Tag Archives: psychology

NFIB Survey Trips Economic Alarms

Last week, I wrote an article discussing the August employment report, which clearly showed a slowdown in employment activity and an overall deterioration the trend of the data. To wit:

“While the recent employment report was slightly below expectations, the annual rate of growth is slowing at a faster pace. Therefore, by applying a 3-month average of the seasonally-adjusted employment report, we see the slowdown more clearly.”

I want to follow that report up with analysis from the latest National Federation of Independent Businesses monthly Small Business Survey. While the mainstream media overlooks this data, it really shouldn’t be.

There are 28.8 million small businesses in the United States, according to the U.S. Small Business Administration, and they have 56.8 million employees. Small businesses (defined as businesses with fewer than 500 employees) account for 99.7% of all business in the U.S. The chart below shows the breakdown of firms and employment from the 2016 Census Bureau Data.

Simply, it is small businesses that drive the economy, employment, and wages. Therefore, what the NFIB says is extremely relevant to what is happening in the actual economy versus the headline economic data from Government sources.

In August, the survey declined 1.6 points to 103.1. While that may not sound like much, it is where the deterioration occurred that is most important.

As I discussed previously, when the index hit its record high:

Record levels of anything are records for a reason. It is where the point where previous limits were reached. Therefore, when a ‘record level’ is reached, it is NOT THE BEGINNING, but rather an indication of the MATURITY of a cycle.” 

That point of “exuberance” was the peak.

It is also important to note that small business confidence is highly correlated to changes in, not surprisingly, small-capitalization stocks.

The stock market, and the NFIB report, confirm risk is rising. As noted by the NFIB:

“The Uncertainty Index rose four points in August, suggesting that small business owners are reluctant to make major spending commitments.”

Before we dig into the details, let me remind you this is a “sentiment” based survey. This is a crucial concept to understand.

“Planning” to do something is a far different factor than actually “doing” it.

For example, the survey stated that 28% of business owners are “planning” capital outlays in the next few months. That’s sounds very positive until you look at the trend which has been negative. In other words, “plans” can change very quickly.

This is especially the case when you compare their “plans” to the outlook for economic growth.

The “Trump” boom appears to have run its course.

This has significant implications to the economy since “business investment” is an important component of the GDP calculation. Small business “plans” to make capital expenditures, which drives economic growth, has a high correlation with Real Gross Private Investment.

As I stated above, “expectations” are very fragile. The “uncertainty” arising from the ongoing trade war is weighing heavily on that previous exuberance.

If small businesses were convinced that the economy was “actually” improving over the longer term, they would be increasing capital expenditure plans rather than contracting their plans. The linkage between the economic outlook and CapEx plans is confirmation that business owners are concerned about committing capital in an uncertain environment.

In other words, they may “say” they are hopeful about the “economy,” they are just unwilling to ‘bet’ their capital on it.

This is easy to see when you compare business owner’s economic outlook as compared to economic growth. Not surprisingly, there is a high correlation between the two given the fact that business owners are the “boots on the ground” for the economy. Importantly, their current outlook does not support the ideas of stronger economic growth into the end of the year.

Of course, the Federal Reserve has been NO help in instilling confidence in small business owners to deploy capital into the economy. As NFIB’s Chief Economist Bill Dunkleberg stated:

“They are also quite unsure that cutting interest rates now will help the Federal Reserve to get more inflation or spur spending. On Main Street, inflation pressures are very low. Spending and hiring are strong, but a quarter-point reduction will not spur more borrowing and spending, especially when expectations for business conditions and sales are falling because of all the news about the coming recession. Cheap money is nice but not if there are fewer opportunities to invest it profitably.”

Fantasy Vs. Reality

The gap between those employers expecting to increase employment versus those that did has been widening. Currently, hiring has fallen back to the lower end of the range and contrasts the stats produced by the BLS showing large month gains every month in employment data. While those “expectations” should be “leading” actions, this has not been the case.

The divergence between expectations and reality can also be seen in actual sales versus expectations of increased sales. Employers do not hire just for the sake of hiring. Employees are one of the highest costs associated with any enterprise. Therefore, hiring takes place when there is an expectation of an increase in demand for a company’s product or services. 

This is also one of the great dichotomies the economic commentary which suggests retail consumption is “strong.” While business remain optimistic at the moment, actual weakness in retail sales is continuing to erode that exuberance.

Lastly, despite hopes of continued debt-driven consumption, business owners are still faced with actual sales that are at levels more normally associated with the onset of a recession.

With small business optimism waning currently, combined with many broader economic measures, it suggests the risk of a recession has risen in recent months.

Customers Are Cash Constrained

As I discussed previously, the gap between incomes and the cost of living is once again being filled by debt.

Record levels of consumer debt is a problem. There is simply a limit to how much “debt” each household can carry even at historically low interest rates. In turn, business owners remain on the defensive, reacting to increases in demand caused by population growth rather than building in anticipation of stronger economic activity. 

What this suggests is an inability for the current economy to gain traction as it takes increasing levels of debt just to sustain current levels of economic growth. However, that rate of growth is on the decline which we can see clearly in the RIA Economic Output Composite Index (EOCI). 

All of these surveys (both soft and hard data) are blended into one composite index which, when compared to GDP and LEI, has provided strong indications of turning points in economic activity. (See construction here)

As shown, the slowdown in economic activity has been broad enough to turn this very complex indicator lower.

No Recession In Sight

When you compare this data with last week’s employment data report, it is clear that “recession” risks are rising. One of the best leading indicators of a recession are “labor costs,” which as discussed in the report on “Cost & Consequences Of $15/hr Wages” is the highest cost to any business.

