“You better tuck that in. You’re gonna’ get that caught on a tripwire.” – Lieutenant Dan, Forrest Gump

There is a popular game called Jenga in which a tower of rectangular blocks is arranged to form a sturdy tower. The objective of the game is to take turns removing blocks without causing the tower to fall. At first, the task is as easy as the structure is stable. However, as more blocks are removed, the structure weakens. At some point, a key block is pulled, and the tower collapses. Yes, the collapse is a direct cause of the last block being removed, but piece by piece the structure became increasingly unstable. The last block was the catalyst, but the turns played leading up to that point had just as much to do with the collapse. It was bound to happen; the only question was, which block would cause the tower to give way?

A Coronavirus

Pneumonia of unknown cause first detected in Wuhan, China, was reported to the World Health Organization (WHO) on December 31, 2019. The risks of it becoming a global pandemic (formally labeled COVID-19) was apparent by late January. Unfortunately, it went mostly unnoticed in the United States as China was slow to disclose the matter and many Americans were distracted by impeachment proceedings, bullish equity markets, and other geopolitical disruptions.

The S&P 500 peaked on February 19, 2020, at 3393, up over 5% in the first two months of the year. Over the following four weeks, the stock market dropped 30% in one of the most vicious corrections of broad asset prices ever seen. The collapse erased all of the gains achieved during the prior 3+ years of the Trump administration. The economy likely entered a recession in March.

There will be much discussion and debate in the coming months and years about the dynamics of this stunning period. There is one point that must be made clear so that history can properly record it; the COVID-19 virus did not cause the stock and bond market carnage we have seen so far and are likely to see in the coming months. The virus was the passive triggering mechanism, the tripwire, for an economy full of a decade of monetary policy-induced misallocations and excesses leaving assets priced well beyond perfection.

Never-Ending Gains

It is safe to say that the record-long economic expansion, to which no one saw an end, ended in February 2020 at 128 months. To suggest otherwise is preposterous given what we know about national economic shutdowns and the early look at record Initial Jobless Claims that surpassed three million. Between the trough in the S&P 500 from the financial crisis in March 2009 and the recent February peak, 3,999 days passed. The 10-year rally scored a total holding-period return of 528% and annualized returns of 18.3%. Although the longest expansion on record, those may be the most remarkable risk-adjusted performance numbers considering it was also the weakest U.S. economic expansion on record, as shown below.

They say “being early is wrong,” but the 30-day destruction of valuations erasing over three years of gains, argues that you could have been conservative for the past three years, kept a large allocation in cash, and are now sitting on small losses and a pile of opportunity with the market down 30%.

As we have documented time and again, the market for financial assets was a walking dead man, especially heading into 2020. Total corporate profits were stagnant for the last six years, and the optics of magnified earnings-per-share growth, thanks to trillions in share buybacks, provided the lipstick on the pig.

Passive investors indiscriminately and in most cases, unknowingly, bought $1.5 trillion in over-valued stocks and bonds, helping further push the market to irrational levels. Even Goldman Sachs’ assessment of equity market valuations at the end of 2019, showed all of their valuation measures resting in the 90-99th percentile of historical levels.

Blind Bond Markets

The fixed income markets were also swarming with indiscriminate buyers. The corporate bond market was remarkably overvalued with tight spreads and low yields that in no way offered an appropriate return for the risk being incurred. Investment-grade bonds held the highest concentration of BBB credit in history, most of which did not qualify for that rating by the rating agencies’ own guidelines. The junk bond sector was full of companies that did not produce profits, many of whom were zombies by definition, meaning the company did not generate enough operating income to cover their debt servicing costs. The same held for leveraged loans and collateralized loan obligations with low to no covenants imposed. And yet, investors showed up to feed at the trough. After all, one must reach for extra yield even if it means forgoing all discipline and prudence.

To say that no lessons were learned from 2008 is an understatement.

Black Swan

Meanwhile, as the markets priced to ridiculous valuations, corporate executives and financial advisors got paid handsomely, encouraging shareholders and clients to throw caution to the wind and chase the market ever higher. Thanks also to imprudent monetary policies aimed explicitly at propping up indefensible valuations, the market was at risk due to any disruption.

What happened, however, was not a slow leaking of the market as occurred leading into the 2008 crisis, but a doozy of a gut punch in the form of a pandemic. Markets do not correct by 30% in 30 days unless they are extremely overvalued, no matter the cause. We admire the optimism of formerly super-intelligent bulls who bought every dip on the way down. Ask your advisor not just to tell you how he is personally invested at this time, ask him to show you. You may find them to be far more conservative in their investment posture than what they recommend for clients. Why? Because they get paid on your imprudently aggressive posture, and they do not typically “eat their own cooking”. The advisor gets paid more to have you chasing returns as opposed to avoiding large losses.

Summary

We are facing a new world order of DE-globalization. Supply chains will be fractured and re-oriented. Products will cost more as a result. Inflation will rise. Interest rates, therefore, also will increase contingent upon Fed intervention. We have become accustomed to accessing many cheap foreign-made goods, the price for which will now be altered higher or altogether beyond our reach. For most people, these events and outcomes remain inconceivable. The widespread expectation is that at some point in the not too distant future, we will return to the relative stability and tranquility of 2019. That assuredly will not be the case.

Society as a whole does not yet grasp what this will mean, but as we are fond of saying, “you cannot predict, but you can prepare.” That said, we need to be good neighbors and good stewards and alert one another to the rapid changes taking place in our communities, states, and nation. Neither investors nor Americans, in general, can afford to be intellectually lazy.

The COVID-19 virus triggered these changes, and they will have an enormous and lasting impact on our lives much as 9-11 did. Over time, as we experience these changes, our brains will think differently, and our decision-making will change. Given a world where resources are scarce and our proclivity to – since it is made in China and “cheap” – be wasteful, this will probably be a good change. Instead of scoffing at the frugality of our grandparents, we just might begin to see their wisdom. As a nation, we may start to understand what it means to “save for a rainy day.”

Save, remember that forgotten word.

As those things transpire – maybe slowly, maybe rapidly – people will also begin to see the folly in the expedience of monetary and fiscal policy of the past 40 years. Expedience such as the Greenspan Put, quantitative easing, and expanding deficits with an economy at full employment. Doing “what works” in the short term often times conflicts with doing what is best for the most people over the long term.

“The process by which money is created is so simple that the mind is repelled.” – JK Galbraith

By formally announcing quantitative easing (QE) infinity on March 23, 2020, the Federal Reserve (Fed) is using its entire arsenal of monetary stimulus. Unlimited purchases of Treasury securities and mortgage-backed securities for an indefinite period is far more dramatic than anything they did in 2008. The Fed also revived other financial crisis programs like the Term Asset-Backed Securities Loan Facility (TALF) and created a new special purpose vehicle (SPV), allowing them to buy investment-grade corporate bonds and related ETF’s. The purpose of these unprecedented actions is to unfreeze the credit markets, stem financial market losses, and provide some ballast to the economy.

Most investors seem unable to grasp why the Fed’s actions have been, thus far, ineffective. In this article, we explain why today is different from the past. The Fed’s current predicament is unique as they have never been totally up against the wall of zero-bound interest rates heading into a crisis. Their remaining tools become more controversial and more limited with the Fed Funds rate at zero. Our objective is to assess when the monetary medicine might begin to work and share our thoughts about what is currently impeding it.

All Money is Lent in Existence.

That sentence may be the most crucial concept to understand if you are to make sense of the Fed’s actions and assess their effectiveness.

Under the traditional fractional reserve banking system run by the U.S. and most other countries, money is “created” via loans. Here is a simple example:

• John deposits a thousand dollars into his bank
• The bank is allowed to lend 90% of their deposits (keeping 10% in “reserves”)
• Anne borrows $900 from the same bank and buys a widget from Tommy
• Tommy then deposits $900 into his checking account at the same bank
• The bank then lends to someone who needs $810 and they spend that money, etc…

After Tommy’s deposit, there is still only $1,000 of reserves in the banking system, but the two depositors believe they have a total of $1,900 in their bank accounts.  The bank’s accountants would confirm that. To make the bank’s accounting balance, Anne owes the bank $900. The money supply, in this case, is $1,900 despite the amount of real money only being $1,000.

That process continually feeds off the original $1,000 deposit with more loans and more deposits. Taken to its logical conclusion, it eventually creates $9,000 in “new” money through the process from the original $1,000 deposit.

To summarize, we have $1,000 in deposited funds, $10,000 in various bank accounts and $9,000 in new debt. While it may seem “repulsive” and risky, this system is the standard operating procedure for banks and a very effective and powerful tool for generating profits and supporting economic growth. However, if everyone wanted to take their money out at the same time, the bank would not have it to give. They only have the original $1,000 of reserves.

How The Fed Operates

Manipulating the money supply through QE and Fed Funds targeting are the primary tools the Fed uses to conduct monetary policy. As an aside, QE is arguably a controversial blend of monetary and fiscal policy.

When the Fed provides banks with reserves, their intent is to increase the amount of debt and therefore the money supply. As such, more money should result in lower interest rates. Conversely, when they take away reserves, the money supply should decline and interest rates rise. It is important to understand, the Fed does not set the Fed Funds rate by decree, but rather by the aforementioned monetary actions to incentivize banks to increase or reduce the money supply.

The following graph compares the amount of domestic debt outstanding versus the monetary base.

Data Courtesy: St. Louis Federal Reserve

Why is QE not working?

So with an understanding of how money is created through fractional reserve banking and the role the Fed plays in manipulating the money supply, let’s explore why QE helped boost asset prices in the past but is not yet potent this time around.

In our simple banking example, if Anne defaults on her loan, the money supply would decline from $1,900 to $1,000. With a reduced money supply, interest rates would rise as the supply of money is more limited today than yesterday. In this isolated example, the Fed might purchase bonds and, in doing so, conjure reserves onto bank balance sheets through the magic of the digital printing press. Typically the banks would then create money and offset the amount of Anne’s default.  The problem the Fed has today is that Anne is defaulting on some of her debt and, at the same time, John and Tommy need and want to withdraw some of their money.

The money supply is declining due to defaults and falling asset prices, and at the same time, there is a greater demand for cash. This is not just a domestic issue, but a global one, as the U.S. dollar is the world’s reserve currency.

For the Fed to effectively stimulate financial markets and the economy, they first have to replace the money which has been destroyed due to defaults and lower asset prices. Think of this as a hole the Fed is trying to fill. Until the hole is filled, the new money will not be effective in stimulating the broad economy, but instead will only help limit the erosion of the financial system and yes, it is a stealth form of bailout. Again, from our example, if the banks created new money, it would only replace Anne’s default and would not be stimulative.

During the latter part of QE 1, when mortgage defaults slowed, and for all of the QE 2 and QE 3 periods, the Fed was not “filling a hole.” You can think of their actions as piling dirt on top of a filled hole.

These monetary operations enabled banks to create more money, of which a good amount went mainly towards speculative means and resulted in inflated financial asset prices. It certainly could have been lent toward productive endeavors, but banks have been conservative and much more heavily regulated since the crisis and prefer the liquid collateral supplied with market-oriented loans.

QE 4 (Treasury bills) and the new repo facilities introduced in the fall of 2019 also stimulated speculative investing as the Fed once again piled up dirt on top of a filled hold.  The situation changed drastically on February 19, 2020, as the virus started impacting perspectives around supply chains, economic growth, and unemployment in the global economy. Now QE 4, Fed-sponsored Repo, QE infinity, and a smorgasbord of other Fed programs are required measures to fill the hole.

However, there is one critical caveat to the situation.

As stated earlier, the Fed conducts policy by incentivizing the banking system to alter the supply of money. If the banks are concerned with their financial situation or that of others, they will be reluctant to lend and therefore impede the Fed’s efforts. This is clearly occurring, making the hole progressively more challenging to fill. The same thing happened in 2008 as banks became increasingly suspect in terms of potential losses due to their exorbitant leverage. That problem was solved by changing the rules around how banks were required to report mark-to-market losses by the Federal Accounting Standards Board (FASB). Despite the multitude of monetary and fiscal policy stimulus failures over the previous 18 months, that simple re-writing of an accounting rule caused the market to turn on a dime in March 2009. The hole was suddenly over-filled by what amounted to an accounting gimmick.

Summary

Are Fed actions making headway on filling the hole, or is the hole growing faster than the Fed can shovel as a result of a tsunami of liquidity problems? A declining dollar and stability in the short-term credit markets are essential gauges to assess the Fed’s progress.

The Fed will eventually fill the hole, and if the past is repeated, they will heap a lot of extra dirt on top of the hole and leave it there for a long time. The problem with that excess dirt is the consequences of excessive monetary policy. Those same excesses created after the financial crisis led to an unstable financial situation with which we are now dealing.

While we must stay heavily focused on the here and now, we must also consider the future consequences of their actions. We will undoubtedly share more on this in upcoming articles.

As the pandemic drives markets to the 2018 lows, certain relationships in trends between the markets and the COVID-19 virus are evident.  As social distancing increases, markets continue to fall. So, by looking at the expected breakout levels of the virus, we can assess possible market reactions. The chart below shows the inverse correlation between the expected peaks of the virus and potential lows in the markets: 

Source: FIPhysician – & Patrick Hill  – 3/18/20

In the COVID-19 – SPX model above, the steep red line is a forecast of new cases if social distancing were not in place.  The green line shows how social distancing will flatten the curve of new cases. The blue curve shows how growth in the pandemic may unfold doubling every 4 – 7 days.  The lower chart shows how social distancing correlates to movements in the SPX. As the number of cases peak, there is a related trough in the SPX. Looking at present levels, we are likely to see more selling as the number of cases increases to a possible low of 2000 in the May-June time frame.

Epidemiologists currently forecast the COVID -19 pandemic will unfold in two waves, with the current breakout and remission during the summer followed by a possible second breakout in the fall and winter of this year.  Researchers think the closest analog to the COVID -19 pandemic is the Spanish Flu in 1918, which came roaring back the following winter resulting in a second wave of even greater infections and death. 

The first blue dot shows where the SPX is today at this early stage in the pandemic.  The SPX index may continue to fall as the economic damage increases and GDP declines in the first and second quarters. Two consecutive declines will officially put the economy in a recession.  

The SPX may fall to 2030 in this first wave, which represents a Fibonacci retracement of 50 % from the 2008 low to the 2020 peak.  From there, markets may rebound back up to 2350, a Fibonacci retracement of 61% as the virus breakout fades, relief rally emerges, and economic activity picks up.  However, as this occurs, higher interest rates from massive stimulus spending may weigh on financial markets, as seen in the spike of bond yields, the decline in gold prices and other safe haven assets. 

Consumers who are already financially stretched are being furloughed or laid off, which will trigger loan defaults.  Finally, corporations are now at the highest level of debt since 2008 and are experiencing a steep decline in sales, causing a cash squeeze leading to layoffs.  The most important consideration is that the virus is exposing the heavy reliance on debt on major institutions and consumers in our economic system.

The slide into a recession is evident in announced layoffs by significant corporations. Marriott and other hotels have announced thousands of layoffs. Other hospitality industry companies will follow. Harley-Davidson, GM, Ford, Fiat Chrysler, Nissan, and Tesla have all suspended manufacturing for several weeks in the U.S. Thousands of workers are on furlough until manufacturing resumes. There is a growing risk consumer demand may not return to pre coronavirus levels forcing permanent layoffs.

While manufacturing is 30% of GDP, services contribute 70% of GDP.  Many services can be offered online or via web conferencing.  The present social distancing experiment will provide significant insights into how well the economy can perform when many knowledge workers are working from home.  If working from home is successful, we expect to see more companies permanently move employees to their homes to reduce office space and cut expenses. This has grave implications for the commercial real estate industry and investors of those properties. 

The diverse U.S. economy is likely to recover quicker than the world economy.  However, an earnings recovery may stall due to the fact most S&P 100 companies derive 55% of their sales from overseas and 60% of their profits from international markets.  

Looking at a possible second virus wave in the fall, it is likely that economic damage will grow worse due to increasing unemployment, declining corporate spending, falling consumer spending, and a resumption of social distancing. The second wave fits a decline model seen in 2000 from the Y2K software bug scare.  That crisis was an external event, causing a demand shock, though little supply shock.  The bottom for the NDX did not happen until 18 months after the market peak. The virus seems to be compressing the market drop period as there have been three trading halts of 7% in the markets in just eight days of trading.  SPX support is near 1810 – 1867 in 2016, just above the Fibonacci 38% level of 1708.

In our post of February 14^th about the coronavirus triggering a downturn, we saw the strong possibility of the economy sliding into a recession.  In the post we noted that Allianz Chief Economic Advisor, Mohammed El-Arian observed that we are likely headed into a U or L shaped recession:

“…analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”

Hope is not a strategy. Of course, we hope the virus is contained, lives saved, and the economy can weather the stress on corporations and consumers.  However, as long term investors, we need to look at the reality of what may happen based on research and plan our strategic investments accordingly. Plan for the worst, and hope for the best.

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Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

As if waking up to an economic nightmare, investors see headlines like these and many others flashing across their Bloomberg terminals:

• Facebook says Oculus headphone production will be delayed due to virus
• Apple extends country wide store closing for another week
• Foxconn delays iPhone production
• Qualcomm cuts production forecast due to virus uncertainty
• Starbucks announces China store closures through Lunar New Year, uncertain when they may reopen
• US Steel flashes a warning of a cut in demand
• Nike shoe production halted
• Under Armour missed on sales, and their outlook is weak. They partially blamed the Corona Virus outbreak.
• IEA forecasts drop in oil demand this quarter- first time in a decade

The seemingly never ending list of delays, disruptions, and cuts rolls on from retail to high technology. Even services are impacted as flights and train trips are canceled within and to and from China.  While some technology-based services are provided over the Internet service, restaurants, training, and consulting, as examples, must be performed in person.  Manufacturing operations require workers to be at the factory to produce products. Thus, manufacturing is much more acutely affected by quarantines, shutdowns, transportation disruption, and other government actions.

