginning in 2000, debt exceeded personal consumption expenditures for the first time in history. Therefore, any tax relief will most likely evaporate into the maintaining the current cost of living and debt service which will have an extremely limited, if any, impact on fostering a higher level of consumption in the economy.

But again, there is a vast difference between the level of indebtedness (per household) for those in the bottom 80% versus those in the top 20%.

The rise in the cost of living has outpaced income growth over the past 14 years. While median household incomes may have grown over the last couple of years, expenses have outpaced that growth significantly. As Stephanie Pomboy recently stated:

” In January, the savings rate went from 2.5% to 3.2% in one month—a massive increase. People look at the headline for spending and acknowledge that it’s not fabulous, but they see it as a sustainable formula for growth that will generate the earnings necessary to validate asset price levels.”

Unfortunately, the headline spending numbers are actually far more disturbing once you dig into “where” consumers are spending their dollars. As Stephanie goes on to state:

“When you go through that kind of detail, you discover that they are buying more because they have to. They are spending more on food, energy, healthcare, housing, all the nondiscretionary stuff, and relying on credit and dis-saving [to pay for it]. Consumers have had to draw down whatever savings they amassed after the crisis and run up credit-card debt to keep up with the basic necessities of life.”

When a bulk of incomes are diverted to areas which must be purchased, there is very little of a “multiplier effect” through the economy and spending on discretionary products or services becomes restricted. This problem is magnified when the Fed hikes short-term interest rates, which increases debt payments, and an Administration engages in a “trade war” which increases prices of purchased goods.

Higher costs and stagnant wages are not a good economic mix.

The Corporate Tax Cut Sham

But this was never actually a “tax cut for the middle-class.”

The entire piece of legislation was a corporate lobby-group inspired “give away” disguised as a piece of tax reform legislation. A total sham.

Why do I say that? Simple.

If the Administration were truly interested in a tax cut for the middle class, every piece of the legislation would have been focused on the nearly 80% of Federal revenue collected from individual income and payroll taxes.

Instead, the bulk of the “tax reform” plan focused on the 8.8% of total Federal revenue collected from corporate taxes. 

“But business owners and CEO’s will use their windfall to boost wages and increase productivity. Right?”

As I showed previously, there is simply no historical evidence to support that claim.

Corporations are thrilled with the bill because corporate tax cuts immediately drop to the bottom lines of the income statement. With revenue growth, as shown below, running at exceptionally weak levels, corporations continue to opt for share buybacks, wage suppression and accounting gimmicks to fuel bottom lines earnings per share. The requirement to meet Wall Street expectations to support share prices is more important to the “C-suite” executives than being benevolent to the working class.

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

The historical evidence provides a very different story than the bill of goods being sold to citizens and investors. There is no historical evidence that cutting corporate tax rates increases economic growth. In fact, as recently noted by Michael Lebowitzthe opposite has been true with high correlation between lower tax rates and slower economic growth. 

With the deficit set to exceed $1 Trillion next year, and every year afterward, the government must borrow money to fund the shortfall. This borrowing effectively crowds out investment that could have funded the real economy.

“Said differently, the money required to fund the government’s deficit cannot be invested in the pursuit of innovation, improving workers skills, or other investments that pay economic dividends in the future. As we have discussed on numerous occasions, productivity growth drives economic growth over the longer term. Therefore, a lack productivity growth slows economic growth and ultimately weighs on corporate earnings.

A second consideration is that the long-term trend lower in the effective corporate tax has also been funded in part with personal tax receipts. In 1947, total personal taxes receipts were about twice that of corporate tax receipts. Currently, they are about four times larger. The current tax reform bill continues this trend as individuals in aggregate will pay more in taxes.

As personal taxes increase, consumers who account for approximately 70% of economic activity, have less money to spend.”

Summary

This issue of whether tax cuts lead to economic growth was examined in a 2014 study by William Gale and Andrew Samwick:

“The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

Again, the timing is not advantageous, the economic dynamics and the structure of the tax cuts are not self-supporting. As Dr. Lacy Hunt recently noted in his quarterly outlook:

“Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for Presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57.0%, respectively, when the 1981 and 2002 tax laws were implemented. 

However, if the household and corporate tax reductions and infrastructure tax credits proposed are not financed by other budget offsets, history suggests they will be met with little or no success.

Since the current Administration has chosen to do the exact opposite by massively increasing spending, having no budget offsets, or slowing the rate of growth of either deficits or debts, the success of tax reform to boost economic growth is highly suspect.

Policymakers had the opportunity to pass true, pro-growth, tax reform and show they were serious about our nations fiscal future, they instead opted to continue enriching the top 1% at the expense of empowering the middle class. 

The outcome will be very disappointing.