When those costs become onerous, businesses raise prices, consumers stop buying, and a recession sets in. So, what does this chart tell you?

Don’t ignore the data.

Today, we once again see many of the early warnings. If you have been paying attention to the trend of the economic data, and the yield curve, the warnings are becoming more pronounced.

In 2007, the market warned of a recession 14-months in advance of the recognition. 

Today, you may not have as long as the economy is running at one-half the rate of growth.

However, there are three lessons to be learned from this analysis:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

We do know, with absolute certainty, this cycle will end.

“Economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, cannot be repealed.” 

Being optimistic about the economy and the markets currently is far more entertaining than doom and gloom. However, it is the honest assessment of the data, along with the underlying trends, which are useful in protecting one’s wealth longer-term.

The Costs & Consequences Of $15/Hour – The Update

In 2016, I first touched on the impacts of hiking the minimum wage.

“What’s the big ‘hub-bub’ over raising the minimum wage to $15/hr? After all, the last time the minimum wage was raised was in 2009.

According to the April 2015, BLS report the numbers were quite underwhelming:

‘In 2014, 77.2 million workers age 16 and older in the United States were paid at hourly rates, representing 58.7 percent of all wage and salary workers. Among those paid by the hour, 1.3 million earned exactly the prevailing federal minimum wage of $7.25 per hour. About 1.7 million had wages below the federal minimum.

Together, these 3.0 million workers with wages at or below the federal minimum made up 3.9 percent of all hourly-paid workers. Of those 3 million workers, who were at or below the Federal minimum wage, 48.2% of that group were aged 16-24. Most importantly, the percentage of hourly paid workers earning the prevailing federal minimum wage or less declined from 4.3% in 2013 to 3.9% in 2014 and remains well below the 13.4% in 1979.'”

Hmm…3 million workers at minimum wage with roughly half aged 16-24. Where would that group of individuals most likely be found?


Not surprisingly, they primarily are found in the fast-food industry.

“So what? People working at restaurants need to make more money.”

Okay, let’s hike the minimum wage to $15/hr. That doesn’t sound like that big of a deal, right?

My daughter turned 16 in April and got her first summer job. She has no experience, no idea what “working” actually means, and is about to be the brunt of the cruel joke of “taxation” when she sees her first paycheck.

Let’s assume she worked full-time this summer earning $15/hour.

  • $15/hr X 40 hours per week = $600/week
  • $600/week x 4.3 weeks in a month = $2,580/month
  • $2580/month x 12 months = $30,960/year.

Let that soak in for a minute.

We are talking paying $30,000 per year to a 16-year old to flip burgers.

Now, what do you think is going to happen to the price of hamburgers when companies must pay $30,000 per year for “hamburger flippers?”

Not A Magic Bullet

After Seattle began increased their minimum wage, the NBER published a study with this conclusion:

“Using a variety of methods to analyze employment in all sectors paying below a specified real hourly rate, we conclude that the second wage increase to $13 reduced hours worked in low-wage jobs by around 9 percent, while hourly wages in such jobs increased by around 3 percent. Consequently, total payroll fell for such jobs, implying that the minimum wage ordinance lowered low-wage employees’ earnings by an average of $125 per month in 2016.”

This should not be surprising as labor costs are the highest expense to any business. It’s not just the actual wages, but  also payroll taxes, benefits, paid vacation, healthcare, etc. Employees are not cheap, and that cost must be covered by the goods or service sold. Therefore, if the consumer refuses to pay more, the costs have to be offset elsewhere.

For example, after Walmart and Target announced higher minimum wages, layoffs occurred (sorry, your “door greeter” retirement plan is “kaput”) and cashiers were replaced with self-checkout counters. Restaurants added surcharges to help cover the costs of higher wages, a “tax” on consumers, and chains like McDonald’s, and Panera Bread, replaced cashiers with apps and ordering kiosks.

A separate NBER study revealed some other issues:

“The workers who worked less in the months before the minimum-wage increase saw almost no improvement in overall pay — $4 a month on average over the same period, although the result was not statistically significant. While their hourly wage increased, their hours fell substantially. 

The potential new entrants who were not employed at the time of the first minimum-wage increase fared the worst. They noted that, at the time of the first increase, the growth rate in new workers in Seattle making less than $15 an hour flattened out and was lagging behind the growth rate in new workers making less than $15 outside Seattle’s county. This suggests that the minimum wage had priced some workers out of the labor market, according to the authors.”

Again, this should not be surprising. If a business can “try out” a new employee at a lower cost elsewhere, such is what they will do. If the employee becomes an “asset” to the business, they will be moved to higher-cost areas. If not, they are replaced.

Here is the point that is often overlooked.

Your Minimum Wage Is Zero

Individuals are worth what they “bring to the table” in terms of skills, work ethic, and value. Minimum wage jobs are starter positions to allow businesses to train, evaluate, and grow valuable employees.

  • If the employee performs as expected, wages increase as additional duties are increased.
  • If not, they either remain where they are, or they are replaced.

Minimum wage jobs were never meant to be a permanent position, nor were they meant to be a “living wage.”

Individuals who are capable, but do not aspire, to move beyond “entry-level” jobs have a different set of personal issues that providing higher levels of wages will not cure.

Lastly, despite these knock-off effects of businesses adjusting for higher costs, the real issue is that the economy will quickly absorb, and remove, the benefit of higher minimum wages. In other words, as the cost of production rises, the cost of living will rise commensurately, which will negate the intended benefit.