It is as if an economic tsunami is rolling over the global economy. China’s economy was 18 % of world GDP in 2019.  For most S & P 100 corporations, the Asian giant is their fastest growing market at 20 – 30 % per year.  Even more critical, China has become the hub of world manufacturing after entering the World Trade Organization in 2000. Over the past two decades, U.S. corporations have relocated manufacturing to China to leverage an inexpensive labor force and modern business infrastructure.

Source: The Wall Street Journal – 2/7/20

Prior to the epidemic, world trade had begun to slow as a result of the China – U.S. trade war and other tariffs.  World trade for the first time since the last recession has turned negative.

Source: Haver Analytics, The Wall Street Journal, The Daily Shot – 1/19/20

Based on severity estimates, analysts have forecasted the impact on first-quarter China GDP growth. In the chart below from Fitch Ratings, growth for first quarter drops almost in half and for year growth drops to 5.2 % if containment is delayed:

Sources: The Wall Street Journal, The Daily Shot – 2/6/20

When news of the virus first was announced, the market sustained a quick modest decline. The next day, investors were reassured by official news from China and the World Health Organization that the virus could be contained. Market valuations bounced on optimism that the world economy would see little to no damage in the first quarter of 2020.  Yet, there is growing skepticism that the official tolls of the virus are short of reality. Doctors report that at the epicenter of Wuhan that officials are grossly underestimating the number of people infected and dead. The London School of Hygiene and Tropical Medicine has an epidemic model indicating there will be at least 500,000 infections at the peak in a few weeks far greater than the present 45,000 officially reported.

The reaction, and not statements, of major governments to the epidemic hint that the insider information they have received is far worse and uncertain.  U.S. global airlines have canceled flights to China until mid-March and 30 other carriers have suspended flights indefinitely – severely reducing business and tourist activities.  The U.S. government has urged U.S. citizens to leave the country, flown embassy staff and families back to the U.S., and elevated the alert status of China to ‘Do Not Travel’ on par with Syria and North Korea. All of these actions have angered the Chinese government. While protecting U.S. citizens from the illness it adds stress to an already tense trade relationship. To reduce trade tension, China announced a relaxation of import tariffs on $75 billion of U.S. goods, reducing tariffs by 5 to 10 %.  President Xi on a telephone call with President Trump committed to complete all purchases of U.S. goods on target by the end of the year while delaying shipments temporarily.  It remains to be seen if uncontrolled events will drive a deeper trade wage between the U.S. and China.

Inside China, chaos in the supply chain operations is creating great uncertainty. Workers are being told to work from home and stay away from factories for at least for another week beyond the Lunar New Year and now well into late-February.  Foxconn and Tesla announced plant openings on February 10^th, yet ramping up output is still an issue. It will be a challenge to staff factories as many workers are in quarantined cities and train schedules have been curtailed or canceled.  Many factories are dependent on parts from other cities around the country that may have more severe restrictions on transportation and/or workers reporting to work. Thus, even when a plant is open, it is likely to be operating at limited capacity.

On February 7^th, the Federal Reserve announced that while the trade war pause has improved the global economy, it cautioned that the coronavirus posed a ‘new threat to the world economy.’  The Fed is monitoring the situation. The central bank of China infused CNY 2 trillion in the last four weeks to provide fresh liquidity.  The liquidity will help financially stretched Chinese companies survive for a while, but they are unlikely to be able to continue operations unless production and sales return to pre epidemic levels quickly.

Will the Federal Reserve really be able to buffer the supply chain disruption and sales declines in the first quarter of 2020?  The Fed already seems overwhelmed, keeping a $1+ trillion yearly federal deficit under control and providing billions in repo financing to banks and hedge funds causing soaring prices in risk assets. While the Fed may be able to assist U.S. corporations with liquidity through a tough stretch of declining sales and supply chain disruptions, it cannot create sales or build products.

Prior to the virus crisis, CEO Confidence was at a ten year low.  Then, CEO confidence levels improved a little with the Phase One trade deal driving brighter business prospects for the coming year. Now, a possible black swan epidemic has entered the world economic stage creating extreme levels of sales and operational uncertainty.  Marc Benioff, CEO of Salesforce, expresses the anxiety many CEOs feel about trade:

 “Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”

Adding to the uncertainty is a deteriorating political environment in China.  During the first few weeks of December, local Wuhan officials denounced a doctor that was calling for recognition of the new virus. He later died of the disease, triggering a social media uproar over the circumstances of his treatment. Many Chinese people have posted on social media strident criticisms of the delayed government response.  Academics have posted petitions for freedom of speech, laying the blame on government censors for making the virus outbreak worse.  The wave of freedom calls is rising as Hong Kong protester’s messages seem to be spreading to the mainland. The calls for freedom of speech and democracy are posing a major challenge to President Xi.  Food prices skyrocketed by 20 % in January with pork prices rising 116 % adding to consumer concerns. Political observers see this challenge to government policies on par with the Tiananmen Square protests in 1989. The ensuing massacre of protestors is still in the minds of many mainland people. As seems to be true of many of these events that it is not the crisis itself, but the reaction and ensuing waves of social disorder which drive a major economic impact.

Oxford Economics has forecast a slowdown in US GDP growth in the first quarter of 2020 to just .6 %

Sources: Oxford Economics, The Wall Street Journal, The Daily Shot – 2/6/20

Will U.S. GDP growth really be shaved by just .4 %?  If we consider the compounding effect of the epidemic to disrupt both demand and supply, the social chaos in China challenging government authority (i.e., Hong Kong), and a lingering trade war – these factors all make a decline into a recession a real and growing possibility.  We hope the epidemic can be contained quickly and lives saved with a return to a more certain world economy.  Yet, 1930s historical records show rising world nationalism, trade wars, and the fracturing of the world order does not bode well for a positive outcome. Mohammed A. El-Arian. Chief Economic Advisor at Allianz in a recent Bloomberg opinion warns of a U shaped recession or worse an L :

“I worry that many analysts do not fully appreciate the notable differences between financial and economic sudden stops. Rather than confidently declare a V, economic modelers need more time and evidence to assess the impact on the Chinese economy and the related spillovers – a consideration that is made even more important by two observations. First, the Chinese economy was already in an unusually fragile situation because of the impact of trade tensions with the U.S. Second, it has been navigating a tricky economic development transition that has snared many countries before China in the “middle income trap. All this suggests it is too early to treat the economic effects of the coronavirus on China and the global economy as easily containable, temporary and quickly reversible. Instead, analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”

Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

A recent article on MarketWatch by Sanjib Saha caught my attention:

“After taking the Series 65 exam last February, I set a goal for 2019: Help 10 friends and family members with their finances. Instead of giving specific investment advice, I wanted to educate them on money matters. I knew that they would benefit from one-on-one discussions, well-regarded books, educational videos and credible websites.”

Think about that for a moment. Here is a young man, who grew up during the longest bull market in history, just took his exam last year, has no real investment experience to speak of, and is now giving advice to people with no investment knowledge.

What could possibly go wrong?

While the majority of the article is grossly misinformed and a regurgitation of the “bullish mantras,” there was one paragraph that jumped out with respect to investment success and failure over time. To wit:

“Many years ago, Aisha, received a windfall that she needed to invest. She interviewed a few financial advisers and went with someone who had an impressive job title, a long list of designations and a friendly demeanor. She regularly reviewed her portfolio with the adviser, but never considered there might be performance problems. After all, a paid professional ought to do better than the market, not worse—or so she thought.

As it turned out, her portfolio had more than doubled over 16½ years.Aisha was impressed, until she backtested an identical asset allocation—one with half U.S. stocks and half corporate bonds. A 50-50 allocation consisting of just two broadly diversified index funds would have quadrupled her money over the same holding period. She stared at the results in disbelief. The opportunity cost was huge.”

The Comparison Trap

This is one of the biggest tools used by financial advisors to get clients to switch their accounts over to a “better” program. Let me explain.

Comparison is the cause of more unhappiness in the world than anything else. Perhaps it is inevitable that human beings as social animals have an urge to compare themselves with one another. Maybe it is just because we are all terminally insecure in some cosmic sense. Social comparison comes in many different guises. “Keeping up with the Joneses,” is one well-known way.

Think about it this way.

If your boss gave you a Mercedes as a yearly bonus, you would be thrilled, right? However, what if you found out shortly afterward that everyone else in the office got two cars.

WTF? Now, you are ticked.

But really, are you deprived of getting a Mercedes? Shouldn’t that enough?

Comparison-created unhappiness and insecurity is pervasive, judging from the amount of spam touting everything from weight-loss to plastic surgery. The basic principle seems to be that whatever we have is enough, until we see someone else who has more. Whatever the reason, comparison in financial markets can lead to remarkably bad decisions.

It is this ongoing measurement against some random benchmark index which remains the key reason why investors have trouble patiently sitting on their hands, letting whatever process they are comfortable with, work for them. They get waylaid by some comparison along the way and lose their focus.

If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that “everyone else” made 14%, you’ve now made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy.

Therein lies the dirty little secret. Money in motion creates revenue. The creation of more and more benchmarks, indexes, and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.

Aisha, for example, was completely happy with doubling her money over the last 16-years, until our young, inexperienced, newly minted financial advisor showed her “what she could have had.” Now she will make decisions which will potentially increase the amount of risk she is taking in the second most expensive bull market in history.

Our Worst Enemy

I have written about the psychological issues which impede investors returns over longer-term time frames in the past. The two biggest factors, according to Dalbar Research, which lead to chronic investor underperformance over time are:

• Lack of capital to invest, and;

• Psychological behaviors

Psychological factors account for fully 50% of investor shortfalls in the investing process. Of course, not having the capital to invest is equally important.

These factors, as shown by data from Dalbar, lead to the lag in performance between investors and the markets over all time periods.

Behavioral biases are an issue which remains little understood and accounted for when individuals begin their investing journey. There are (9) nine of these behavioral biases specifically which impact investors the most.

• 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.

These cognitive biases impair our ability to remain emotionally disconnected from our money. As a consequence, we are continually lured into making decisions which are inherently bad for our long-term outcomes.

The Advisor’s Role

These psychological and behavioral issues are exceedingly difficult to control and lead us regularly to making poor investment decisions over time. But this is where the role of an “experienced advisor” should be truly defined and valued.

While the performance chase, a by-product of the very behavioral issues we wish to control, leads everyone to seek out last years “hottest” performing manager or advisor, this is not really the advisor’s main role. The role of an advisor is NOT beating some random benchmark index or to promote a “buy and hold” strategy. (There is no sense in paying for a model you can do yourself.)

Jason Zweig summed it well:

“The only legitimate response of the investment advisory firm, in the face of these facts, is to ensure that it gets no blood on its hands. Asset managers must take a public stand when market valuations go to extremes — warning their clients against excessive enthusiasm at the top and patiently encouraging clients at the bottom.”

Given that individuals are emotional and subject to emotional swings caused by market volatility, the advisors role is not only to be a portfolio manager, but also a psychologist. Dalbar suggested four successful practices to reduce harmful behaviors:

1. Set Expectations Below Market Indices: Change the threshold at which the fear of failure causes investors to abandon an investment strategy. Set reasonable expectations and do not permit expectations to be inferred from historical records, market indexes, personal experiences or media coverage. The average investor cannot be above average. Investors should understand this fact and not judge the performance of their portfolio based on broad market indices.
2. Control Exposure to Risk: Include some form of portfolio protection that limits losses during market stresses. Explicit, reasonable expectations are best set by agreeing on a goal that consists of a predetermined level of risk and expected return. Keeping the focus on the goal and the probability of its success will divert attention away from frequent fluctuations that lead to imprudent actions
3. Monitor Risk Tolerance: Periodically reevaluate investor’s tolerance for risk, recognizing that the tolerance depends on the prevailing circumstances and that these circumstances are subject to change. Even when presented as alternatives, investors intuitively seek both capital preservation and capital appreciation. Risk tolerance is the proper alignment of an investor’s need for preservation and desire for capital appreciation. Determination of risk tolerance is highly complex and is not rational, homogenous nor stable.
4. Present Forecasts In Terms Of Probabilities: Simply stating that past performance is not predictive creates a reluctance to embark on an investment program. Provide credible information by specifying probabilities, or ranges, that create the necessary sense of caution without negative effects. Measuring progress based on a statistical probability enables the investor to make a rational choice among investments based on the probability of reward.

The challenge, of course, it understanding that the next major impact event, and market reversion, will NOT HAVE the identical characteristics of the previous events. This is why comparing today’s market to that of 2000 or 2007 is pointless. Only the outcome will be the same.

One thing that all the negative behaviors have in common is that they can lead investors to deviate from a sound investment strategy which was narrowly tailored towards their goals, risk tolerance, and time horizon.

The best way to ward off the aforementioned negative behaviors is to employ a strategy that focuses on one’s goals and is not reactive to short-term market conditions. The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.

The reality is that the majority of advisors are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high.

When the impact event occurs, advisors who are prepared to handle responses, provide clear messaging, and an action plan for both conserving investment capital and eventual recovery will find success in obtaining new clients.

The “do-it-yourself” crowd will also come to learn the value of experience. When the impact event occurs, the losses in passive investments, “yield-chase” investments, and ETF’s will be substantially larger than individuals currently imagine. Those losses will permanently impair individuals ability to obtain their financial goals.

If you don’t believe me, then explain why, with 30 of the last 40 years in major bull market trends, is a large majority of the population woefully underfunded for retirement?

The reason is that investing is not simple. If it was, everyone would be rich. The reality is that whatever gains investors have garnered over the last decade will be largely wiped away by the next impact event.

Of course, this is the sad history of individual investors in the financial markets as they are always “told to buy” but never “when to sell.”

You can do better.

Piper Jaffray forecasts by year end 2020, the S&P 500 (SPX) will hit 3600, a 12.8 % increase. Of eighteen analysts interviewed by Marketwatch only three forecasters expect a decline for the SPX. Will the SPX reach 3600?  The SPX has soared over 400 % from a low of 666 in 2009 to over 3200 at the close of 2019. Mapping the SPX ten year history onto a psychology market cycle map of growth and decline phases poses interesting questions. As the market has zoomed over 400% upwards over ten years, it is clearly in the Mania Phase. Yet, the US economy is growing at the slowest rate of any economic recovery since WWII at 2.2 % GDP per year, why the disconnect?

Source: Patrick Hill – 12-31-19

One reason for the disconnect is investment analysts and the media lead investors to believe there is no downside risk. On New Year’s Eve, Goldman Sachs released a prediction for 2020 claiming that the ‘tools of the Great Moderation’ (Fed policy shift) begun 30 years ago low-interest rates, low volatility, sustainable growth and muted inflation are still in place and were only interrupted by the 2008 financial crisis. Plus we would add the Dotcom crash. GS concluded that the economy ‘was nearly recession-proof.’

The mainstream financial media also feed the Mania Phase with stories like Goldman Sachs declaring the Great Moderation is working with our economy in a ‘new paradigm’. We are to believe there will not be a recession because our policymakers have the economy under control.  Really?  With over $17 trillion of negative debt worldwide to keep the world economy going, central banks have succeeded in sustaining worldwide GDP at 1 – 2 % and falling as of late! For the SPX market to not descend into the Blow Off phase, investors will need to continue to believe in six economic myths:

1. The Growth Phase of the Economic Cycle is Continuing
2. Consumers Will Bailout the Economy
3. The Fed Will Keep the Economy Humming
4. If the Fed Fails Then the Federal Government Will Provide Stimulus
5. The Trade War Won’t Hurt Global Growth
6. The Economy and Markets Are Insulated from World Politics

Let’s look at each myth that is likely to affect portfolio and market performance in the next year.  This analysis is based on research data of economic, social, government, business trends and observation of markets and the economy. If markets are to continue to climb, either policymakers must solve difficult issues or investors must continue to believe these myths are true. The first myth establishes a critical framework for viewing all economic activity. We are actually at the end of the growth phase of the economic cycle; here is why.

Myth 1. The Growth Phase of the Economic Cycle is Continuing

The Fed has reported that the economy is still in ‘mid-cycle’ phase.  We differ with this position as several indicators show the economy is reaching the end of its growth cycle and ready to revert to the mean. As GDP is driven 70 % by consumers, let’s look at what is really happening to consumers.  The ratio of current consumer conditions minus consumer expectations is at levels seen just before prior recessions not mid-stage growth economies.

Sources: The Conference Board, The Wall Street Journal, The Daily Shot – 6/14/19

In the chart below, consumers are stretched as loan default rates are rising despite a 50-year low unemployment rate. Rising delinquencies tend to signal rising unemployment and economic decline is likely in the near future.

Sources: Deutsche Bank, Bureau of Labor Statistics, The Wall Street Journal, The Daily Shot – 6/4/19

Of major concern is that the manufacturing sector is now in a recession based on five months of ISM reports below the 50 % economic expansion benchmark. The overall contraction is validated as 70 % of manufacturing sub-sectors are contracting as noted in the report below.  While the US economy is primarily driven by services, the manufacturing sector has a multiplier effect on productivity, support services, and employment with high paying jobs. Note the contraction in sub-sectors is reaching levels last seen before recessions.