The reality is that while increasing the minimum wage may allow workers to bring home higher pay in the short term; ultimately they will be sent to the unemployment lines as companies either consolidate or eliminate positions, or replace them with machines.

There is also other inevitable unintended consequences of boosting the minimum wage.

The Trickle Up Effect:

According to Payscale, the median hourly wage for a fast-food manager is $11.00 an hour.

Therefore, what do you think happens when my daughter, who just got her first job with no experience, is making more than the manager of the restaurant? The owner will have to increase the manager’s salary. But wait. Now the manager is making more than the district manager which requires another pay hike. So forth, and so on.

Of course, none of this is a problem as long as you can pass on higher payroll, benefit and rising healthcare costs to the consumer. But with an economy stumbling along at 2%, this may be a problem.

A report from the Manhattan Institute concluded:

By eliminating jobs and/or reducing employment growth, economists have long understood that adoption of a higher minimum wage can harm the very poor who are intended to be helped. Nonetheless, a political drumbeat of proposals—including from the White House—now calls for an increase in the $7.25 minimum wage to levels as high as $15 per hour.

But this groundbreaking paper by Douglas Holtz-Eakin, president of the American Action Forum and former director of the Congressional Budget Office, and Ben Gitis, director of labormarket policy at the American Action Forum, comes to a strikingly different conclusion: not only would overall employment growth be lower as a result of a higher minimum wage, but much of the increase in income that would result for those fortunate enough to have jobs would go to relatively higher-income households—not to those households in poverty in whose name the campaign for a higher minimum wage is being waged.”

This is really just common sense logic but it is also what the CBO recently discovered as well.

The CBO Study Findings


  • “Raising the minimum wage has a variety of effects on both employment and family income. By increasing the cost of employing low-wage workers, a higher minimum wage generally leads employers to reduce the size of their workforce.
  • The effects on employment would also cause changes in prices and in the use of different types of labor and capital.
  • By boosting the income of low-wage workers who keep their jobs, a higher minimum wage raises their families’ real income, lifting some of those families out of poverty. However, real income falls for some families because other workers lose their jobs, business owners lose income, and prices increase for consumers. For those reasons, the net effect of a minimum-wage increase is to reduce average real family income.”


  • First, higher wages increase the cost to employers of producing goods and services. The employers pass some of those increased costs on to consumers in the form of higher prices, and those higher prices, in turn, lead consumers to purchase fewer goods and services.
  • The employers consequently produce fewer goods and services, so they reduce their employment of both low-wage workers and higher-wage workers.
  • Second, when the cost of employing low-wage workers goes up, the relative cost of employing higher-wage workers or investing in machines and technology goes down.
  • An increase in the minimum wage affects those two components in offsetting ways.
    • It increases the cost of employing new hires for firms
    • It also makes firms with raise wages for all current employees whose wages are below the new minimum, regardless of whether new workers are hired.

Effects Across Employers.

  • Employers vary in how they respond to a minimum-wage increase.
  • Employment tends to fall more, for example, at firms whose sales decline when they raise prices and at firms that can readily substitute machines or technology for low-wage workers.
  • They might  reduce workers’ fringe benefits (such as health insurance or pensions) and job perks (such as employee discounts), which would lessen the effect of the higher minimum wage on total compensation. That, in turn, would weaken employers’ incentives to reduce their employment of low-wage workers.
  • Employers could also partly offset their higher costs by cutting back on training or by assigning work to independent contractors who are not covered by the FLSA.

Macroeconomic Effects.

  • Reductions in employment would initially be concentrated at firms where higher prices quickly reduce sales. Over a longer period, however, more firms would replace low-wage workers with higher-wage workers, machines, and other substitutes.
  • A higher minimum wage shifts income from higher-wage consumers and business owners to low-wage workers. Because low-wage workers tend to spend a larger fraction of their earnings, some firms see increased demand for their goods and services, which boosts the employment of low-wage workers and higher-wage workers alike.
  • A decrease in the number of low-wage workers reduces the productivity of machines, buildings, and other capital goods. Although some businesses use more capital goods if labor is more expensive, that reduced productivity discourages other businesses from constructing new buildings and buying new machines. That reduction in capital reduces low-wage workers’ productivity, which leads to further reductions in their employment.

Don’t misunderstand me.

Hiking the minimum wage doesn’t affect my business at all as no one we employee makes minimum wage. This is true for MOST businesses.

The important point here is that the unintended consequences of a minimum wage hike in a weak economic environment are not inconsequential.

Furthermore, given that businesses are already fighting for profitability, hiking the minimum wage, given the subsequent “trickle up” effect, will lead to further increases in automation and the “off-shoring” of jobs to reduce rising employment costs. 

In other words, so much for bringing back those manufacturing jobs.

Shelton, The Fed, & The Realization Of A Liquidity Trap

Last week, President Trump nominated Judy Shelton to a board seat on the Federal Reserve. Shelton has been garnering a lot of “buzz” because of her outspoken and alternative stances, including “zero interest rates” and a “gold standard” for the U.S. dollar.

But, Shelton is full of inconsistent and incongruous views on monetary policy. For instance, in 2017 she stated:

“When governments manipulate exchange rates (by changing interest rates) to affect currency markets, they undermine the honest efforts of countries that wish to compete fairly in the global marketplace. Supply and demand are distorted by artificial prices conveyed through contrived exchange rates. Businesses fail as legitimately earned profits become currency losses,”

In short, when the Fed, or any central bank/government, lowers or raises interest rates it directly affects the currency exchange rates between countries and, ultimately, trade.