            Sources Oxford Economics, The Wall Street Journal, The Daily Shot – 12-20-19

There are other indicators pointing to the end of the growth phase.  For example, the inversion of the 2 – 10 yield curve last summer is now steepening – often seen before an economic slowdown. Another indicator is the number of firms with negative earnings launching IPOs in 2019 was at levels not seen since 2000. Finally, productivity and capital investments are at ten year lows.

Myth 2.  Consumers Will Bailout the Economy

Market pundits have been quick to rely on the consumer to continue spending at growth sustaining rates.  Yet, budgets for the middle class are squeezed as consumers cope with student loan debt payments, new car payments, health care bills, and credit card debt.  The Bloomberg Personal Finance Index dropped significantly in October:

Source: Bloomberg, The Wall Street Journal, The Daily Shot – 11/10/19

Car loans now span seven years on average versus five years a few years ago. Further, the new loans ‘roll in’ debt from previous car purchases due to negative equity in the owner’s trade-in vehicle.  Vehicle price increases up to 10 % over the last year for both cars and trucks add to the debt burden.  Car debt is beginning to weigh on consumers as delinquencies are climbing:

Sources: NY Federal Reserve, The Wall Street Journal, The Daily Shot – 10/29/19

Today, credit card rates are running at a ten-year peak of 17 – 22 % have seen no relief despite the Fed cutting rates.  There is a record spread between the Federal Funds rate and credit card rates as banks seek new revenue sources beyond making loans. Many consumers are turning to credit cards to pay bills to sustain their lifestyle as their wages are not keeping up with rising living costs.

In addition, consumers are increasingly working at more than one job to be sure they can pay their bills.

Sources: Deutsche Bank, Bureau of Labor Statistics, The Wall Street Journal, The Daily Shot – 10/21/19

Workers need to take on multiple jobs in the gig economy. McKinsey & Company estimates that 52 million people are gig workers or a third of the 156 million person workforce. Contractors have no job security.  Gig workers often receive hourly wages with no health, retirement or other benefits. The lack of benefits means they have limited or no financial safety net in the event of an economic slowdown.

There are other key indicators of consumer financial distress, for example, consumer spending on a quarter over quarter basis has continued to decline, Bankrate reports that 50 % of workers received no raise in the last year.  Real wages (taking into account inflation) for 80 % of all workers have been stagnant for the past twenty years.  Uncertain economic forces are putting consumers in a financial bind, for more details, please see our post: Will the Consumer Bailout the Economy?

Myth 3.  The Fed Will Keep the Economy Humming

The Fed has said it will do whatever necessary to keep the economy growing by keeping interest rates low and injecting liquidity into the financial system. However, a survey on Fed actions shows that 70 % of economists interviewed believe the Fed is running out of ammo to turnaround the economy.

Sources: The Wall Street Journal, The Daily Shot – 12-30-19

We agree with their perspective that the Fed is entering an economic space where no central bank has gone before.  In the past, the Fed lowered rates when an economic downturn was evident. Just prior to earlier recession’s interest rates were at a higher starting level of at least 4 – 5 %.  Plus, today the Fed has returned to pumping liquidity into the economy via its repo operation and QE as shown below.

Sources: The Federal Reserve of St. Louis, The Wall Street Journal, The Daily Shot – 12/30/19

The International Bureau of Settlements (BIS) disclosed in their analysis of recent Fed repo operations that funding supported not only banks but hedge funds. A key concern is the nature of the hedge fund bailout. How steep is the loss being mitigated? Is there a possibility of contagion? Is more than one hedge fund involved?  Should the Fed be bailing out hedge funds that are overextended due to speculation? The Fed is already using its tools at the height of the current economic growth cycle. The Fed financial tools are too stretched to turnaround an economy in a recession from multiple financial bubbles bursting.

The Fed continues to declare that inflation is at 2.1 %, missing the reality of what consumers are actually paying for goods and services.  We find from industry research that finds inflation is likely in the 6 – 10% range. Inflation should be defined as price increases of goods and services that consumers buy, not inflation defined by a formula to suit political needs. Using inflation lifestyle ‘cost of living’ data, which is not transparent or available for audit does not meet the foundational data needs of investors.  Gordon Haskett Research Advisors conducted a study by purchasing a basket of 76 typical items consumers frequently buy at Walmart and Target.  Their study showed that from June 2018 to June 2019, prices increased by about 5.5%. 

Other industry research supports inflation running at a much higher level than government figures. On a city by city basis, Chapwood has developed an index for 500 items in major metropolitan areas of the US.  Chapwood reports the average national inflation level to be about 10 %.  Note inflation is compounded; for example, in San Jose a five year average price increase of 13% is for each year. An item costing $1.00 would cost $1.13 the next year and then $1.28 the third year and so forth. It is likely workers caught in a squeeze between stagnant wages and 10 % inflation will not be able to continue to sustain present levels of economic growth.

Real inflation at 6 – 10 % has major policy, portfolio, and social implications.  For example, with the ten year Treasury Bond at 1.90% and inflation at 6 %, we are actually living in a ’de facto negative interest’ economy of – 4.10 %.  Higher inflation levels fit the financial reality of what workers, portfolio managers, and retirees are facing in managing their finances.  Many workers must take multiple jobs and develop a ‘side hustle’ to just keep up with inflation much less get ahead. For portfolio managers, they must grow their portfolio at much higher rates than was previously thought just to maintain portfolio value.  Finally, for retirees on a fixed income portfolio it is imperative they have additional growth income sources or part-time work to keep up with inflation eating away at their portfolio. For more details on our analysis of a variety of inflation, categories see our post: Is Inflation Really Under Control?

One additional assumption about Fed intervention repeated by many analysts is the Fed liquidity injections mean that corporate sales and profits will bounce back.  For some financially sensitive industries this argument may be true. For other firms with excellent credit ratings, they may be able to obtain low-interest loans to ride out falling sales. But, the reality is that corporations build and sell products based on demand. If demand falls, low-interest loans will not increase sales.  Only new products, new channels, reduced pricing, marketing and other initiatives will revive sales.

Myth 4.  If the Fed Fails Then the Federal Government Will Provide Stimulus

European Central Bank leaders have called on European governments to provide economic stimulus for their markets.  Picking up on this idea, analysts have proposed the US government move on infrastructure and other spending programs. However, tax cuts, low-interest rates, stock buybacks, and record corporate debt offerings have shifted a huge balance of world-wide wealth to the private sector.  For 40 years, there has been a significant increase in private capital worldwide while public wealth has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al. – 2018

Essentially, central banks, Wall Street, and governments have built monetary and economic systems that have increased private wealth at the expense of public wealth.  The lack of public capital makes the creation of major levels of public goods and services nearly impossible. The US government is now running $1 trillion yearly deficits with public debt at record levels not seen since WWII and total debt to GDP at all-time highs. The development of public goods and services like basic research and development, education, infrastructure, and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions.  Congress may pass an ‘infrastructure’ bill in 2020 but given the election, it is likely to be lightly funded to pass both houses of Congress and receive the president’s signature.

Myth 5.  The Trade War Won’t Hurt Global Growth

By closing the Phase One trade deal, the market has been sighing with relief with observers declaring that trade will resume a growth track.  Yet, the Phase One deal is not a long term fix. If anything, the actions on the part of both governments have been to dig in for the long term.  The Chinese government has taken several key actions in parallel to the deal to move their agenda ahead.

China has quietly raised the exchange rate of their currency to offset some of the impact of still in place tariffs on the U.S. economy.  The government made a major move to block US and foreign companies from providing key technical infrastructure. The technology ministry has told government agencies that all IT hardware and software from foreign firms are to be replaced by Chinese systems within three years. If the Chinese government decides to establish ‘China only’ network standards it may be difficult for US firms to even work with state-sponsored companies or private businesses that must meet China’s only standards. Apple and Microsoft would have to build two versions of their products. One version for the Chinese economy and one for the world.  A critical change is taking place in world trade which is the establishment of a two-block trading world.  China is a key growth market at a 20 % – 30 % increase in sales annually for US multinational companies. For these corporations navigating the trade war will be problematic even with the Phase One agreement.  Our post characterizing this major change in world trade can be found at: Navigating a Two Block Trading World.  

The U.S. has placed sanctions on Chinese sponsored network provider Huawei, effectively limiting the network vendor from US government and private networks.  The Phase One agreement includes the US canceling planned tariffs for December 15^th in 2019 and rolling back tariffs to 7.5 % on $120 billion of goods imposed on September 1^st of last year. Yet, tariffs of 25 % remain in place on $250 billion of Chinese goods.  The Chinese have canceled retaliatory tariffs planned for December 15^th and plan to increase purchases of US goods and services by $200 billion over two years. In addition, China will purchase US agriculture products at a $40 billion rate per year from a baseline of $24 billion in 2017.  If the Chinese follow through on their purchase commitments US companies should see increased sales.  However, history on Chinese purchases shows they forecast large purchases but small purchases are made.

A major trade issue has been created when the US decided not to appoint any new judges to the World Trade Organization court for disputes. The court cannot hear or make decisions on any disputes any longer; meaning countries will resort to free-for-all negotiations on trade disputes.  We expect as economies falter, nationalist policies on trade will gain more popularity and world trade will continue to decline after a slight blip up from the U.S.-China Phase One deal.

Sources: BCOT Research, The Wall Street Journal, The Daily Shot – 12/16/19

Finally, prior to the trade war global trade has been facing major headwinds. Since 2008, global firms have looked to open more international markets to sell their goods, but have met sales resistance causing revenue and profits to be flat or decline.  We expect the flattening of global sales to output to continue and eventually decline as overall world trade falls.

CEOs in a Conference Board survey rate trade as a major concern as they look at a highly uncertain economic picture.  Marc Benioff, CEO of Salesforce, described his concerns at a company all hands meeting last November:

 “Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”

Myth 6. The Economy and Markets Are Insulated from World Politics

Protests have broken out in Hong Kong, Iraq, Iran, Chile, and other world cities while stock markets continue their climb.  Yet, when the U.S. killed a key Iranian general the overnight S &P futures market fell 41 pts before recovering and closing 23 pts lower. The VIX soared 22 % overnight before settling back to close for a 12 % increase at 14.02.  The U.S. – Iran conflict does not seem to be under control with most Middle East analysts predicting a major retaliation by the Iranian government. The price of oil spiked 4 % before settling to a 3.57 % increase on fears the Iranians may attack oil tankers in the Gulf.  An escalating conflict will drive oil prices higher, disturb supply chains and likely tip the world economy into a recession.

We saw during the negotiations for the Phase One trade deal how rumors both in China and the U.S. would send the S & P futures market up or down by 10 – 15 points depending upon whether the news was positive or negative. Algo traders would drop 30k contracts in a matter of seconds to make huge moves in SPX price, while the VIX was at 12.50, supposedly a calm market. The chart below shows how positive and negative news whipsawed the market.

Source: Liz Ann Sonders – Schwab – 12-7-19

Political news not only moves markets but the economy as well.  When the president tweets a tariff threat, consumers and industry move swiftly to buy those goods before their prices go up.  Businesses have to build the product quickly, sell it and they are left with falling sales as future purchases are pulled forward.  Business to business deals are caught up in this constant flip flop on trade policies as well. CEOs must make investment decisions to build a plant in a particular country 1 – 3 years in advance. They must calculate their allocation plans based on inadequate information and in a highly uncertain policy environment.  Often, rather than make an investment decision, executives will wait for the economic clouds to clear.

Summary:

The current bull market run has set record highs continuously.  Yet, as the saying goes: markets go up in stair steps and down in an elevator.  As a selling panic sets in the market goes into a free fall. If an economic myth is revealed by market action, corporate results, economic reports or an event the loss of belief causes the market to fall much faster than a slow stair step up.

The prudent investor will recognize the end of the business cycle is likely underway. It is time to prepare for an economic slowdown and a resulting equity market reversion to the mean. A reversion to the mean quite often requires that markets swing beyond the mean.

The wary investor will ask hard questions of their financial advisor and review corporate reports with an eye on fundamentals. Financial success is likely to result from good risk management and implementation combined with agility to make mid-course corrections.  Investors should test their assumptions based on breaking trends that may impact portfolio performance.  At the same time, constantly flipping investments will lead to poor performance. Allocate funds to different portfolio groups based on long, medium and short term goals to keep from being emotionally swept up in temporary market swings. The key is to be prepared for the unknown, or a black swan event.  Expect the unexpected and consider the advice of market legends like Bernard Baruch:

“Some people boast of selling at the top of the market and buying at the bottom – I don’t believe this can be done. I had bought when things seemed low enough and sold when they seemed high enough. In that way, I have managed to avoid being swept along to those wild extremes of market fluctuations which prove so disastrous.”

Patrick Hill is the Editor of The Progressive Ensign, https://theprogressiveensign.com/ writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

The bull market turned in an impressive gain of over 30% (on a total return basis) in 2019. While not a rarity in market history, it certainly falls into the “outlier” category. Not surprisingly, the media has been quick to jump on the story suggesting that if 2019 was strong, just wait until 2020. To wit:

“BTIG’s Julian Emanuel believes 2020 will be a milestone year. With the major indexes kicking off Christmas week at fresh all-time highs, he’s not ruling out a 22% surge in the S&P 500. 

The reason: Most investors don’t trust the record rally.”

I am not sure such is the case judging by both our “Smart/Dumb Money” and “Investor Positioning Fear/Greed” indices.

One of the primary tenants of investing, other than “buy low and sell high,” is always analyzing BOTH sides of every argument to avoid confirmation bias. Therefore, while many are making the case for being invested in the market, we should at least question the possibility of what could go wrong?

With the S&P 500’s stellar gain for 2019, the case for raising some cash is comprised of three primary issues:

1. 1. The impact of reversions,
   2. Historical length of economic recoveries, and;
   3. Historical returns following years of 30% market returns.

The Impact Of Reversions

There have been numerous studies and discussions on the historical impact to returns due to “reversions to the mean.” However, the impact of reversions remains lost on most individuals as the emotion of “greed” overtakes rationality during strong market advances.

One of the biggest mistakes that individuals make when investing is “not doing the math.” Let’s assume that the S&P 500 is trading at 3000 (nice round number for easy math purposes). If the market advances 30% it would then be trading at 3900 (3000 x 1.3).

However, the “risk,” and inherently the reality for the majority of investors, is that individuals would not “sell out” of their portfolios at the next market peak and would suffer the next 20% decline.

“So what, I am still up 10%.”

That is where the flaw in “the math” comes in. A 20% decline, following a 30% advance, does not leave you holding a 10% gain. In reality, the 30% gain is reduced to just 4%, as the market reverts back to 2600.

In other words, if a 20% correction occurs at any point in the next year, your previous gain would be almost entirely wiped out, not to mention the emotional strain of the decline.

The impact of reversions are devastating to long term portfolio returns, particularly when individuals, as opposed to financial markets, have a finite period within which to save and invest before needing those savings for retirement.

Economic Recoveries & Subsequent Market Returns

However, the real issue is the market is unlikely to correct “just 20%.” The next major market correction will very likely coincide with the next economic recession. (Of course, by simply writing the “R” word, this article will be summarily dismissed by the ‘financial illuminati’ who continue to marvel at the day to day levitation of the market with the inherent belief ‘trees can grow to the sky'”). However, all economic recoveries will eventually contract. The chart below shows every post-recession economic recovery from 1879 to the present.

The statistics are quite interesting:

• Number of economic recoveries = 29
• Average number of months per recovery = 42
• Current economic recovery = 126 months
• Number of economic recoveries that lasted longer than current = 0
• Percentage of economic recoveries lasting 60 months or longer = 20.6%

Think about this for a moment. We are currently experiencing the longest economic recovery in history, with most analysts and economists giving no consideration for a recession in the near future.  This is important because, as stated above, major market corrections occur during economic recessions, and those “reversions” tend to be much larger than 20%. The chart shows each of the past economic recoveries and the subsequent market correction during the inevitable contraction.

The statistics are equally interesting:

• Average number of months of contraction: 14
• Average market declines during all contractions: -29.13%
• Average market decline following top seven economic recoveries: -36%

With these statistics, it is somewhat easy to assess the risk/reward of remaining invested in the markets currently in hopes of further advances. If we assume that the markets reach our target of 3300 before the onset of the next economic contraction, the resulting decline, using the historical average of -36%, would push the markets back down to 2100ish.

In other words, all your gains since 2015 would be wiped away.

30% Gains And Sideways Markets

The following chart shows the annual real returns (capital appreciation only) using monthly data for the S&P 500. The purple bars are years of gains 29% or greater. I then showed the subsequent years following that 30% gain and the P/E cycle (expansion or contraction) they were contained in.

Here are the statistics:

• Number of years the market gained 29% or more:  19
• Average return of 19 markets:  35.65%
• Number of total subsequent years measured: 53
• Average return in subsequent years following a 30% year:  1.48%

What you should notice is that 29%+ return years tended to mark the beginning of a period of both declining rates of annualized returns and typically sideways markets. It is also essential to notice that some of the biggest negative annual returns eventually followed 30% up years.

While it is entirely possible that the markets could “melt up” another 20% from current levels due to the ongoing monetary interventions; history suggests that forward returns not only decline, but bad things have eventually happened.

Go To Cash Now?

I want to be clear that I am not advocating that anyone should go to cash today. The problem with this analysis, unfortunately, is while individuals are unlikely to sell at the top of the market; they are just as unlikely to buy at the bottom. History is replete with market booms and busts and the devastation of individuals along the way.

This is why chasing an all equity benchmark is inherently flawed. Benchmark indexes are riddled with issues that you can not replicate in your portfolio which I discussed in detail in “Active vs. Passive & The Simple Reasons You Can’t Beat An Index:”

The reason that individuals are plagued by these emotional behaviors is due to well-meaning articles espousing stock ownership at cyclical valuation peaks.

Sure, it is entirely possible the current cyclical bull market is not over yet.

Momentum driven markets are hard to kill in the latter stages, particularly as exuberance builds. However, they do eventually end. That is unless the Fed has truly figured out a way to repeal economic and business cycles altogether. As we enter into the next decade, we are likely closer to the next contraction than not. This is particularly the case as the Federal Reserve continues to build a bigger economic void in the future by pulling forward consumption through its monetary policies.

Will the market likely be higher in another decade from now? Maybe. However, if interest rates or inflation rise sharply, the economy moves through a normal recessionary cycle, or if Jack Bogle is right – then things could be much more disappointing. As Seth Klarman from Baupost Capital once stated:

“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

We saw much of the same mainstream analysis at the peak of the markets in 1999, and again in 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were all common themes. Unfortunately, the outcomes were always the same.

Occasionally, problems reveal themselves gradually. A water stain on the ceiling is potentially evidence of a much larger problem. Painting over the stain will temporarily relieve the unsightly condition, but in time, the water stain will return. This is analogous to a situation occurring within the banking system. Almost three months after water stains first appeared in the overnight funding markets, the Fed has stepped in on a daily basis to “re-paint the ceiling” and the problem has appeared to vanish. Yet, every day the stain reappears and the Fed’s work begins anew. One is left to wonder why the leak hasn’t been fixed. 

In mid-September, evidence of issues in the U.S. banking system began to appear. The problem occurred in the overnight funding markets which serve as one of the most important components of a well-functioning financial and economic system. It is also a market that few investors follow and even fewer understand. At that time, interest rates in the normally boring repo market suddenly spiked higher with intra-day rates surpassing a whopping 8%. The difference between the 8% repo rate recorded on September 16, 2019 and Treasuries was an eight standard deviation event. Statistically, such an event should occur once every three billion years.

For a refresher on the details of those events, we suggest reading our article from September 25, 2019, entitled Who Could Have Known: What The Repo Fiasco Entails.  

At the time, it was surprising that the sudden change in overnight repo borrowing rates caught the Fed completely off guard and that they lacked a reasonable explanation for the disruption. Since then, our surprise has turned to concern and suspicion.

We harbor doubts about the cause of the problem based on two excuses the Fed and banks use to explain the situation. Neither are compelling or convincing. 

As we were putting the finishing touches on this article, the Bank of International Settlements (BIS) reported that the overnight repo problems might stem from the reluctance of the four largest U.S. banks to lend to some of the largest hedge funds. The four banks are being forced to fund a massive surge in U.S. Treasury issuance and therefore reallocated funding from the hedge funds to the U.S. Treasury.  Per the Financial Times in Hedge Funds key in exacerbating repo market turmoil, says BIS: “High demand for secured (repo) funding from non-financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades,” – was a key factor behind the chaos, said Claudio Borio, Head of the monetary and economic department at the BIS.

In the article, the BIS implies that the Fed is providing liquidity to banks so that banks, in turn, can provide the hedge funds funding to maintain their leverage. The Fed is worried that hedge funds will sell assets if liquidity is not available. Instead of forcing hedge funds to deal with a funding risk that they know about, they are effectively bailing them out from having to liquidate their holdings. If that is the case, and as the central bank to central bankers the BIS should be well informed on such matters, why should the Fed be involved in micro-managing leverage to hedge funds? It would certainly represent another extreme example of mission creep.

Excuse #1

In the article linked above, we discussed the initial excuse for the funding issues bandied about by Wall Street, the banks, and the media as follows:

“Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons.”

While the excuse seemed legitimate, it made little sense as we surmised in the next sentence:

“We are not convinced by either excuse as they were easily forecastable weeks in advance.”

If the dearth of liquidity in the overnight funding markets was due to predictable, one-time cash demands, the problem should have been fixed easily. Simply replenish the cash with open market operations as the Fed routinely did prior to the Financial Crisis.

Since mid-September, the Fed has elected instead to increase their balance sheet by over $320 billion.  In addition to conducting daily overnight repo auctions, they introduced term repo that extends for weeks and then abruptly restarted quantitative easing (QE).

Imagine your plumber coming into your house with five other plumbers and a bull dozer to fix what you assumed was a leaky pipe.

The graph below, courtesy Bianco Research, shows the dramatic rise in the Fed’s balance sheet since September.

Based on the purported cash shortfall excuse, one would expect that the increase in the Fed’s balance sheet would have easily met demands for cash and the markets would have stabilized. Liquidity hole filled, problem solved.

However, as witnessed by the continuing growth of the Fed’s balance sheet and ever-increasing size of Fed operations, the hole seems to be growing. It is worth noting that the Fed has committed to add $60 billion a month to their balance sheet through March of 2020 via QE. In other words, the stain keeps reappearing and getting bigger despite increasing amounts of paint. 

Excuse #2

The latest rationale used to explain the funding problems revolves around banking regulations. Many Fed members and banking professionals have recently stated that banking regulations, enacted after the Financial Crisis, are constraining banks’ ability to lend to other banks and therefore worsening the funding situation. In the words of Randy Quarles, Federal Reserve Vice Chair for Banking Supervision, in his testimony to the House Financial Services Committee:

“We have identified some areas where our existing supervision of the regulatory framework…may have created some incentives that were contributors”

Jamie Dimon, CEO of JP Morgan, is quoted in MarketWatch as saying the following:

“The turmoil may be a precursor of a bigger crisis if the Fed doesn’t adjust its regulations. He said the liquidity requirements tie up what was seen as excess reserves.”

Essentially, Quarles and Dimon argue that excess reserves are not really excess. When new post Financial Crisis regulatory requirements are factored in, banks only hold the appropriate amount of reserves and are not exceeding requirements.

This may be the case, and if so, the amount of true excess reserves was dwindling several months prior to the repo debacle in September.  Any potential or forecasted shortfalls due to the constraints should have been easily identifiable weeks and months in advance of any problem.

The banks and the Fed speak to each other quite often about financial conditions and potential problems that might arise. Most of the systemically important financial institutions (SIFI banks) have government regulators on-site every day. In addition, the Fed audits the banks on a regular basis. We find it hard to believe that new regulatory restraints and the effect they have on true excess reserves were not discussed. This is even harder to believe when one considers that the Fed was actively reducing the amount of reserves in the system via Quantitative Tightening (QT) through 2018 and early 2019. The banks and the regulators should have been alerting everyone they were getting dangerously close to exhausting their true excess reserves. That did not occur, at least not publicly.

Theories and Speculation

A golden rule we follow is that when we think we are being misled, especially by market participants, the Fed, or the government, it pays to try to understand the motive.  “Why would they do this?” Although not conclusive, we have a few theories about the faulty explanations for the funding shortage. They are as follows:

• The banks and the Fed would like to reduce the regulatory constraints imposed on them in recent years. Disruptions demonstrating that the regulations not only inhibit lending but can cause a funding crisis allow them to leverage lobbying efforts to reduce regulations.
• There may be a bank or large financial institution that is in distress. In an effort to keep it out of the headlines, the Fed is indirectly supplying liquidity to the institution. This would help explain why the September Repo event was so sudden and unexpected. Rumors about troubles at certain European banks have been circulating for months.
• The Fed and the banks grossly underestimated how much of the increased U.S. Treasury debt issuance they would have to buy. In just the last quarter, the Treasury issued nearly $1 trillion dollars of debt. At the same time, foreign sponsorship of U.S. Treasuries has been declining. While predictable, the large amount of cash required to buy Treasury notes and bonds may have created a cash shortfall. For more on why this problem is even more pronounced today, read our article Who Is Funding Uncle Sam. If this is the case, the Fed is funding the Treasury under the table via QE. This is better known as “debt monetization”.
• Between July and November the Fed reduced the Fed Funds rate by 0.75% without any economic justification for doing so. The Fed claims that the cuts are an “insurance” policy to ensure that slowing global growth and trade turmoil do not halt the already record long economic expansion. Might they now be afraid that further cuts would raise suspicion that the Fed has recessionary concerns? QE, which was supposedly enacted to combat the overnight funding issues, has generously supported financial markets in the past. Maybe a funding crisis provides the Fed cover for QE despite rates not being at the zero bound. Since 2008, the Fed has been vocal about the ways in which market confidence supports consumer confidence. 

The analysis of what is true and what is rhetoric spins wildly out of control when we allow our imaginations to run. This is what happens when pieces do not fit neatly into the puzzle and when sound policy decisions are subordinated to public relations sound bites. One thing seems certain, despite what we are being told, there likely something else is going on.

Of greater concern in this matter of overnight funding, is the potential the Fed and banks were truly blindsided. If that is the case, we should harbor even deeper concern as there is likely a much bigger issue being painted over with temporary liquidity injections.

Summary

In the movie The Outlaw Josey Wales, one of the more famous quotes is, “Don’t piss down my back and tell me it’s raining.”

We do not accept the rationale the Fed is using to justify the reintroduction of QE and the latest surge in their balance sheet. Although we do not know why the Fed has been so incoherent in their application of monetary policy, our theories offer other ideas for thinking through the monetary policy maze. They also have various implications for the markets, none of which should be taken lightly.

We are just as certain that we are not entirely correct as we are certain that we aren’t entirely wrong. Like the water spot on the ceiling, financial market issues normally reveal themselves gradually. Prudent risk management suggests finding and addressing the source of the problem rather than cosmetics. We want to reiterate that, if the Fed is papering over problems in the overnight funding market, we are left to question the Fed’s understanding of global funding markets and the global banking system’s ability to weather a more significant disruption than the preview we observed in September.

In our RIA Pro article, To Buy, Or Not To Buy- An Investors Guide To QE4, we studied asset performance returns during the first three episodes of QE. We then normalized the data for the duration and amount of QE to project how QE4 might affect various assets.  

With a month of QE4 under our belt, we update you on the pacing of this latest version of extreme monetary policy and review how various assets are performing versus our projections. Further, we share some recent comments from Fed speakers and analyze trading in the Fed Funds market to provide some unique thoughts about the future of QE4.

QE4

Since October 14^th, when QE4 was announced by Fed Chairman Jerome Powell, the Fed’s balance sheet has increased by approximately $100 billion. The graph below compares the current weekly balance sheet growth with the initial growth that occurred during the three prior iterations of QE.  

Data Courtesy St. Louis Federal Reserve

As shown above, the Fed is supplying liquidity at a pace greater than QE2 but slightly off the pace of QE 1 and 3. What is not shown is the $190 billion of growth in the Fed’s balance sheet that occurred in the weeks before announcing QE4. When this amount is considered along with the amount shown since October 14^th, the current pacing is much larger than the other three instances of QE.

To put this in context, take a step back and consider the circumstances under which QE1 occurred. When the Fed initiated QE1 in November of 2008, markets were plummeting, major financial institutions had already failed with many others on the brink, and the domestic and global economy was broadly in recession. The Fed was trying to stop the worst financial crisis since the Great Depression from worsening.

Today, U.S. equity markets sit at all-time highs, the economic expansion has extended to an all-time record 126 months, unemployment at 3.6% is at levels not seen since the 1960s, and banks are posting record profits.

The introduction of QE4 against this backdrop reveals the possibility that one of two things is occurring, or quite possibly both.

One, there could be or could have been a major bank struggling to borrow or in financial trouble. The Fed, via repo operations and QE, may be providing liquidity either to the institution directly or indirectly via other banks to forestall the ramifications of a potential banking related default.

Two, the markets are struggling to absorb the massive amount of Treasury debt issued since July when Congress extended the debt cap. From August through October 2019, the amount of Treasury debt outstanding grew by $1 trillion. Importantly, foreign entities are now net sellers of Treasury debt, which is worsening the problem. For more read our recent article, Who Is Funding Uncle Sam?

The bottom line is that the Fed has taken massive steps over the last few months to provide liquidity to the financial markets. As we saw in prior QEs, this liquidity distorts financial markets.  

QE4 Projections and Updates

The following table provides the original return projections by asset class as well as performance returns since October 14^th.  The rankings are based on projected performance by asset class and total.  

Here are a few takeaways about performance during QE4 thus far:

• Value is outperforming growth by 1.67% (5.95% vs. 4.28%)
• There is general uniformity amongst the equity indexes
• Equity indices have captured at least 50%, and in the case of value and large caps (S&P 100) over 100% of the expected gains, despite being only one-sixth of the way through QE4
• The sharp variation in sector returns is contradictory to the relatively consistent returns at the index level
• Discretionary stocks are trading poorly when compared to other sectors and to the expected performance forecast for discretionary stocks
• Defensive sectors are trading relatively weaker as occurred during prior QE
• The healthcare sector has been the best performing sector within the S&P as well as versus every index and commodity in the tables
• The yield curve steepened as expected
• In the commodity sector, precious metals are weaker, but oil and copper are positive

Are Adjustments to QE4 Coming?

The Fed has recently made public statements that lead us to believe they are concerned with rising debt levels. In particular, a few Fed speakers have noted the sharp rise in corporate and federal debt levels both on an absolute basis and versus earnings and GDP. The increase in leverage is made possible in part by low interest rates and QE. In addition, some Fed speakers over the last year or two have grumbled about higher than normal equity valuations.

It was for these very reasons that in 2013, Jerome Powell voiced concerns about the consequences of asset purchases (QE). To wit: 

“What of the potential costs or risks of the asset purchases? A variety of concerns have been raised over time. With inflation in check, the most important potential risk, in my view, is that of financial instability. One concern is that our policies might drive excessive risk-taking or create bubbles in financial assets or housing.”

Earlier this month, Jerome Powell, in Congressional testimony said:

“The debt is growing faster than the economy. It’s as simple as that. That is by definition unsustainable. And it is growing faster in the United States by a significant margin.”

With more leverage in the financial system and higher valuations in the equity and credit markets, how does Fed Chairman Powell reconcile those comments with where we are today? It further serves to highlight that political expediency has thus far trumped the long-run health of the economy and the financial system.

Based on the Fed’s prior and current warnings about debt and valuations, we believe they are trying to fix funding issues without promoting greater excesses in the financial markets. To thread this needle, they must supply just enough liquidity to restore financing markets to normal but not over stimulate them. This task is much easier said than done due to the markets’ Pavlovian response to QE.

Where the fed funds effective rate sits within the Fed’s target range can be a useful gauge of the over or undersupplying of liquidity. Based on this measure, it appears the Fed is currently oversupplying liquidity as seen in the following chart. For the first time in at least two years, as circled, the effective Fed Funds rate has been consistently below the midpoint of the Fed’s target range.

If the Fed is concerned with debt levels and equity valuations and is comfortable that they have provided sufficient liquidity, might they halt QE4, reduce monthly amounts, or switch to a more flexible model of QE?

We think all of these options are possible.

Any effort to curtail QE will be negative for markets that have been feasting on the additional liquidity. Given the symbiotic relationship between markets and QE, the Fed will be cautious in making changes. As always, the first whisper of change could upset the apple cart.

Summary

Equity markets have been rising on an almost daily basis despite benign economic reports, negative trade and tariff headlines, and Presidential impeachment proceedings, among other worrisome factors. We have little doubt that investors have caught QE fever again, and they are more concerned with the FOMO than fundamentals.

As the fresh round of liquidity provided by the Fed leaks into the markets, it only further advances more misallocation of capital, such as excessive borrowing by zombie companies and borrowing to further fund unproductive stock buybacks. Like dogs drooling at the sound of a ringing bell, most investors expect the bull run to continue. It may, but there is certainly reason for more caution this time around as the contours of the economy and the market are vastly different from prior rounds. Add to this the incoherence of this policy action in light of the record expansion, benign inflation readings, and low unemployment rate and we have more questions about QE4 than feasible answers.

In a poll administered by the CFA Institute of America {Link}, readers, many of whom are professional investors, were asked which behavioral biases most affect investment decisions. The results are shown in the chart below.

We are not surprised by the results, but we believe a rational investor would put these in reverse order.

Compounding wealth, which should be the primary objective of every investor, depends first and foremost on avoiding large losses. Based on the poll, loss aversion was the lowest ranked bias. Warren Buffett has commented frequently on the importance of limiting losses. His two most important rules are: “Rule #1 of investing is don’t lose money. Rule #2 is never forget rule #1.”

At Real Investment Advice, we have covered a lot of ground on investor behavioral biases. In 5 Mental Traps Investors are Falling In To Right Now, Lance Roberts lucidly points out, “Cognitive biases are a curse to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money.”

Lance’s quote nicely sums up the chart above. These same biases driving markets higher today also drove irrational conduct in the late 1920s and the late 1990s. Currently, valuations are at or near levels reached during those two historical market peaks. Current valuations have long since surpassed all other prior valuation peaks.

One major difference between the late 1920s, the late 1990s, and today is the extent to which the Federal Reserve (Fed) is fostering current market conditions and imprudent investor behavior. To what extent have investors fallen into the overconfidence trap as the herd marches onward?

This “ignorance is bliss” type of behavior raises some serious questions, especially in light of the recent changes in Fed policy.

Not QE

As predicted in QE By Any Other Name, the Fed recently surprised investors with a resumption of quantitative easing (QE). The announcement of $60 billion in monthly Treasury bill purchases to replenish depleted excess reserves and another $20 billion to sustain existing balances was made late in the afternoon on Friday October 11. With a formal FOMC meeting scheduled in less than three weeks, the timing and substance of this announcement occurred under unusual circumstances.

The stated purpose of this new round of QE is to address recent liquidity issues in the short-term funding markets. Up to this point, the Fed added additional liquidity through its repo facility. These are actions not taken since the financial crisis a decade ago. The liquidity problems, though not resolved, certainly have largely subsided.