However, when recently asked on her views about whether the Fed should cut rates to boost economic growth, she said:

“The answer is yes.”

So, the U.S. should lower rates as long as it is beneficial for the U.S., but no one else should be allowed to do so because it is “unfair” to U.S. businesses.


This is also the same woman who supports a return to the “gold standard” for the U.S. dollar. With a limited supply of gold and a massive level of global trade based on the U.S. dollar reserve system, the value of the dollar would skyrocket effectively collapsing the entire global trade system. Zero interest rates and “gold back dollar” can not co-exist.

Shelton’s nomination by Trump is not surprising as he has been lobbying the Fed to cut rates in the misguided belief it will support economic growth. Shelton, who has been supportive of Trump’s views, recently stated her support to the WSJ which again shows her ignorance as to the actual workings of the economy.

“Today we are seeing impressive gains in productivity, which more than justify the meaningful wage gains we are likewise seeing—a testimonial to the pro-growth agenda. The Fed’s practice of paying banks to keep money parked at the Fed in deposit accounts instead of going into the economy is unhealthy and distorting; the rate should come down quickly as the practice is phased out.”

Well, this is the point, as we say in Texas, “We call Bulls**t.” 

As shown, the U.S. is currently running at lower levels of GDP, productivity, and wage growth than before the last recession. While this certainly doesn’t confirm Shelton’s analysis, it also doesn’t confirm the conventional wisdom that $33 Trillion in bailouts and liquidity, zero interest rates, and surging stock markets, are conducive to stronger economic growth for all.

However, what the data does confirm is the Fed is caught in a “liquidity trap.” 

The Liquidity Trap

Here is the definition:

“A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

Let’s take a moment to analyze that definition by breaking it down into its overriding assumptions.

There is little argument that Central Banks globally are injecting liquidity into the financial system.

However, has the increase in liquidity into the private banking system lowered interest rates?  That answer is also “yes.”  The chart below shows the increase in the Federal Reserve’s balance sheet, since they are the “buyer” of bonds, which in turn increases the excess reserve accounts of the major banks, as compared to the 10-year Treasury rate.

Of course, that money didn’t flow into the U.S. economy, it went into financial assets. With the markets having absorbed the current levels of accommodation, it is not surprising to see the markets demanding more, (The chart below compares the deviation between the S&P 500 and the Fed’s balance sheet. That deviation is the highest on record.)

While, in the Fed’s defense, it may be clear the Fed’s monetary interventions have suppressed interest rates, I would argue their liquidity-driven inducements have done much to support durable economic growth. Interest rates have not been falling just since the monetary interventions began – it began four decades ago as the economy began a shift to consumer credit leveraged service society.  The chart below shows the correlation between the decline of GDP, Interest Rates, Savings, and Inflation.

In reality, the ongoing decline in economic activity has been the result of declining productivity, stagnant wage growth, demographic trends, and massive surges in consumer, corporate and, government debt.

For these reasons, it is difficult to attribute much of the decline in interest rates and inflation to monetary policies when the long term trend was clearly intact long before these programs began.

There is also no real evidence excess liquidity and artificially low interest rates have spurred economic activity judging by some of the most common measures – Real GDP, Industrial Production, Employment, and Consumption.

While an argument can be made that the early initial rounds of QE contributed to the bounce in economic activity it is important to also remember several other supports during the latest economic cycle.

  1. Economic growth ALWAYS surges after recessionary weakness. This is due to the pent up demand that was built up during the recession and is unleashed back into the economy when confidence improves.
  2. There were multiple bailouts in 2009 from “cash for houses”, “fast cash loans”, “cash for clunkers”, “cash l” to direct bailouts of the banking system and the economy, etc., which greatly supported the post-recessionary boost.
  3. Several natural disasters from the “Japanese Trifecta” which shut down manufacturing temporarily, to massive hurricanes and wildfires, provided a series of one-time boosts to economic growth just as weakness was appearing.
  4. A massive surge in government spending which directly feeds the economy

The Fed’s interventions from 2010 forward, as the Fed became “the only game in town,” seems to have had little effect other than a massive inflation in asset prices. The evidence suggests the Federal Reserve has been experiencing a diminishing rate of return from their monetary policies.

Lack Of Velocity

Once again, we find Judy Shelton completely clueless as to how monetary policy actually translates into the economy. She recently stated:

“When you have an economy primed to grow because of reduced taxes, less regulation, dynamic energy, and trade reforms, you want to ensure maximum access to capital. The Fed’s practice of paying banks to keep money parked at the Fed in deposit accounts instead of going into the economy is unhealthy and distorting; the rate should come down quickly as the practice is phased out.”

Poor Judy.

There is absolutely no evidence that the Fed’s “zero interest rate policy” spurred a dramatic increased in lending over the last decade. Monetary velocity has been clear on this point.

The definition of a “liquidity trap” states that people begin hoarding cash in expectation of deflation, lack of aggregate demand or war. As the “tech bubble” eroded confidence in the financial system, followed by a bust in the credit/housing market, and wages have failed to keep up with the pace of living standards, monetary velocity has collapsed to the lowest levels on record.

The issue of monetary velocity is the key to the definition of a “liquidity trap.”  As stated above:

“The signature characteristic of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.” 

The chart below shows that, in fact, the Fed has actually been trapped for a very long time. The “economic composite” indicator is comprised of 10-year rates, inflation (CPI), wages, and the dollar index. While the BEA measure of GDP ticked up (due to consistent adjustments to calculation) the economic composite has not. More importantly, downturns in the composite lead the BEA measure.