So why the strange off-cycle announcement? In other words, why did the Fed seemingly scramble over the prior few days to announce a resumption of QE now? Why not wait to make this announcement through the normal FOMC meeting statement and press conference process? The answer to those questions tells us more about current circumstances than the actual policy change itself.

The Drowning Man

As is always the case with human beings, actions speak louder than words. If you observe the physical behavior of someone in distress and know what to look for, you learn far more about their circumstance than you would by listening to their words. As an example, the signs of drowning are typically not what we would expect.  A person who is drowning can often appear to be playing in the water. When a person in the water is in distress, their body understands the threat and directs all energy toward staying alive.

People who drown seldom flail and scream for help as is often portrayed on television. If you ask a drowning person if they are okay, you might not receive a response. They are often incapable of producing the energy to speak or scream as all bodily functions are focused on staying afloat.

Since the Financial Crisis, investors, market analysts, and observers are helplessly watching the Fed, a guardian that does not realize the market is drowning. The Fed, the lifeguard of the market, is unaware of the signs of distress and unable to diagnose the problem (see also The Voice of the Market – The Millennial Perspective).

In this case, it is the global banking system that has become so dependent on excess reserves and dollar liquidity that any shortfall, however temporary, causes acute problems. Investor confidence and Fed hubris are blinding many to the source of the turbulence.

Lifeguards

Fortunately, there are a few other “lifeguards” who have not fallen into the behavioral traps that prevent so many investors from properly assessing the situation and potential consequences.

One of the most articulate “lifeguards” on this matter is Jeff Snyder of Alhambra Investments. For years, he has flatly stated that the Fed and their army of PhDs do not understand the global money marketplace. They set domestic policy and expect global participants to adjust to their actions. What is becoming clear is that central bankers, who more than anyone else should understand the nature of money, do not. Therefore, they repeatedly make critical policy errors as a result of hubris and ignorance.

Snyder claims that without an in-depth understanding of the dollar-based global lending market, one cannot grasp the extent to which problems exist and monetary policy is doomed to fail. Like the issues that surfaced around the sub-prime mortgage market in 2007, the funding turmoil that emerged in September was a symptom of that fact. Every “solution” the Fed implements creates another larger problem.

Another “lifeguard” is Daniel Oliver of Myrmikan Capital. In a recently published article entitled QE for the People, Oliver eloquently sums up the Fed’s policy situation this way:

“The new QE will take place near the end of a credit cycle, as overcapacity starts to bite and in a relatively steady interest rate environment. Corporate America is already choked with too much debt. As the economy sours, so too will the appetite for more debt. This coming QE, therefore, will go mostly toward government transfer payments to be used for consumption. This is the “QE for the people” for which leftwing economists and politicians have been clamoring. It is “Milton Friedman’s famous ‘helicopter drop’ of money.” The Fed wants inflation and now it’s going to get it, good and hard.”

We added the emphasis in the quote because we believe that to be a critically important point of consideration. Inflation is the one thing no one is looking for or even considering a possibility.

Summary

Today, similar to the months leading up to the Financial Crisis, irrational behavioral biases are the mindset of the market. As such, there are very few “lifeguards” that know what to look for in terms of distress. Those who do however, are sounding the alarm. Thus far warnings go largely unheeded because blind confidence in the Fed and profits from yesteryear are blinding investors. Similar to the analogy James Grant uses, where he refers to the Fed as an arsonist not a firefighter, here the Fed is not the lifeguard on duty but the invisible undertow.

Investors should frequently evaluate a list of cognitive biases and be aware of their weaknesses. Humility will be an enormous asset as this economic and market expansion ends and the inevitable correction takes shape.  We have attached links to our other behavioral investing articles as they may be helpful in that difficult task of self-evaluation.

Finally, we must ask what asset can be a life preserver that is neither being chased higher by the herd nor providing any confirmation bias.

Gold is currently one of the most hated investments by the media and social media influencers. The only herd following gold are thought to be relics of ancient history and doomsday preppers. Maybe, as we saw in the aftermath of the prior valuation peaks, those who were ridiculed for their rigor and discipline will once again come out on top.

Gold provides ballast to a portfolio during troubling times and should definitely be considered today as the distress becomes more pronounced and obvious.

Please find below links to some of our favorite behavioral investing articles:  

Dalbar 2017: Investors Suck at Investing and Tips for Advisors

8 Reasons to Hold Some Extra Cash

The 5-Laws Of Human Stupidity & How To Be A “Non-Stupid” Investor

The Money Game & the Human Brain

The Definitive Guide to Investing for the Long Run

“In no sense is this QE” – Jerome Powell

On October 9, 2019, the Federal Reserve announced a resumption of quantitative easing (QE). Fed Chairman Jerome Powell went to great lengths to make sure he characterized the new operation as something different than QE. Like QE 1, 2, and 3, this new action involves a series of large asset purchases of Treasury securities conducted by the Fed. The action is designed to pump liquidity and reserves into the banking system.

Regardless of the nomenclature, what matters to investors is whether this new action will have an effect on asset prices similar to prior rounds of QE. For the remainder of this article, we refer to the latest action as QE 4.

To quantify what a similar effect may mean, we start by examining the performance of various equity indexes, equity sectors, commodities, and yields during the three prior QE operations. We then normalize the data for the duration and amount of QE to project what QE 4 might hold in store for the assets.

Equally important, we present several factors that are unique to QE 4 and may result in different outcomes. While no one has the answers, we hope that the quantitative data and the qualitative commentary we provide arms you with a better appreciation for asset return possibilities during this latest round of QE. 

How QE 1, 2, and 3 affected the markets

The following series of tables, separated by asset class, breaks down price performance for each episode of QE. The first table for each asset class shows the absolute price return for the respective assets along with the maximum and minimum returns from the start of each QE. The smaller table below it normalizes these returns, making them comparable across the three QE operations. To normalize the data, we annualize the respective QE returns and then scale the returns per $100 billion of QE. For instance, if the S&P 500 returned 10% annualized and the Fed bought $500 billion of assets during a particular QE, then the normalized return would be 2% per $100 billion of QE.

Data in the tables are from Bloomberg.  Click on any of the tables to enlarge.

QE 4 potential returns

If we assume that assets will perform similarly under QE 4, we can easily forecast returns using the normalized data from above. The following three tables show these forecasts. Below the tables are rankings by asset class as well as in aggregate. For purposes of this exercise, we assume, based on the Fed’s guidance, that they will purchase $60 billion a month for six months ($360 billion) of U.S. Treasury Bills.

Takeaways

The following list provides a summarization of the tables.

• Higher volatility and higher beta equity indexes generally outperformed during the first three rounds of QE.
• Defensive equity sectors underperformed during QE.
• On average, growth stocks slightly outperformed value stocks during QE. Over the last decade, inclusive of non-QE periods, growth stocks have significantly outperformed value stocks.
• Longer-term bond yields generally rose while shorter-term yields were flat, resulting in steeper yield curves in all three instances. 
• Copper, crude oil, and silver outperformed the S&P 500, although the exceptional returns primarily occurred during QE 1 for copper and crude and QE 1 and 2 for Silver.
• On a normalized basis, Silver’s 10.17% return per $100bn in QE 2, is head and shoulders above all other normalized returns in all three prior instances of QE.
• In general, assets were at or near their peak returns as QE 1 and 3 ended. During QE 2, a significant percentage of early gains were relinquished before QE ended.
• QE 2 was much shorter in duration and involved significantly fewer purchases by the Fed.
• The expected top five performers during QE4 on a normalized basis from highest to lowest are: Silver, S&P 400, Discretionary stocks, S&P 600, and Crude Oil. 
• Projected returns for QE 4 are about two-thirds lower than the average of prior QE. The lesser expectations are, in large part, a function of our assumption of a smaller size for QE4. If the actual amount of QE 4 is larger than current expectations, the forecasts will rise.

QE, but in a different environment

While it is tempting to use the tables above and assume the future will look like the past, we would be remiss if we didn’t point out that the current environment surrounding QE 4 is different from prior QE periods. The following bullet points highlight some of the more important differences.

• As currently planned, the Fed will only buy Treasury Bills during QE 4, while the other QE programs included the purchase of both short and long term Treasury securities as well as mortgages backed securities and agency debt. 
• Fed Funds are currently targeted at 1.75-2.00%, leaving the Fed multiple opportunities to reduce rates during QE 4. In the other instances of QE, the Fed Funds rate was pegged at zero. 
• QE 4 is intended to provide the banking system needed bank reserves to fill the apparent shortfall evidenced by high overnight repo funding rates in September 2019. Prior instances of QE, especially the second and third programs, supplied banks with truly excess reserves. These excess reserves helped fuel asset prices.
• Equity valuations are significantly higher today than during QE 1, 2, and 3.
• The amount of government and corporate debt outstanding is much higher today, especially as compared with the QE 1 and 2 timeframes.
• Having achieved a record-breaking duration, the current economic expansion is old and best described as “late-cycle”.

Déjà vu all over again?

The prior QE operations helped asset prices for three reasons.

• The Fed removed a significant amount of securities from the market, which forced investors to buy other assets. Because the securities removed were the least risky available in the market, investors, in general, moved into riskier assets. This had a circular effect pushing investors further and further into riskier assets.
• QE 4 appears to be providing the banks with needed reserves. Assuming that true excess reserves in the system do not rise sharply, as they did in prior QE, the banks will probably not use these reserves for proprietary trading and investing. 
• Because the Fed is only purchasing Treasury Bills, the boost of liquidity and reserves is relatively temporary and will only be in the banking system for months, not years or even decades like QE 1, 2, and 3.

Will QE 4 have the same effect on asset prices as QE 1, 2, and 3?

Will the bullish market spirits that persisted during prior episodes of QE emerge again during QE 4?

We do not have the answers, but we caution that this version of QE is different for the reasons pointed out above. That said, QE 4 can certainly morph into something bigger and more akin to prior QE. The Fed can continue this round beyond the second quarter of 2020, an end date they provided in their recent announcement. They can also buy more securities than they currently allude to or extend their purchases to longer maturity Treasuries or both. If the economy stumbles, the Fed will find the justification to expand QE4 into whatever they wish.

The Fed is sensitive to market returns, and while they may not want excessive valuations to keep rising, they will do anything in their power to stop valuations from returning to more normal levels. We do not think investors can blindly buy on QE 4, as the various wrinkles in Fed execution and the environment leave too many unanswered questions. Investors will need to closely follow Fed meetings and Fed speakers for clues on expectations and guidance around QE 4.

The framework above should afford the basis for critical evaluation and prudent decision-making. The main consideration of this analysis is the benchmark it provides for asset prices going forward. Should the market disappoint despite QE 4 that would be a critically important contrarian signal.

“What’s in a name? That which we call a rose, By any other name would smell as sweet.” – Juliet Capulet in Romeo and Juliet by William Shakespeare

Burgeoning Problem

The short-term repo funding turmoil that cropped up in mid-September continues to be discussed at length. The Federal Reserve quickly addressed soaring overnight funding costs through a special repo financing facility not used since the Great Financial Crisis (GFC). The re-introduction of repo facilities has, thus far, resolved the matter. It remains interesting that so many articles are being written about the problem, including our own. The on-going concern stems from the fact that the world’s most powerful central bank briefly lost control over the one rate they must control.

What seems clear is the Fed measures to calm funding markets, although superficially effective, may not address a bigger underlying set of issues that could reappear. The on-going media attention to such a banal and technical topic could be indicative of deeper problems. People who understand both the complexities and importance of these matters, frankly, are still wringing their hands. The Fed has applied a tourniquet and gauze to a serious wound, but permanent medical attention is still desperately needed.

The Fed is in a difficult position. As discussed in Who Could Have Known – What the Repo Fiasco Entails, they are using temporary tools that require daily and increasingly larger efforts to assuage the problem. Taking more drastic and permanent steps would result in an aggressive easing of monetary policy at a time when the U.S. economy is relatively strong and stable, and such policy is not warranted in our opinion. Such measures could incite the most underrated of all threats, inflationary pressures.

Hamstrung

The Fed is hamstrung by an economy that has enjoyed low interest rates and stimulative fiscal policy and is the strongest in the developed world. By all appearances, the U.S. is also running at full employment. At the same time, they have a hostile President sniping at them to ease policy dramatically and the Federal Reserve board itself has rarely seen internal dissension of the kind recently observed. The current fundamental and political environment is challenging, to be kind.

Two main alternatives to resolve the funding issue are:

1. More aggressive interest rate cuts to steepen the yield curve and relieve the banks of the negative carry in holding Treasury notes and bonds
2. Re-initiating quantitative easing (QE) by having the Fed buy Treasury and mortgage-backed securities from primary dealers to re-liquefy the system

Others are putting forth their perspectives on the matter, but the only real “permanent” solution is the second option, re-expanding the Fed balance sheet through QE. The Fed is painted into a financial corner since there is no fundamental justification (remember “we are data-dependent”) for such an action. Further, Powell, when asked, said they would not take monetary policy actions to address the short-term temporary spike in funding. Whether Powell likes it or not, not taking such an action might force the need to take that very same action, and it may come too late.

Advice from Those That Caused the Problem

There was an article recently written by a former Fed official now employed by a major hedge fund manager.

Brian Sack is a Director of Global Economics at the D.E. Shaw Group, a hedge fund conglomerate with over $40 billion under management. Prior to joining D.E. Shaw, Sack was head of the New York Federal Reserve Markets Group and manager of the System Open Market Account (SOMA) for the Federal Open Market Committee (FOMC). He also served as a special advisor on monetary policy to President Obama while at the New York Fed.

Sack, along with Joseph Gagnon, another ex-Fed employee and currently a senior fellow at the Peterson Institute for International Economics, argue in their paper LINK that the Fed should first promptly establish a standing fixed-rate repo facility and, second, “aim for a higher level of reserves.” Although Sack and Gagnon would not concede that reserves are “low”, they argue that whatever the minimum level of reserves may be in the banking system, the Fed should “steer well clear of it.” Their recommendation is for the Fed to increase the level of reserves by $250 billion over the next two quarters. Furthermore, they argue for continued expansion of the Fed balance sheet as needed thereafter.

What they recommend is monetary policy slavery. No matter what language they use to rationalize and justify such solutions, it is pure pragmatism and expediency. It may solve short-term funding issues for the time being, but it will leave the U.S. economy and its citizens further enslaved to the consequences of runaway debt and the monetary policies designed to support it.

If It Walks and Quacks Like a Duck…

Sack and Gagnon did not give their recommendation a sophisticated name, but neither did they call it “QE.” Simply put, their recommendation is in fact a resumption of QE regardless of what name it is given.

To them it smells as sweet as QE, but the spin of some other name and rationale may be more palatable to the public. By not calling it QE, it may allow the Fed more leeway to do QE without being in a recession or bringing rates to near zero in attempts to avoid becoming a political lightening rod.

The media appears to be helping with what increasingly looks like a sleight of hand. Joe Weisenthal from Bloomberg proposed the following on Twitter:

To help you form your own opinion let’s look at some facts about QE and balance sheet increases prior to the QE era. From January of 2003 to December of 2007, the Fed’s balance sheet steadily increased by $150 billion, or about $30 billion a year. The new proposal from Sack and Gagnon calls for a $250 billion increase over six months. QE1 lasted six months and increased the Fed’s balance sheet by $265 billion. Maybe its us, but the new proposal appears to be a mirror image of QE.

Summary

The challenge, as we see it, is that these former Fed officials do not realize that the policies they helped create and implement were a big contributor to the financial crisis a decade ago. The ensuing problems the financial system is now enduring are a result of the policies they implemented to address the crisis. Their proposed solutions, regardless of what they call them, are more imprudent policies to address problems caused by imprudent policies since the GFC.

We are thrilled to introduce Jess L. as a new contributor to RIA. Jess started her career nearly two decades ago as a market maker at Goldman Sachs, followed by a stint at Merrill Lynch. After that, she moved over to the buy-side as a Portfolio Manager at Caxton Associates before ending her career at Millennium Partners. Throughout her career, she has had the opportunity to trade a number of different asset classes, but the one nearest & dearest to her heart is the front-end of the USD rates curve. She now lives in Malibu with two children, adoring husband, and border collie – Rosie.

Follow Jess on Twitter at @MacroMorning

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The fate of LIBOR is likely to precipitate one of the largest one-off structural changes to the interest rates market in our lifetimes. Regulators are growing increasingly concerned because we’re ill-prepared for what comes next. Thus, more ad lib experimentation by policymakers.

It’s a tectonic shift in a $400 trillion+ market.

On Monday, New York Fed President John Williams gave a speech entitled “LIBOR: The Clock is Ticking” to address the ultimate liquidation of a ubiquitous benchmark rate. He summed up the motive behind invoking time-bomb imagery as follows.

“Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes, and the end of LIBOR.”

https://www.newyorkfed.org/newsevents/speeches/2019/wil190923

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Here’s what you need to know

If nothing else, there are really just a few take-away bullet points.

The shift from LIBOR to SOFR rates is happening & has massive implications.

The fate of benchmark rates will be driven by events such as last week’s move in repo. The Fed’s decision to embark on OMOs will extend far beyond October for a number of reasons. Key among them? Protect the sanctity of the incoming LIBOR replacement.

We’re talking about $400 trillion.

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What’s $400 trillion between friends?

400 trillion is such a large figure, it’s really, really difficult to conceive.   

Imagine human beings began counting to 400 trillion around the time of the first discovered form of writing (about 32 centuries ago). A weary descendent today would be still counting… with 99.75% remaining.

If (in a more financial, but equally less pragmatic way) you were somehow able to cover the surface of the Earth in gold plating a meter thick, $400 trillion would get enough gold for a second copy as well – and then some.

If (while recreating a cult movie classic) you spent $400 trillion on gas, you’d have enough to drive the distance from here to Alpha Centauri – and back. About 40 times. In a Winnebago.

But perhaps that’s because we’re using the wrong yardstick, using as a basis for comparison concepts that are familiar to us in our daily lives. If we change dimensions, the idea of such a quantity becomes a little easier to picture.

If every neural synapse in the brain cost $1, $400 trillion would get you only enough for a typical NFL Quarterback. Though to be clear, in the case of the Jets, we’d be talking about Ryan Fitzpatrick – not, y’know… anybody else.

Spend a dollar programming every possible chess combination into a supercomputer? You’d only have enough for an opening of four moves (a “Fool’s Gambit” if you reach checkmate).

And if you tallied up the total notional outstanding of interest rate derivative contracts that are about to be significantly altered by coming benchmark reform… well, that’s why we’re here, you’d have about $400 trillion.

It’s a huge number, even in the scheme of other large markets outstanding. And it’s due to be transformed – one might argue – beyond a shadow of its former self.

Here’s why.

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It’s (still) all about funding markets

During last week’s repo debacle, here’s how the replacement for LIBOR did (more on the distinction between these two lines below):

Lest you think I’m cherry-picking by showing an overnight rate versus a 3-month tenor, take a look at what the “overnight” LIBOR rate did by comparison. The relative shock wave is of similar magnitude.

Now, in order to combat these types of violent moves, the Fed has embarked upon a series of Open Market Operations (OMOs) to provide funding from now until Thursday October 10^th. But if you think this all ends on that date, you haven’t been paying attention.

https://www.newyorkfed.org/markets/opolicy/operating_policy_190920

Last week, ISDA released their final consultation on the remaining thorny issues to be hashed out regarding fallbacks – with responses due from participants no later than October 23^rd.

https://www.isda.org/2019/09/18/isda-publishes-consultation-on-final-parameters-for-benchmark-fallback-adjustments

In other words, this is an issue that is very much front & center – now.

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Making LIBOR Great Again

The saga around “the end of LIBOR” aka Benchmark Reform has been ongoing for nearly a decade. Really ever since regulators determined that “asking a cabal of bank executives who could pick up a phone call from their trading desks what they’d like the daily rate to be…” underpinning the largest derivatives market in the world left open a little room for bad actors to operate. LIBOR (the “London InterBank Offered Rate”) needed to be replaced. And the replacement would need to be something that was observable & representative of conditions in money markets.

Enter SOFR – the Secured Overnight Financing Rate.

This isn’t the place to get into the minutiae around LIBOR vs SOFR, but a basic understanding is important. LIBOR is a “forecast of unsecured funding” and SOFR is an “actual measure of secured funding”.  In other words, the key is that LIBOR is only a guess at where you could borrow without having to provide collateral and SOFR is where the borrowing actually gets done that’s collateralized by US Treasuries. I’ve included links at the bottom of this article & an excellent series of blog posts on the topic, here & here.

Secured vs Unsecured

You might assume that the SOFR rate (in which you provide collateral) is always lower than the LIBOR rate (in which it’s just based on a bank’s estimate of where they could get funding, based on nothing more than a promise to return it). And, of course, because this is the world we live in – you’d be wrong.

One has to be a little cynical (or at least an active trader in today’s paradoxical market) to grasp the distinction. Banks never want to admit that funding is scarce or that they’d have a tough time tapping capital markets. Bank stocks don’t tend to like that sort of admission. So, forecasts are based on an information waterfall that, as best as we can tell, is “where have things been recently?”

PM: “Wherefore art thou Libor?” 6/28/2019

On the other hand, collateralized funding is not exactly the cheap source of financing you might have thought. Banks already have plenty of what you’re trying to offload in exchange for the cash: collateral. Much of this, however, is required due to the increase in considerations around capitalization post-crisis. Increasingly, it’s due to the fact that the Treasury is aggressively ramping up debt issuance.

Collateral supersaturation

Why this becomes problematic is the fact we’re whirling further & further into an environment where oversupply of collateral is causing these rates to become more & more volatile – see the most recent episode for a point of reference.

To say that last week’s repo debacle was precipitated by either the KSA or by the timing of corporate taxes & bills supply is a little like saying World War I was caused by Gavrilo Princip. Yes, that’s true – but the conditions had to be right & the stage appropriately set.

It’s a bit like the grade school chemistry lesson where you drop additional solute into an already supersaturated solution:

But, this is what regulators have decided we’re going with & we’re a few details away from getting a complete picture of what LIBOR’s replacement will look like.

Back to the future, part 1

Accordingly, efforts have been made to reduce the type of noise we saw last week. Regulators were aware of the fact this could happen well in advance.

For example, what was previously “3-month LIBOR” (i.e. the trimmed mean of daily bank estimates of where they could borrow unsecured cash for 3 months) will now be a daily-compounded in arrears SOFR rate (i.e. the daily fixings over that equivalent period compounded over that same period). Instead of using just one rate that covers the entire 3-month period which is set at the START of the period, we’ll take every business day during that period & compound all the fixings together at the END of the period.

Here’s a schematic from Oliver Wyman that shows the difference:

Back to the future, part 2

In other words, we’re going from an “expectations based” benchmark to a “present realized” index. While that might not exactly violate the space-time continuum, that does cause some quirks.

Again, the reason for this consideration is to remove some of the daily “noise” around the fixings. That’s “noise” due to things like holidays, reporting periods & unexpected vaporization of liquidity. This is obvious just from a cursory glance at that historical chart of the daily fixings for the SOFR rate compared to the 3-month LIBOR rate.

However, LIBOR doesn’t just have a 3-month term. An overnight term, a 1-month term, a 6-month term & so on also exist.

Consider what events like last week’s move in repo did to LIBOR’s replacement, even after the “smoothing”. Even without looking, you can probably guess it’s not good.

Not exactly “easing”

Let’s play this out. The LIBOR fixing that was delivered on the morning of June 17^th was the one which covered an “effective” period that started T+2 (June 19^th) for 3-months. Therefore, that rate would pick up all the fixings from last week. That caused the “rate” from nearly 3-months ago to increase a little over 3 basis points. Previously, you wouldn’t have cared much about what happens in the 3-months following your LIBOR fixing. Now, you care quite a bit about any significant moves in SOFR underlying that might transpire over the ensuing period.

The VaR-Shock to rule them all

What’s even more important is that the shorter LIBOR rates are the ones that underpin things like Student Loan Securitizations & Commercial Mortgage-Backed Securitizations. Well, those happen to be two areas of the market precariously balanced at the moment.

Here’s what the 1mL rate & its replacement did…

Consider: the magnitude of the move works out to a little over 12.5bps – or half of what the Fed just cut rates by. That’s a pretty big difference – in the opposite direction of what the Fed’s intending to do as they “ease” policy.

Now, this past week’s episode won’t do much since LIBOR is still clinging on. It won’t even affect the proposed spread adjustment, since that will most likely use a trimmed mean or median observation of the last 5-10 years. Stay tuned: it’s one of the biggest outstanding decisions remaining.

But, it’s a good example of how policymakers have designed a replacement benchmark to take over the largest derivatives market in the world which could deviate from the original. Best summed up in the words of Job & George Bluth.

Trillion Dollar PNL Implications

In the context of a $400 trillion market it’s a lot. Especially, since you’ve just caused the entire index to shift up by 12.5bps when it should have been shifting lower as the Fed “eases” policy. For a 1-month coupon, that difference is $42bn in PNL terms for just this one episode. That episode lasted only about 3 days.

Over a longer period (a few weeks, for example), implications are north of a trillion dollars in market PNL.

Imagine if regulators enacted by decree an instantaneous drop of $1 trillion in market PNL from US equities. You’d take notice.

Furthermore, the index jumped 12.4bps on the day that the 1mL rate moved 1.5bps. A 1.5bps move for 1mL is barely a half a standard deviation move on the long-term history, going back to 1998. That 12.4bps move for SOFR? An 8+ standard deviation event.

Regulators take heed

We live in a world where risk has been increasingly calibrated to historical VaR. That’s a seismic shock that poses a serious threat to future position concentration.

Regulators have told us in no uncertain terms that this is happening. Williams’ speech on Monday is an example of their determination to enact a shift. But, the Fed knows in order to make it stick, one must have a reliable fallback instrument.

Reliable fallback instruments for a $400 trillion market don’t move 8+ standard deviations because of a regularly scheduled tax date. Even if it just so happens to compound a number of other structural issues.

So, it’s in the Fed’s best interests to lean against such moves. That’s yet another reason why we should expect OMOs are really Permanent (with a capital “P” = POMOs). They’re due to extend well beyond the October date that’s currently on the calendar.

With that, regulators are more than happy to issue one final valediction to LIBOR.

LINKS

ARRC FAQ: https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/ARRC-faq.pdf

ISDA Fallback Consultation: https://www.isda.org/2019/09/18/september-2019-consultation-on-final-parameters/

CALCULATION METHODOLOGY

Disclosure/Disclaimers:

This material may contain indicative terms & there is no representation that any transaction could have been executed at such terms. Proposed terms are for discussion purposes only.

OTC Derivatives Risk Disclosures:

Understand clearly the terms of any OTC derivative transaction you may enter into. You should carefully review these terms with your counterparty.

Also, understand the nature of your exposure. Consequently, you should be satisfied that such transactions are appropriate. In addition, you may be required to post margin.

This post was written by me & the material is my own, except where sourced. I am not receiving compensation for it.

Imagine approaching a friend that you think is very wealthy and asking her to borrow ten thousand dollars for just one night. To entice her, you offer as collateral the title to your 2019 Lexus parked in her driveway along with an interest rate that is 5% above that which she is earning in the bank. Shockingly, your friend says she can’t. Given the risk-free nature of the transaction and excellent one-day profit, we can assume that our friend may not be as wealthy as we thought.

On Monday, September 16^th, 2019, a similar situation occurred in the overnight repurchase agreement (repo) funding market. On that day, banks were unwilling or unable to lend on a collateralized basis, even with the promise of large risk-free profits. This behavior reveals something very important about the banking system and points to the end of market stimulus that has been around for the past decade.

The Plumbing of the Banking System and Financial Markets

Interbank borrowing is the engine that allows the financial system to run smoothly. Banks routinely borrow and lend to each other on an overnight basis to ensure that all banks have ample funds to meet daily cash flow needs and that banks with excess funds can earn interest on them. Literally, years go by with no problems in the interbank markets and not a mention in the media.

Before proceeding, what follows is a definition of the funding instruments used in the interbank markets.

• Fed Funds are uncollateralized interbank loans that are almost exclusively done on an overnight basis. Except for a few exceptions, only banks can trade Fed Funds.
• Repo (repurchase agreements) are collateralized loans. These transactions occur between banks but often involve other non-bank financial institutions such as insurance companies. Repo can be negotiated on an overnight and longer-term basis. General collateral, or “GC,” is a term used to describe Treasury, agency, and mortgage collateral that backs certain repo loans. In a GC repo, the particular securities backing the loan are not determined until after the transaction is agreed upon by the counterparties. The securities delivered must meet certain pre-defined criteria.

On September 16^th, overnight GC repo traded as high as 8%, almost 6% higher than the Fed Funds rate, which theoretically should keep repo and other money market rates closely tied to it. The billion-dollar question is, “Why did a firm willing to pay a hefty premium, with risk-free collateral, struggle to borrow money”?  Before the 16^th, a premium of 25 to 50 basis points versus Fed Funds would have enticed a mob of financial institutions to lend money via the repo markets. On the 16^th, many multiples of that premium were not enticing enough.

Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons. We are not convinced by either excuse as they were easily forecastable weeks in advance.

Regardless of what caused the liquidity crunch, we do know, that in aggregate, banks did not have the capacity to lend money. Given the capacity, they would have done so in a New York minute and at much lower rates.

To highlight the enormity of the aberration, consider the following:

• Since 2006, the average daily difference between the overnight GC repo rate and the Fed Funds effective rate was .025%.
• Three standard deviations or 99.5% of the observances should have a spread of .56% or less.
• 8% is a bewildering 42 standard deviations from the average, or simply impossible assuming a traditional bell curve.

What was revealed on the 16^th?

The U.S. and global banking systems revolve around fractional reserve banking. That means banks need only hold a fraction of the cash deposits that they hold in reserve accounts at the Fed. For example, if a bank has $1,000 in deposits (a liability to the bank), they may lend $900 of those funds and retain only 10% in reserves. This is meant to ensure they have enough funding on hand to make payments during the day and also as a buffer against unanticipated liquidity needs. Before 2008, banks held only just as many reserves as were required by the Fed. Holding anything more than the required minimum was a drag on earnings, as excess reserves were unremunerated at the time.

Quantitative Easing (QE) and the need for the Fed to pay interest on newly formed excess reserves changed that. When the Fed conducted QE, they bought U.S. Treasury, agency, and mortgage-backed securities and credited the selling bank’s reserve account. The purpose of QE1 was to ensure that the banking system was sufficiently liquid and equipped to deal with the ramifications of the ongoing financial crisis. Round one of QE was logical given the growing list of bank/financial institution failures. However, additional rounds of QE appear to have had a different motive and influence as banks were highly liquid after QE1 and had shored up their capital as well. That is a story for another day.

The graph below shows how “excess” reserves were close to zero before 2008 and soared by over $2.5 trillion after the three rounds of QE. Before QE, “excess” reserves were tiny, measured in the hundreds of millions. The amount is so small it is not visible on the graph below. The reserves produced by multiple rounds of quantitative easing may have been truly excess, meaning above required reserves, on day one of QE. However, on day two and beyond that is not necessarily true for any particular bank or the system as a whole, as we are about to explain.

Data courtesy: St. Louis Federal Reserve

The Fed, having pushed an enormous amount of reserves on the banks, created a potential problem. The Fed feared that once the smoke cleared from the financial crisis, banks would revert to their pre-crisis practice of keeping only the minimum amount of reserves required. This would leave them an unprecedented surplus of excess funds to buy financial assets and/or create loans which would vastly increase the money supply with inflationary consequences. To combat this problem, they incentivized the banks to keep the reserves locked down by paying them a rate of interest on the reserves that were higher than the Fed funds rates and other prevailing money market rates. This rate is called the IOER or the interest on excess reserves.

The Fed assumed banks would hold excess reserves because they could make risk free profits at no cost. This largely worked, but some reserves were leveraged by the banks and flowed into the financial markets. This was a big factor in driving stock prices higher, credit spreads tighter, and bond yields lower. This form of inflation the Fed seemed to desire as evidenced from their many speeches talking about generating household net worth.

From the banks’ perspective, the excess reserves supplied by the Fed during QE were preferential to traditional uses of excess reserves. Historically, excess bank reserves were invested in the Treasury market or lent on to other banks in the Fed Funds market. Purchasing Treasury securities had no credit risk, but banks are required to mark their Treasury holdings to market and therefore produce unexpected gains and losses. Lending reserves in the interbank market also incurred counterparty risk, as there was always the chance the borrowing bank would be unable to repay the loan, especially in the immediate post-crisis period. Additionally, as QE had produced trillions in excess reserves, there was not much demand from other banks. Therefore, the banks preferred use of excess reserves was leaving them on deposit with the Fed to earn IOER. This resulted in no counterparty risk and no mark to market risk.

Beginning in 2018, the Fed began reducing their balance sheet via QT and the amount of excess reserves held by banks began to decline appreciably.

Solving Our Mystery

It is nearly impossible for the public to figure out how much in excess reserves the banking system is truly carrying. Indeed, even the Fed seems uncertain. It is common knowledge that they have been declining, and over the last six months, clues emerged that the amount of “truly excess reserves,” meaning the amount banks could do without, was possibly approaching zero.  

Clue one came on March 20^th, 2019 when the Fed said QT would end in October 2019. Then, on July 31^st, 2019, as small problems occurred in the funding markets, the Fed abruptly announced that they would halt the balance sheet reduction in August, two months earlier than originally planned. The QT effort, despite assurances from Bernanke, Yellen, and Powell that it would be uneventful, ended 22 months after it began. The Fed’s balance sheet declined only $800 billion as a result of QT, less than a quarter of what the Fed added to their balance sheet during QE.

Clue two was the declining spread between the IOER rate and the effective Fed Funds rate as the level of excess reserves was declining, as seen in the chart below. The spread between IOER and the Fed Funds rate was narrowing because the Fed was having trouble maintaining the Fed Funds rate within the targeted range. In March 2019, the spread became negative, which was counter to the Fed’s objectives. Not surprisingly, this is when the Fed first announced that QT would end.

Data courtesy: St. Louis Federal Reserve

The third and final clue emerged on September 16, 2019, when overnight repo traded at 7%-8%. If banks truly had excess reserves, they would have lent some of that excess into the repo market and rates would never have gotten close to 7-8%. It seems logical that banks would have been happy to lend on a collateralized basis at 3%, much less 7-8%, when their alternative, leaving excess reserves to the Fed, would have earned them 2.25%.   

Further confirmation that something was amiss occurred on September 17^th, 2019, when the Fed Funds effective rate was above the upper end of the Fed’s target range of 2-2.25% at the time. This marked the first time the Fed Funds rate traded above its target since 2008.

On September 17^th, the Fed entered the repo markets with a $53 billion overnight repo operation, whereby banks could pledge Treasury collateral to the Fed and receive cash. The temporary liquidity injection worked and brought repo rates back to normal. The following day the Fed pumped $75 billion into the markets. These were the first repo transactions executed by the Fed since the Financial Crisis, as shown below.

These liquidity operations will likely continue as long as there is demand from banks. The Fed will also conduct longer-term repo operations to reduce the amount of daily liquidity they provide.