The problem for the Fed has been that for the last three decades every time they have tightened monetary policy it has led to an economic slowdown or worse. More importantly, each rate hike cycle has continued to start at a lower rate level than the previous low, and has stopped at a level lower than the previous low as economic weakness set in.

While, in the short term, it appeared such accommodative policies aided in economic stabilization, it was actually lower interest rates increasing the use of leverage. However, the dark side of the increase in leverage was the erosion of economic growth, and increased deflationary pressures, as dollars were diverted from productive investment into debt service.

No Escape From The Trap

The Federal Reserve is now caught in the same “liquidity trap” that has been the history of Japan for the last three decades. With an aging demographic, which will continue to strain the financial system, increasing levels of indebtedness, and unproductive fiscal policy to combat the issues restraining economic growth, it is unlikely continued monetary interventions will do anything other than simply continuing the boom/bust cycles in financial assets.

The chart below shows the 10-year Japanese Government Bond yield as compared to their quarterly economic growth rates and the BOJ’s balance sheet. Low interest rates, and massive QE programs, have failed to spur sustainable economic activity over the last 20 years. Currently, 2, 5, and 10 year Japanese Government Bonds all have negative real yields.

The reason you know the Fed is caught in a “liquidity trap” is because they are being forced to lower rates due to economic weakness.

It is the only “trick” they know.

Unfortunately, such action will likely have little, or no effect, this time due to the current stage of the economic cycle.

While Judy Shelton may certainly have the President’s ear, her recent statements clearly show inconsistencies and a lack of understanding about how the economy and monetary policies function in the real world.

Of course, as we learned from Jerome Powell, what officials say before they are appointed, and do afterward, tend to be two very different things particularly when they have become “political animals.”

Exclusive Interview: Peter Boockvar

Last week, I visited with Peter Boockvar, Chief Investment Officer at Bleakley Advisory Group and Editor of The Boock Report. He previously was the Chief Market Analyst for The Lindsey Group, a macro economic and market research firm started by Larry Lindsey. Prior to this, Peter spent a brief time at Omega Advisors, a New York-based hedge fund, as a macro analyst and portfolio manager. Before this, he was an employee and partner at Miller Tabak + Co for 18 years where he was recently the equity strategist and a portfolio manager with Miller Tabak Advisors.

Peter and I cover a wide range of topics from the market, the coming recession, the impact and risks of higher rates, and the Federal Reserve.

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Exclusive Interview: Chris Martenson

I recently spent some time with Chris Martenson from Peak Prosperity about the market, the economy, and the “Great Reset” which is approaching.

Chris Martenson, PhD (Duke), MBA (Cornell) is an economic researcher and futurist specializing in energy and resource depletion, and co-founder of PeakProsperity.com (along with Adam Taggart). As one of the early econobloggers who forecasted the housing market collapse and stock market correction years in advance, Chris rose to prominence with the launch of his seminal video seminar: The Crash Course which has also been published in book form (Wiley, March 2011). It’s a popular and extremely well-regarded distillation of the interconnected forces in the Economy, Energy and the Environment (the “Three Es” as Chris calls them) that are shaping the future, one that will be defined by increasing challenges to growth as we have known it. In addition to the analysis and commentary he writes for his site PeakProsperity.com, Chris’ insights are in high demand by the media as well as academic, civic and private organizations around the world, including institutions such as the UN, the UK House of Commons and US State Legislatures.

The interview has been broken down into 3-chapters for your viewing consumption.

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Exclusive Interview: Daniel LaCalle

My interview with Daniel LaCalle on everything from Central Bank policy, interest rates, market risk, and the future of economic growth.

Read more from Daniel Lacalle at D-Lacalle.com

Daniel Lacalle is a PhD in Economy and fund manager. He holds the CIIA financial analyst title, with a post graduate degree in IESE and a master’s degree in economic investigation (UCV).

  • Chief Economist at Tressis SV
  • Fund Manager at Adriza International Opportunities.
  • Member of the advisory board of the Rafael del Pino foundation.
  • Commissioner of the Community of Madrid in London.
  • President of Instituto Mises Hispano.
  • Professor at IE business school, IEB and UNED.
  • Ranked Top 20 most influential economist in the world 2016

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Exclusive Interview: Doug Kass

My interview with the brilliant Doug Kass on the recent market rout, his views on the world, economic growth, and earnings outlook going into next year. We also talk bonds, market cycles, and why the bull market remains at risk.

You can subscribe to Doug’s excellent commentary at Real Money Pro

Doug cut his teeth as an investigator and truth-teller as a member of “Nader’s Raiders,” Ralph Nader’s crusaders for consumer protection and safety. In fact, he co-authored Citibank: The Ralph Nader Report with Ralph Nader and the Center for the Study of Responsive Law.

Kass started his investment career as a housing analyst at Kidder, Peabody in 1972 after receiving his bachelor’s from Alfred University and his MBA in Finance from the University of Pennsylvania’s Wharton School.

After holding a number of senior positions at brokerages, hedge funds and other institutions for the next three decades, he launched his own hedge fund, Seabreeze Partners Management, where he is President.

At Seabreeze, and as the top investor at Real Money Pro, Doug Kass identifies big winners again and avoids nasty losses by challenging Wall Street’s conventional wisdom.

He’s appeared in the New York Times, Wall Street Journal, Bloomberg, Barron’s, The Washington Post, The New York Post, CNBC and most major financial media.