The Fed can continue to resort to the pre-QE era tactics and use temporary daily operations to help target overnight borrowing rates. They can also reduce the reserve requirements which would, at least for some time, provide the system with excess reserves. Lastly, they can permanently add reserves with QE. Recent rhetoric from Fed Chairman Powell and New York Fed President Williams suggests a resumption of QE in some form may be closer than we think.

Why should we care?

The QE-related excess reserves were used to invest in financial assets. While the investments were probably high-grade liquid assets, they essentially crowded out investors, pushing them into slightly riskier assets. This domino effect helped lift all asset prices from the most risk-free and liquid to those that are risky and illiquid. Keep in mind the Fed removed about $3.6 trillion of Treasury and mortgage securities from the market which had a similar effect.

The bottom line is that the role excess reserves played in stimulating the markets over the last decade is gone. There are many other factors driving asset prices higher such as passive investing, stock buybacks, and a broad-based, euphoric investment atmosphere, all of which are byproducts of extraordinary monetary policies. The new modus operandi is not necessarily a cause for concern, but it does present a new demand curve for the markets that is different from what we have become accustomed to.

Summary

Short-term funding is never sexy and rarely if ever, the most exciting part of the capital markets. A brief recollection of 2008 serves as a reminder that, when it is exciting, it is usually a harbinger of volatility and disruption.

In a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.”

Much more recently, Jay Powell stated, “We’ve been operating in this regime for a full decade. It’s designed specifically so that we do not expect to be conducting frequent open market operations to keep fed fund [sic] rates in the target range.” 

Today, a decade after the financial crisis, we see that Bernanke and Powell have little appreciation for the inner-workings of the financial system. 

In the Wisdom of Peter Fisher, an RIA Pro article released in July, we discussed the insight of Peter Fisher, a former Treasury, and Federal Reserve official. Unlike most other Fed members and politicians, he discussed how hard getting back to normal will be. As we are learning, it turns out that Fisher’s wisdom from 2017 was visionary.

“As Fisher stated in his remarks, “The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.”

Prophetic indeed.

“During the last year, the Federal Reserve has hinted that the period of ‘ultra-accommodative monetary policy’ was coming to an end. The Fed started that process last October by terminating the latest ‘Quantitative Easing’ program, which induced massive amounts of liquidity into the financial markets. Subsequently, the Fed has turned its focus towards the near ZERO level of the ‘Fed Funds’ rate.” – July 6, 2015

It seems like an eternity ago now, but I warned then the Fed was too late in the cycle to tighten monetary policy due to the impact higher rates have on economic growth.

“While the Federal Reserve hopes that they can effectively raise interest rates without cratering economic growth, the problem is that the bond market may have already beaten them to the punch.

While I do not expect Treasury rates to rise very much, the increase in borrowing costs in an already weak economic environment has an almost immediate impact. The chart below shows the periods in history where Treasury rates have risen and the impact of subsequent rates of economic growth.”

As we suggested, the rise in rates to 3.25% was all the economy could withstand at the time.

I followed up that previous analysis in October 2015 suggesting the Fed had missed its window to hike rates. To wit:

“The problem for the Federal Reserve is that getting caught in a liquidity trap was not an unforeseen outcome of monetary policy, but rather an inevitable conclusion. The current low levels of inflation, interest rates, and economic growth are the result of more than 30-years of misguided monetary policies that have led to a continued misallocation of capital.”

“From our cyclical vantage point, we have long been aware of the truism that ‘recessions kill inflation.’ Therefore, when the next recession arrives, it is more likely to push inflation below zero at a time when the Fed has no obvious policy response. The resulting deflation will be the stuff of policy nightmares.”

Why am I reminding you of this?

It is becomingly increasingly clear from a variety of inputs that deflationary pressures are mounting in the economy. Recent declines in manufacturing, and production reports, along with the collapse in commodity prices, all suggest that something is amiss in the production side of the economy.

As shown in the chart below, the Fed should have started lifting rates as the spike in economic growth occurred in 2010-2011 as both the Fed and Government flooded the economy with liquidity. While hiking rates would have slowed the advance in the financial markets, the excess liquidity sloshing around the system would have offset tighter monetary policy.

If they had hiked rates sooner, interest rates on the short-end of would have risen giving the Fed a policy tool to combat economic weakness with in the future. However, assuming a historically normal response to economic recoveries, the yield curve has been negative for quite some time. This explains why “financial conditions” remain at historically low levels despite higher Fed Funds rates.

The chart above also explains the delay in the “yield curve” turning negative earlier in this cycle.

1. As shown in the chart above, the 2-year Treasury has a very close relationship with the Effective Fed Funds Rate. Historically, the Federal Reserve began to lift rates shortly after economic growth turned higher. Post-2000 the Fed lagged in raising rates which led to the real estate bubble / financial crisis. Since 2009, the Fed has held rates at the lowest level in history artificially suppressing the short-end of the curve.
2. The artificial suppression of shorter-term rates has skewed the effectiveness of the yield curve as a recession indicator.
3. Lastly, negative yield spreads have historically occurred well before the onset of a recession. Despite their early warnings, market participants, Wall Street, and even the Fed came up with excuses each time to why “it was different.” Historically, it has never been the case.

However, the Fed is now trapped in a difficult position and is making a “policy mistake” once again.

Given the Fed waiting so long into the economic cycle to hike rates to begin with, they weren’t able to gain much of a spread before the economy was negatively impacted. There have been absolutely ZERO times in history when the Federal Reserve began an interest-rate hiking campaign that did not eventually lead to a negative outcome. To wit:

While the Federal Reserve clearly should not raise rates in the current environment, there is a possibility they will, regardless of the outcome. 

The Fed understands that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates would likely accelerate a potential slowdown and a significant market correction, from the Fed’s perspective, it might be the ‘lesser of two evils. Being caught at the ‘zero bound’ at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline.”

The problem for the Fed is that the bond market was NEVER worried about inflation.

Only the Fed saw an “inflation-monster under the bed.” All the bond market needed was the Fed to come out and indicate a “shift” in their stance to worrying about “deflation” to seal the deal.

Despite the many arguments to the contrary, we have repeatedly stated that the rise in interest rates was a temporary phenomenon as “rates impact real economic activity.” 

The “real economy,” due to a surge in debt-financed activity, was not nearly strong enough to withstand substantially higher rates. Of course, such has become readily apparent in the recent housing and auto sales data. Consequently, the Fed was unable to gain much clearance between the current level of rates and the “zero-bound.” 

Navarro’s Naivety 

On Tuesday, Peter Navarro, who is the White House trade advisor, called on the Federal Reserve to lower rates.

“The Federal Reserve before the end of the year has to lower interest rates by at least another 75 basis points or 100 basis points to bring interest rates here in America in line with the rest of the world. We have just too big a spread between our rates and that costs us jobs.’

While Peter, and President Trump, both want an “aggressive rate-cutting cycle” to sustain economic growth while he fights an unwinnable “trade war,” the reality is that rate cuts, and even additional measures of quantitative easing, or Q.E., are likely to have a muted effect. As I explained previously, the effectiveness of QE, and zero interest rates, is based upon the point at which you apply the stimulus.

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bailout’ the markets today, is much more limited than it was in 2008. But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to the present.”

“The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the ‘norm’ are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.”

A simple analogy is throwing gasoline on a raging bonfire. The fire will burn for a bit longer, but it won’t burn any hotter. However, throwing gasoline on a pile of dry wood and hitting it with a match provides a better outcome.

Such was the case in 2009. Even without Federal Reserve interventions, it is highly probable the economy would have begun a recovery as the normal economic cycle took hold. No, the recovery would not have been as strong, and asset prices would be about half of where they are today, but an improvement would have happened nonetheless.

The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

The Fed has a long history of making policy mistakes which have led to negative outcomes, crisis, bear markets, and recessions.

As I showed, above, the Fed made a mistake not using the flood of liquidity to lift rates. Instead, the Fed opted to create an asset bubble instead. Or, should I say, “again.”

While another $2-4 Trillion in QE, and a return to the “zero bound,” might indeed be successful in further inflating asset prices, there is a finite ability to continue to pull forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. 

Currently, there is evidence the cycle peak has been reached.

If I am correct, and the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

If more “accommodation” works, great.

But as investors, with our retirement savings at risk, what if it doesn’t?

Last week, President Donald Trump reiterated his call for the Fed to cut interest rates:

President Trump is technically correct in saying that the economy (or, more accurately, the stock market) would “go up like a rocket” if the Fed cut rates by 1%, but only because doing that would supercharge the dangerous bubbles that are driving our growth. If Trump theoretically got his way and the Fed cut rates by 1% (assuming it was a preemptive move rather than a reaction to a sharp economic slowdown), the stock market would most likely launch a powerful 1999-style melt-up, which would ultimately culminate in an equally devastating bust like we experienced in the early-2000s.

Here’s what led to the 1999 market melt-up: the Asian financial crisis, the Russian debt default, and the resulting failure of U.S. hedge fund Long Term Capital Management roiled the financial markets in 1997 and 1998 and led to concerns about a more extensive contagion. Even though U.S. economic data was still very strong, Fed Chair Alan Greenspan cut the Fed Funds rate three times in rapid succession in late-1998 (25 basis points each time for a total cut of .75%) in an effort to shore up confidence and help cushion the U.S. economy.

Prudential Securities analyst Michelle Laughlin captured the thinking behind the rate hikes at the time:

This tells me the Fed is correctly looking forward, looking at the risk of consumers pulling back in spending because stocks have fallen. They’re working in anticipation of that to make sure the U.S. economy does not slip into recession. I’m very encouraged by the Fed’s action.

The Fed’s aggressive preemptive interest rate cuts in 1998 were like pouring gasoline onto a fire: the Nasdaq Composite Index exploded 280% in the next year-and-half as the dot-com bubble went into overdrive. Of course, the dot-com bubble peaked in March 2000 and the Nasdaq proceeded to crash 80% over the next three years. The Nasdaq’s bear market erased the entire post-1998 gain and then some.

There are enough parallels between today’s market and the late-1990s market that if Trump got his way and the Fed slashed rates aggressively, the U.S. stock market could pull another ’99. Though the S&P 500 is up 300% from its 2009 lows, it has basically stalled since the start of 2018. The market pulled back approximately 20% in late-2018 (in a move similar to 1998’s pullback), before the Fed panicked and backpedaled on its previously hawkish outlook for rate hikes and quantitative tightening.

In 1998, the U.S. stock market was already quite overvalued just like it is now (in both 1998 and now, the cyclically-adjusted P/E ratio was in the low-30s). After the Fed slashed rates in 1998, the stock market surged and the cyclically-adjusted P/E ratio went into the low-40s – an all-time high. If Trump gets his way, the market would likely surge and valuations would approach their old highs.

Considering how stretched today’s market already is, Trump’s demand for a 1% rate cut is nonsensical and downright dangerous. As a result of the current stock and bond market bubbles, U.S. household net worth has hit record levels relative to the GDP in recent years, which is a sign that household wealth is overly inflated. The last two times household wealth became so stretched relative to the GDP were during the dot-com bubble and housing bubble, both of which ended in disaster. If Trump got his way, the current household wealth bubble would inflate even further, which would result in an even more powerful crash in the end.

It is extremely irresponsible for President Trump to demand a strong interest rate cut and more quantitative easing at a time when asset prices are already so inflated. It appears that he cares more about having the Fed juice the financial markets to help ensure his 2020 election win rather than the long-term economic health of the country. Although the Fed is supposed to be independent to avoid influence from political leaders, reality is quite different: heavy pressure from Trump during the late-2018 market rout likely contributed to the Fed’s about-face on rate hikes. If there is another market rout or even the slightest sign of economic weakness, President Trump will undoubtedly step up the pressure on the Fed to cut rates. If Trump gets his way, the market may take off like a rocket, but will ultimately experience the mother of all crashes.

On Sunday, March 11, 2019, Federal Reserve Chairman Jerome Powell was interviewed by Scott Pelley on 60 Minutes. We thought it would be helpful to cite a few sections of their conversation and provide you with prior articles in which we addressed the topics discussed.

We have been outspoken about the role of the Fed, their mission and policy actions over the last ten years. We are quick to point out flaws in Fed policy for a couple of reasons. First, is simply due to the enormous effect that Fed policy actions and words have on the markets. Second, many in the media seem to regurgitate the Fed’s actions and words without providing much context or critique of them. The combination of the Fed’s power over the market coupled with poor media analysis of their words and actions might expose investors to improper conclusions and therefore sub-optimal investment decision-making.

With that, we review various parts of the 60 Minutes interview and offer links to prior articles to help provide alternative views and insight as well as a more thorough context of Chairman Powell’s answers.  

Click the following links for the interview TRANSCRIPT and VIDEO.

Can the Fed Chairman be fired?

PELLEY: Do you listen to the president?

POWELL: I don’t comment on the president or any elected official.

PELLEY: Can the president fire you?

POWELL: Well, the law is clear that I have a four-year term. And I fully intend to serve it.

PELLEY: So no, in your view?

POWELL: No.

Our Take: Yes, the Federal Reserve Act which governs the Fed makes it clear that he can be fired “for cause.”- Chairman Powell You’re Fired

Does the Fed play a role in driving the growing income and wealth inequality gaps?

PELLEY: According to federal statistics, the upper half of the American people take home 90% of income, leaving about 10% for the lower half of Americans. Where are we headed in this country in terms of income disparity?

POWELL: Well, the Fed doesn’t have direct responsibility for these issues. But nonetheless, they’re important.

Our Take:  Inflation hurts the poor and benefits of the wealthy. The Fed has an inflation target and therefore takes direct policy action that fuels the wealth divide. – Two Percent for the One Percent

Will Chairman Powell know when a recession is upon us?

PELLEY: This is the longest expansion in American history. How long can it last?

POWELL: It will be the longest in a few months if it continues. I would just say there’s no reason why it can’t continue.

PELLEY: For years?

Our Take: In January of 2008 Chairman Bernanke said a recession was not in the cards. It turns out the official recession started a month earlier.– Recession Risks Are Likely Higher Than You Think

How healthy is the labor market?

POWELL: So, the U.S. economy right now is in a pretty good place. Unemployment is at a 50-year low.

Our Take: We continually hear about the strength of the labor market. While that may seem to be the case, wages and the labor participation rate paint a different picture. – Quick Take: Unemployment Anomaly (RIA Pro – Unlocked)

Do record high stock valuations represent healthy financial conditions?

PELLEY: We have seen big swings in the stock markets in the United States. And I wonder, do you think the markets today are overvalued?

POWELL: We don’t comment on the valuation of the stock market particularly. And we do though, we monitor financial conditions carefully. Our interest rate policy works through financial conditions. So we look at a very broad range of financial conditions. That includes interest rates, the level of the dollar, the availability of credit and also the stock market. So we look at a range of things. And I think we feel that conditions are generally healthy today.

Our Take: We beg to differ with over 100 years of history on our side. – Allocating on Blind Faith (RIA Pro – Unlocked)

Is the Fed Chairman aware of the burden of debt and its economic consequences?

PELLEY: But the overarching question is are we headed to a recession?

POWELL: The outlook for our economy, in my view, is a favorable one. It’s a positive one. I think growth this year will be slower than last year. Last year was the highest growth that we’ve experienced since the financial crisis, really in more than ten years. This year, I expect that growth will continue to be positive and continue to be at a healthy rate.

Our Take: The record amount of debt on an absolute basis and relative to economic activity is a burden on the economy. Expectations should be greatly tempered. – The Economic Consequences of Debt and Economic Theories – Debt Driven Realities

Does Chairman Powell bow at the altar of the President and Congress?

On December 17 & 18 of 2019 President Trump tweeted the following: 

“It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!”

I hope the people over at the Fed will read today’s Wall Street Journal Editorial before they make yet another mistake. Also, don’t let the market become any more illiquid than it already is. Stop with the 50 B’s. Feel the market, don’t just go by meaningless numbers. Good luck!”

PELLEY: Your Fed is apolitical?

POWELL: Strictly non-political.

Considering the Fed made an abrupt U-Turn of policy following the Tweets above, a sharp market decline and very little change in the data to justify it, we think otherwise. – The Fed Doesn’t Target The Market

Summary

The Fed has a long history of talking out of both sides of their mouths. They make a habit of avoiding candor about policy uncertainties in what appears to be an effort to retain credibility and give an appearance of confidence. The Fed’s defense of their extraordinary actions over the past ten years and reluctance to normalize policy is awkward, to say the least and certainly not confidence inspiring. As evidenced by his responses to Scott Pelley on 60 Minutes, Jerome Powell is picking up where Bernanke and Yellen left off.

This article aims to contrast the inconsistencies of the most current words of the Fed Chairman with truths and reality. Thinking for oneself and taking nothing for granted remains the most powerful way to protect and compound wealth and avoid large losses.

NOTE: This article was released yesterday to our RIA PRO subscribers. For timely, actionable information, you can get a FREE trial now by entering the CODE: PRO30.

The statement and press conference following the January 30^th Federal Reserve policy meeting was, with little doubt, a further pivot to a dovish stance. The statement below is from the prior December meeting and marked up in red to highlight changes in the current January 30th statement. The big clue about future interest rate policy is in the following addition:  “the Fed will be patient as it determines what future adjustments to the target range…” “Patient” tells us that the Fed’s plans to raise rates two or three times in 2019 are now on hold. It also leads the reader to believe the next move could just as easily be a reduction in rates.