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Orignal Article: Did Something Just Break?


The Risk Of An ETF Driven Liquidity Crash

Last week, James Rickards posted an interesting article discussing the risk to the financial markets from the rise in passive indexing. To wit:

“Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition.

This is the problem of ‘active’ versus ‘passive’ investors.

The active investor contributes to markets while trying to make money in them.

A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery.”

Evelyn Cheng highlighted the rise of passive investing as well:

Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets, according to a new report from JPMorgan.

‘While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals,‘ Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, said in a Tuesday note to clients.

Kolanovic estimates ‘fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago, he said.

‘Derivatives, quant fund flows, central bank policy and political developments have contributed to low market volatility’, Kolanovic said. Moreover, he said, ‘big data strategies are increasingly challenging traditional fundamental investing and will be a catalyst for changes in the years to come.’”

The rise in passive investing has been a byproduct of a decade-long infusion of liquidity and loose monetary policy which fostered a rise in asset prices to a valuation extreme only seen once previously in history. The following chart shows that this is exactly what is happening. Since 2009, over $2.5 trillion of equity investment has been added to passive-strategy funds, while $2.0 trillion has been withdrawn from active-strategy funds.

As James aptly notes:

“This chart reveals the most dangerous trend in investing today. Since the last financial crisis, $2.5 trillion has been added to “passive” equity strategies and $2.0 trillion has been withdrawn from “active” investment strategies. This means more investors are free riding on the research of fewer investors. When sentiment turns, the passive crowd will find there are few buyers left in the market.

When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.”

He is correct, and makes the same point that Frank Holmes recently penned in Forbes:

“Nevertheless, the seismic shift into indexing has come with some unexpected consequences, including price distortion. New research shows that it has inflated share prices for a number of popular stocks. A lot of trading now is based not on fundamentals but on low fees. These ramifications have only intensified as active managers have increasingly been pushed to the side.”

“This isn’t just the second largest bubble of the past four decades. E-commerce is also vastly overrepresented in equity indices, meaning extraordinary amounts of money are flowing into a very small number of stocks relative to the broader market. Apple alone is featured in almost 210 indices, according to Vincent Deluard, macro-strategist at INTL FCStone.

If there’s a rush to the exit, in other words, the selloff would cut through a significant swath of index investors unawares.”

As Frank notes, the problem with even 35% of the market being “passive” is the liquidity issues surrounding the market as a whole. With more ETF’s than individual stocks, and the number of outstanding shares traded being reduced by share buybacks, the risk of a sharp and disorderly reversal remains due to compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities, and contagion across asset markets.

The risk of a disorderly unwinding due to a lack of liquidity was highlighted by the head of the BOE, Mark Carney.

“Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.’”

In other words, the problem with passive investing is simply that it works, until it doesn’t.

You Only Think You Are Passive

As Howard Marks, mused in his ‘Liquidity’ note:

“ETF’s have become popular because they’re generally believed to be ‘better than mutual funds,’ in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours. But do the investors in ETFs wonder about the source of their liquidity?’”

What Howard is referring to is the “Greater Fool Theory,” which surmises there is always a “greater fool” than you in the market to sell to. While the answer is “yes,” as there is always a buyer for every seller, the question is always “at what price?” 

More importantly, individual investors are NOT passive even though they are investing in “passive” vehicles.

Today, more than ever, advisors are actively migrating portfolio management to the use of ETF’s for either some, if not all, of the asset allocation equation. However, they are NOT doing it “passively.”

The rise of index funds has turned everyone into “asset class pickers” instead of stock pickers. However, just because individuals are choosing to “buy baskets” of stocks, rather than individual securities, it is not a “passive” choice, but rather “active management” in a different form.  

While the idea of passive indexing works while all prices are rising, the reverse is also true. The problem is that once prices begin to fall – “passive indexers” will quickly become “active sellers.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic, and damaging, ending.

It is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are stacked against substantial market gains from current levels.

The reason that mean-reverting events have occurred throughout history, is that despite the best of intentions, individuals just simply refuse to act “rationally” by holding their investments as they watch losses mount.

This behavioral bias of investors is one of the most serious risks arising from ETFs as the concentration of too much capital in too few places. But this concentration risk is not the first time this has occurred:

  • In the early 70’s it was the “Nifty Fifty” stocks,
  • Then Mexican and Argentine bonds a few years after that
  • “Portfolio Insurance” was the “thing” in the mid -80’s
  • Dot.com anything was a great investment in 1999
  • Real estate has been a boom/bust cycle roughly every other decade, but 2006 was a doozy
  • Today, it’s ETF’s 

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing.

Until it goes in the other direction.

The sell-off in February of this year was not particularly unusual, however, it was the uniformity of the price moves which revealed the fallacy “passive investing” as investors headed for the door all at the same time.

It should serve as a warning.

When “robot trading algorithms”  begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.

Fortunately, while the price decline was indeed sharp, and a “rude awakening” for investors, it was just a correction within the ongoing “bullish trend.”

For now.

But nonetheless, the media has been quick to repeatedly point out the decline was the worst since 2008.

That certainly sounds bad.

The question is “which” 10% decline was it?

Regardless, it was only a glimpse at what will eventually be the “real” decline when leverage is eventually clipped. I warned of this previously:

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the ‘herding’ into ETF’s begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments. Don’t believe me? It happened in 2008 as the ‘Lehman Moment’ left investors helpless watching the crash.

Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.”

Make no mistake we are sitting on a “full tank of gas.” 

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline.

So, what’s your plan for when the real correction ultimately begins?

“If everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail.” – John C. Bogle.

VLOG – Why $1 Million Ain’t What It Used To Be

Clarity Financial Chief Investment Strategist Lance Roberts reviews the ugly truth behind numbers revealing that being a millionaire doesn’t quite have the same cache it did 30-years ago.

Also, why buy and hold investing, while it will make you money, won’t meet your financial goals in the future.

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VLOG – Are Markets Set To Soar Like 1992?

Clarity Financial Chief Financial Strategist Lance Roberts reviews the history of stock valuations, the CAPE, and how what happened in the early ’90’s is relevant to investors of the twenty-teens.

Orignal Article: Party Like It’s 1992

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Party Like It’s 1992?

Last week, Mark Hulbert warned of an indicator that hasn’t been this inflated since the “Dot.com” bubble. To wit:

“It’s been more than 25 years since the stock market’s long-term trailing return was as low as it is today. Since the top of the internet bubble in March 2000, the S&P 500 has produced a 1.4% annualized return after adjusting for both dividends and inflation. “

Whoa! How can that be given the market just set a record for the “longest bull market” in U.S. history?

This is a point that is lost on many investors who have only witnessed one half of a full market cycle. It is also the very essence of Warren Buffett’s most basic investment lesson:

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

Over the last 147-years of market history, there have only been five (5), relatively short periods, in history where the entirety of market “gains” were made. The rest of the time, the market was simply getting back to even.

Where you start your investing journey has everything to do with outcomes. Warren Buffett, for example, launched Berkshire Hathaway when valuations, and markets, were becoming historically undervalued. If Buffett had launched his firm in 2000, or even today, his “fame and fortune” would likely be drastically different.

Timing, as they say, is everything.

It is also worth noting, as shown below, that valuations clearly run in cycles over time. The current evolution of valuations has been extended longer than previous cycles due to 30-years of falling interest rates, massive increases in debt and leverage, unprecedented amounts of artificial stimulus, and government spending.

This was a point I discussed last week:

“There are two important things to consider with respect to the chart below.

  1. The shift higher in MEDIAN valuations was a function of falling economic growth and inflationary pressures.
  2. Higher prices were facilitated by increasing levels of leverage and debt, which eroded economic growth. “

But with returns low over the last 25-years, future returns should be significantly higher. Right?

Not necessarily. As Mark noted:

“Your conclusion from this sobering factoid depends on whether you see the glass as half-full or half-empty. The ‘half-full’ camp calls attention to what happened to stocks in the years after 1992, when stocks’ trailing two-decade return regressed to the mean — and then some: equities skyrocketed, elevating their trailing 18.5 year inflation-adjusted dividend-adjusted return to 11% annualized.

This optimistic view is the most pervasive. Return estimates for the S&P 500 have steadily risen in recent months as earnings have been buoyed by massive amounts of share buybacks and tax cuts.

With earnings rising, what’s not to love?

I get it.

But I disagree, and here’s why.

Throughout history, there is an undeniable link between valuation and return. More importantly, it is the expansion, or contraction, in valuations which are directly tied to the cycles of the market. When investors are willing to “pay up” for a future stream of cash flows, prices rise. When expectations for future cash flows decline, so do prices.

For those expecting a repeat of the post-1992 period, they are likely to be disappointed. As shown, in 1992, the deviation from the long-term median price/earnings ratio (using Shiller’s CAPE) was just below 0%. This gave investors plenty of room to expand valuations as inflation and interest rates fell, consumer and government debts surged, and the general masses swept into the “Wall Street Casino.” 

Today, valuations are at the second highest level in history. Despite the massive surge in earnings due to tax cuts – inflation and interest rates are low, revenue growth is weak as consumers, government, and corporations are fully leveraged, and households are “all in” the equity pool.

This is an important point which should not be overlooked.

The bullish premise has been that since tax cuts will cause a surge in earnings which we reduce valuations back to their long-term average. However, such is true as long as prices don’t increase during the period earnings are rising. But such as NOT been the case. Currently, the market has continued to “price in” those earnings increases keeping valuations elevated. 

As noted by Mark:

“Unfortunately, the CAPE today is back to within shouting distance of where it stood at the top of the internet bubble. It reached 44.2 then, and is 33.2 today. At no time in U.S. history other than the internet bubble has the CAPE been as high as it is now.”


It is not surprising that during periods of valuation expansion that investors eventually come to the conclusion that “this time is different.” The argument goes something like this:

“Sure, the CAPE ratio is elevated but had you sold, you would have missed out on this booming bull market.”

That statement is 100% true.

However, it grossly misunderstands the “value” of “valuations.” 

Valuations are not, and have never been, useful as a market timing indicator. Valuations should not be used as a “buy” or “sell” indicator in a portfolio management process.

What valuations do provide is a very clear understanding of what future expected returns will be over the next 10-20 years. Bill Hester wrote a very good note in this regard in response to critics of Shiller’s CAPE ratio and future annualized returns:

We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns.

It is also the same over 20-year periods even on a rolling 20-year real total-return basis.

“Even on a 20-year real total return basis, there was a negative return period. But while the three other periods were not negative after including dividends, when it comes to saving for retirement, a 20-year period of 1% returns isn’t much different from zero.”

There is also a reasonable argument that due to the “speed of movement” in the financial markets, a shortening of business cycles, changes to accounting rules, buyback activity, and increased liquidity, there is a “duration mismatch” between Shiller’s 10-year CAPE and the financial markets currently.

Therefore, in order to compensate for the potential “duration mismatch” of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.