The next important takeaway came in regards to the Feds balance sheet. In the press conference Jerome Powell, as he has done recently, alluded to the idea that QT is not on “autopilot” anymore. In other words, it is likely the Fed will not continue to reduce the pace at which they are shrinking their balance sheet without considering the economy and financial markets. We stress the word “autopilot” because that was how Jerome Powell to described the pace of balance sheet reductions at the December 19, 2018 FOMC meeting press conference. The ensuing market mayhem in the days following the press conference appears to have rattled the Fed into modfying that take quite substantially. In fact they have done a 180 degree reversal in only six weeks.

The last takeaway curiously involves QE. The Fed released a supplementary statement entitled Monetary Implementation and Balance Sheet Normalization in conjunction with the FOMC statement.  The bullet point below from the statement makes it clear that increases to the balance sheet, also known as QE, will be a part of their tool kit going forward. This is curious as Powell was adamant that QE two and three should not have been executed after the financial crisis abated. Now, without much reason, the specter of QE is being raised.

Why?

A reporter asked Powell why the abrupt change in the way policy was being discussed. Powell danced around the question with a dialogue of the government shutdown and slowing global growth. The shutdown was temporary, and the effect is very limited, estimated at less than 0.1% of GDP. Global growth is in fact slowing, but that has been the case for the last nine months.

In our opinion, the Fed’s new warm and cuddly tone is all about supporting the stock market. The market fell nearly 20% from record highs in the fourth quarter and fear set in. There is no doubt President Trump’s tweets along with strong advisement from the shareholders of the Fed, the large banks, certainly played an influential role in persuading Powell to pivot.

Speaking on CNBC shortly after the Powell press conference, James Grant stated the current situation well.

“Jerome Powell is a prisoner of the institutions and the history that he has inherited. Among this inheritance is a $4 trillion balance sheet under which the Fed has $39 billon of capital representing 100-to-1 leverage. That’s a symptom of the overstretched state of our debts and the dollar as an institution.”

President Donald Trump has been making a big stink about the Federal Reserve’s rate hikes lately. Last week, after the Dow plunged nearly 2,000 points, he blamed the Fed for it, saying “I think the Fed is making a mistake. They’re so tight. I think the Fed has gone crazy…” On Tuesday, Trump said that the Federal Reserve is “my biggest threat.” Since he became president, Trump has been praising the soaring stock market (something I said was very dangerous to do), viewing it as evidence of the success of his administration’s policies. Trump is worried that rising interest rates will put an end to the stock market boom, which will make him look bad.

Unfortunately, the president is extremely misguided about how interest rates work and the role they play in creating booms in the stock market and economy. As I’ve explained in great detail, the U.S. stock market has been booming because the Fed held interest rates at record low levels for a record length of time after the Great Recession. This Fed-driven stock market boom is an unsustainable bubble instead of a genuine, organic boom.

The fact that the Fed held rates at record low levels and inflated a credit and asset bubble meant that a crisis was already “baked into the cake” whether the Fed raised interest rates or not. Once a credit expansion or bubble is already in motion, the actions of the central bank from that point on can only determine what type of crisis occurs when the credit expansion ends – not whether a crisis will occur or not.

The Austrian School economist Ludwig von Mises said it best in his book Human Action:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

If the Fed or other central bank voluntarily abandons further credit expansion (most commonly by raising interest rates), the credit and asset bubble will experience a deflationary bust. Deflationary episodes entail credit busts, falling consumer prices, bear markets in stocks and housing prices, and falling wages. If the central bank decides to never put an end to the credit expansion (for example, if the Fed never raised rates), however, the result would be a runaway credit and asset bubble that leads to a severe decrease in the value of the currency and high rates of inflation. The latter scenario is what would occur if President Trump got his way – hardly a desirable outcome for the economy.

To summarize, the Fed is crazy – they’re crazy for creating such a large bubble in the first place via loose monetary policy, but not for raising interest rates and normalizing their monetary policy.

We at Clarity Financial LLC, a registered investment advisory firm, specialize in preserving and growing investor wealth in times like these. If you are concerned about your financial future, click here to ask me a question and find out more.

“The market is reacting in a way which does not comport with the strength, the unbelievable strength in President Trump’s economy. I mean, everything in this economy is hitting on all cylinders because of President Trump’s economic policies. We’ve cut taxes. That’s stimulating investment in a way which will be noninflationary. That’s going to drive up productivity and wages. That’s all good.” -Peter Navarro

Unfortunately, as much as we would like to believe that Navarro’s comment is a reality, it simply isn’t the case. The chart below shows the 5-year average of wages, real economic growth, and productivity.

Notice that yellow shaded area on the right.  As I wrote previously:

“Following the financial crisis, the Government and the Federal Reserve decided it was prudent to inject more than $33 Trillion in debt-laden injections into the economy believing such would stimulate an economic resurgence. Here is a listing of all the programs.”

If $33 Trillion dollars didn’t “unleash” the U.S. economy, or even change the trends of the prior years, there should be serious doubt that just reducing some outdated regulations, giving corporations a tax cut, and engaging in a “trade war” with China is going to be the fix. But nonetheless, here goes Navarro:

“We’ve got an unleashing, historically, of the energy sector, which is going to drive down costs to the American manufacturers–make them competitive even as it drives down costs to consumers, and allows them to spend more and get more out of their dollar.”

Wait a second.

Read carefully what Navarro said. By unleashing the energy sector the supply of oil will increase, lowering the price of oil, which is an input into manufacturing thereby lowering their costs.

This is a good thing?

Let’s dissect his statement. The decline in energy costs may be beneficial to parts of the economy, but we must remember it is offset because of the drag from the energy sector which loses revenue on each barrel of oil. As we have discussed many times previously, the energy patch is a huge CapEx contributor and also provides some of the highest wage paying jobs. As we found out previously, energy is a much bigger contributor to the health of the economy than not.

However, according to Navarro, the decline in oil alone will make manufacturing more competitive in the global marketplace. If that were true, wouldn’t the U.S. already be a leading competitive manufacturer considering oil has plunged over the last few years from over $100/bbl to the low $30’s? Furthermore, following Navarro’s logic, wages should have skyrocketed.

None of those things happened.

Navarro isn’t done yet.

“In terms of trade policy, by reducing the trade deficit, which is the intent of the president’s fair and reciprocal trade policies, that will add thousands of jobs to this economy; and bring in foreign investment. I mean, when we put the tariffs on solar and washing machines in January, that brought in a flood of new investment.”

We do indeed have a trade deficit because there are 300+ million American’s demanding cheaper foreign goods and services than there are foreigners demanding our exports.

While people rail about the amount of goods that we import, the simple reality is that we “export” our deflation and import “deflation.” We do this so we can buy flat screen televisions for $299 versus $2999 if they were made in America. The simple problem is that American workers demand higher wages, vacation, health care, benefits, leave, etc. all of which increase the costs of goods made in America. Not to mention the additional costs born by goods and services producers to comply with the myriad of regulations from EPA to OSHA. A previous interview of Greg Hayes, CEO of Carrier Industries, made this point very clearly.

“So what’s good about Mexico? We have a very talented workforce in Mexico. Wages are obviously significantly lower. About 80% lower on average. But absenteeism runs about 1%. Turnover runs about 2%. Very, very dedicated workforce.

Which is much higher versus America.  And I think that’s just part of these — the jobs, again, are not jobs on an assembly line that people really find all that attractive over the long term.“

This leads to the “American Conundrum.” While we believer our “labor” is worth “MORE” than anywhere else in the world, we also want to “buy” cheap products.

In order for that equation to work companies must “export” our “inflation.” This is accomplished by off-shoring labor at substantially lower rates which allows products and services to be provided more cheaply (deflation) to fill American demand. As I wrote yesterday, there is little ability for Americans to absorb the higher costs of goods and services brought about through “tariffs” or other inflationary goals of “balancing trade.”

“The chart below shows is the differential between the standard of living for a family of four adjusted for inflation over time. Beginning in 1990, the combined sources of savings, credit, and incomes were no longer sufficient to fund the widening gap between the sources of money and the cost of living. With surging health care, rent, food, and energy costs, that gap has continued to widen to an unsustainable level which will continue to impede economic rates of growth.”

Of course, while Navarro is optimistic that Trump policies will generate a net creation of a few thousand jobs, such aspirations will fall far short of what is needed to balance the economy.

But honestly, you can’t make up his last statement.

So you wonder–and if I put my old hat on as a financial market analyst, I’m looking at that – this market and the economy and thinking, the smart money will buy on the dips here because the economy is as strong as an ox.”

One chart dispels that notion.

So, be careful taking financial advice from Peter Navarro as well.

But, let me defer to my friend Doug Kass:

“To me, the views that animate Navarro’s policy prescriptions demonstrate his economic illiteracy.

There is no inverse relationship between imports and GDP as Navarro asserts.

In fact, there is a strong positive relationship between changes in trade deficits and changes in GDP.

Both Navarro and Ross are proponents of steel tariffs. As I have mentioned, such tariffs hurt producers that utilize steel products much more than they benefit a smaller population of steel producers. The byproduct of which could be rising steel costs which may ripple throughout the economy.

In reality, the US depends on China – we are in a flat, networked and interconnected global economy:

1. The Chinese export market is important to the U.S.
2. China produces low cost goods that benefit American consumers.
3. China funds our budget deficit, their surplus of savings is imported to the US – squaring the circle. If China stops buying our Treasuries, where do we get funding?“

Misguided Policies Continue

Failing To Plan Is Planning To Fail

by Michael Lebowitz, CFA

There is a durable bit of market wisdom that states “volatility begets volatility.” The gist of the saying is that at times the market can be very calm producing little need for investors to worry. Other times sharp market movements produce anxiety that spreads among investors and tends to exaggerate market moves in both directions for a while.

The graph below shows the daily percentage change between intraday highs and lows. Plain to the eye one can see the period of unprecedented calm that prevailed in the markets throughout 2017 as well as the sudden bout of volatility that picked up in earnest in late January.

Sailors pay close attention to weather conditions at all times. Importantly, however, they need to be highly in tune with the warnings that Mother Nature presents. This doesn’t mean they must head to harbor immediately. It does mean however they must have a plan or two top of mind if the conditions continue to worsen.

Protecting your wealth is no different. When the markets get choppy, as they have been, we need to heed the message that conditions have changed. One should not sell everything and run to cash. However, it is imperative one has a strategies and actionable triggers in place in case the volatility continues.

Last weekend, Lance Roberts shared the following graph and commentary:

“Considering all those factors, I begin to layout the “possible” paths the market could take from here. I quickly ran into the problem of there being “too many” potential paths the market could take to make a legible chart for discussion purposes. However, the bulk of the paths took some form of the three I have listed below.”

No one knows where this market is going and if they tell you otherwise, they are lying. We simply remind you the market winds are picking up, it is time to put a plan in place. Fear and anxiety are the enemy of complacent and unprepared investors. Those emotions are the direct result of not having considered and planned for the unexpected. For the investor who exercises the prudence to strategize on the “what if” and keep a close eye on market conditions, the fear of others’ is his opportunity.

Consider this recent period of choppy seas a gift. The market is allowing you time to plan.

“Failing to plan is planning to fail” –Alan Lakein

The Fed’s Dilemma

The confusion at the Fed continues.

On Wednesday, Jerome Powell justified hiking rates 0.25%, while maintaining their projections of two further hikes this year, by painting an upbeat picture of the U.S. economy.

Such may have been the case in January when the Atlanta Fed sent the current Administration into a “tizzy” with a pronouncement of 5.4% economic growth in the 4th quarter, but not at 1.9% currently. Furthermore, as I discussed just recently:

“Since 1992, as shown below, there have only been 5-other times in which retail sales were negative 3-months in a row (which just occurred). Each time, the subsequent impact on the economy, and the stock market, was not good.”

“So, despite record low jobless claims, retail sales remain exceptionally weak. There are two reasons for this which are continually overlooked, or worse simply ignored, by the mainstream media and economists.

The first is that despite the “longest run of employment growth in U.S. history,” those who are finding jobs continues to grow at a substantially slower pace than the growth rate of the population.”

“Secondly, while tax cuts may provide a temporary boost to after-tax incomes, that income boost is simply being absorbed by higher energy, gasoline, health care and borrowing costs. This is why 80% of Americans continue to live paycheck-to-paycheck and have little saved in the bank.”

The Fed’s dilemma is quite simple.

The Fed must continue to “jawbone” the media and Wall Street as economic growth has continued to remain sluggish. As shown, the Fed continues to remain one of the worst economic forecasters on the planet.

While the Fed is currently “hopeful” of a stronger 2018 and 2019, they are likely once again going to be very disappointed. But in the short-term, they have little choice.

Unwittingly, the Fed has now become co-dependent on the markets. If they acknowledge the risk of weaker economic growth, the subsequent market sell-off would dampen consumer confidence and push economic growth rates lower. With economic growth already running at close to 2% currently, there is very little leeway for the Fed to make a policy error at this juncture.

The Federal Reserve has a very difficult challenge ahead of them with very few options. While increasing interest rates may not “initially” impact asset prices or the economy, it is a far different story to suggest that they won’t. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

The Fed understands economic cycles do not last forever, and after nine years of a “pull forward expansion,” it is highly likely we are closer to the next recession than not. From the Fed’s perspective, hiking rates now, even if it causes a market decline and/or recession, is likely the “lesser of two evils.”

Chart of the Day

Today’s chart of the day shows cumulative U.S. GDP growth minus federal debt issuance. Most studies and discussions of U.S. economic growth assume that it’s natural, organic, and sustainable, but the reality is that it’s largely juiced by deficit spending (particularly since the Great Recession). According to Peter Cook, CFA:

The cumulative figures are even more disturbing. From 2008-2017, GDP grew by $5.051 trillion, from $14.55 trillion to $19.74 trillion.  During that same period, the increase in TDO totaled $11.26 trillion.  In other words, for each dollar of deficit spending, the economy grew by less than 50 cents.  Or, put another way, had the federal government not borrowed and spent the $11.263 trillion, GDP today would be significantly smaller than it is.

How much longer can we continue juicing economic growth like this? The U.S. federal debt recently hit $20 trillion and is expected to hit $30 trillion by 2028. Despite what Modern Monetary Theorists (MMTers), Keynesians, and similar schools of thought claim, common sense dictates that the endgame is not far off.

Have Treasury Yields Peaked for 2018? BMO Thinks So (Bloomberg)

Strong Demand For 30Y Paper Shows No Shortage Of Buyers Amid Surge In Issuance (ZeroHedge)

Gundlach Says 10-Year Treasury Above 3% Would Drive Down Stocks (Bloomberg)

SP500 performance around Fed tightening cycles (The Macro Tourist)

Dodd-Frank Rollback Optimism Hands Bank ETFs Record Inflows (Bloomberg)

FANG Rally Is Outpacing the Heyday of the Tech Frenzy (Bloomberg)

Apple is inching towards a $1 trillion valuation (Business Insider)

Buying Stocks Now Is Betting On Buybacks (Forbes)

Record Stock Buybacks at Worst Possible Time (Mike “Mish” Shedlock)

4 Reasons To Sell Tesla Stock (Forbes)

Everything is shrinking at GE except its massive debt (CNN Money)

Remembering Bear Stearns & Co (Institutional Risk Analyst)

A Worrying Shift for U.S. Pensions: Retirees Will Soon Outnumber Kids (Bloomberg)

The Coming Pension Crisis – Part I, Part II (Daily Reckoning)

The U.S. Retirement Crisis: The Elderly are Broke (Gold Telegraph)

The stock-market correction may be only half over, if history is any guide (MarketWatch)

JPMorgan Moves Closer to Urging a Rotation Away From Equities (Bloomberg)

Bullish On Oil Because of Trump? Don’t Be! (Mike “Mish” Shedlock)

What Event Will Sink the Stock Market? Yields? Tariffs? Trump? (Mike “Mish” Shedlock)

The Netflix Bubble (Seeking Alpha)

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The U.S. Inflation Scare May Be Over (Bloomberg)

Subdued CPI Disappoints Economic Illiterates (Mike “Mish” Shedlock)

Yield-Curve Flattening Gets New Life After Inflation Fears Subside (Bloomberg)

10 years after the financial crisis, have we learned anything? (CNN Money)

Cramer on 2008 crisis: It could happen again ‘because no one went to jail the first time’ (CNBC)

A Decade After Bear’s Collapse, the Seeds of Instability Are Germinating Again (Wall Street Journal)

U.S. CEO Optimism Hits Record (Bloomberg)

Yield Curve Turns Threatening – Again (DollarCollapse.com)

Fed Admits ‘Yield Curve Collapse Matters’ (ZeroHedge)

It’s Just Starting: Moody’s Warns A Deluge Of Retail Bankruptcies Is Coming (ZeroHedge)

Economist Lacy Hunt: These Conditions Preceded The Last 7 Recessions (Forbes)

Subprime Auto Bonds Caught in Vise of Rising Costs, Bad Loans (Bloomberg)

Goldman, Atlanta Fed Slash Q1 GDP Forecasts Below 2.0% (ZeroHedge)

America’s inflation problem isn’t high wages, it’s high rent (MarketWatch)

Investors “Unconcerned” About Record Corporate Debt (Dollar Collapse.com)

Trillion-Dollar Deficits Far as the Eye Can See (Daily Reckoning)

The Everything Bubble – Waiting For The Pin (David Stockman)

Is The U.S. Economy Really Growing? (Peter Cook, CFA)

Why It’s Right To Warn About A Bubble For 10 Years (Jesse Colombo)

Are U.S. Treasury Bonds Breaking Out? (Jesse Colombo)

BTFD or STFR? (Michael Lebowitz)

Technically Speaking: Chart Of The Year? (Lance Roberts)

March Madness For Investors (Michael Lebowitz)

Is The Dot.Com Bubble Back? (Lance Roberts)

Volatility Is Back (John Coumarianos)