The high correlation between the movements of the CAPE-5 and the S&P 500 index shouldn’t be a surprise. However, notice that prior to 1950 the movements of valuations were more coincident with the overall index as price movement was a primary driver of the valuation metric. As earnings growth began to advance much more quickly post-1950, price movement became less of a dominating factor. Therefore, you can see that the CAPE-5 ratio began to lead overall price changes.

A key “warning” for investors, since 1950, has been a decline in the CAPE-5 ratio which has tended to lead price declines in the overall market. The two most recent declines in the CAPE-5 also correlated with drops in the market in 2015-2016 and the beginning of 2018.

To get a better understanding of where valuations are currently relative to past history, and why this is likely NOT 1992, we can look at the deviation between current valuation levels and the long-term average. 

The importance of deviation is crucial to understand. In order for there to be an “average,” valuations had to be both above and below that “average” over history. These “averages” provide a gravitational pull on valuations over time which is why the further the deviation is away from the “average,” the greater the eventual “mean reversion” will be.

The first chart below is the percentage deviation of the CAPE-5 ratio from its long-term average going back to 1900.

Currently, the 76.15% deviation above the long-term CAPE-5 average of 15.86x earnings puts valuations at levels only witnessed two (2) other times in history – 1929 and 2000. As stated above, while it is hoped “this time will be different,” which were the same words uttered during each of the two previous periods, you can clearly see that the eventual outcomes were much less optimal.

However, as noted, the changes that have occurred Post-WWII in terms of economic prosperity, changes in operational capacity and productivity warrant a look at just the period from 1944-present.

Again, as with the long-term view above, the current deviation is 61.8% above the Post-WWII CAPE-5 average of 17.27x earnings. Such a level of deviation has only been witnessed one other time previously over the last 70 years as we headed into the “Dot.com” peak. Again, as with the long-term view above, the resulting “reversion” was not kind to investors.

Is this a better measure than Shiller’s CAPE-10 ratio?

Maybe, as it adjusts more quickly to a faster moving marketplace. However, I want to reiterate that neither the Shiller’s CAPE-10 ratio or the modified CAPE-5 ratio were ever meant to be “market timing” indicators.

Since valuations determine forward returns, the sole purpose is to denote periods which carry exceptionally high levels of investment risk and resulted in exceptionally poor levels of future returns.

Currently, valuation measures are clearly warning the future market returns are going to be substantially lower than they have been over the past ten years. Therefore, if you are expecting the markets to crank out 10% annualized returns over the next 10 years for you to meet your retirement goals, it is likely that you are going to be very disappointed.

Does that mean you should be all in cash today? Of course, not.

However, it does suggest that a more cautious stance to equity allocations and increased risk management will likely offset much of the next “reversion” when it occurs.

My client’s have only two objectives:

  1. Protect investment capital from major market reversions,  and;
  2. Meet investment returns anchored to retirement planning projections.

Not paying attention to rising investment risks, or adjusting for lower expected future returns, are detrimental to both of those objectives.

Or, you can just hope it all works out.

For 80% of Americans, it just simply hasn’t been the case.

VLOG – Why Smart Investors Should Fear An Inversion

Clarity Financial Chief Investment Strategist Lance Roberts shows why the danger of asset bubbles in every investment class is part of a recipe for reversal as the bond yield curves begin to invert…and what that means for your money.

Original Forbes Article By Jesse Colombo

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VLOG – Markets Diverge From The U.S.

Clarity Financial Chief Investment Strategist Lance Roberts examines the divergence of world markets to the U.S. and discusses the message they may be sending to investors.

VLOG – A Shift In Valuations & Investor Perspectives

Clarity Financial Chief Investment Strategist Lance Roberts examines stock valuations vs investor sentiment, and agrees with Prof. Robert Shiller’s assessment that investors have become complacent to the risk of higher valuations.

The Ingredients Of An “Event”

This past week marked the 10th-Anniversary of the collapse of Lehman Brothers. Of course, there were many articles recounting the collapse and laying blame for the “great financial crisis” at their feet. But, as is always the case, an “event” is always the blame for major reversions rather than the actions which created the environment necessary for the crash to occur. In the case of the “financial crisis,” Lehman was the “event” which accelerated a market correction that was already well underway.

I have noted the topping process and the point where we exited the markets. Importantly, while the market was giving ample signals that something was going wrong, the mainstream analysis continued to promote the narrative of a “Goldilocks Economy.” It wasn’t until December of 2008, when the economic data was negatively revised, the recession was revealed.

Of course, the focus was the “Lehman Moment,” and the excuse was simply: “no one could have seen it coming.”

But many did. In December of 2007 we wrote:

“We are likely in, or about to be in, the worst recession since the ‘Great Depression.'”

A year later, we knew the truth.

Throughout history, there have been numerous “financial events” which have devastated investors. The major ones are marked indelibly in our financial history: “The Crash Of 1929,” “The Crash Of 1974,” “Black Monday (1987),” “The Dot.Com Crash,” and the “The Financial Crisis.” 

Each of these previous events was believed to be the last. Each time the “culprit” was addressed and the markets were assured the problem would not occur again. For example, following the crash in 1929, the Securities and Exchange Commission, and the 1940 Securities Act, were established to prevent the next crash by separating banks and brokerage firms and protecting against another Charles Ponzi. (In 1999, legislation was passed to allow banks and brokerages to reunite. 8-years later we had a financial crisis and Bernie Madoff. Coincidence?)

In hindsight, the government has always acted to prevent what was believed to the “cause” of the previous crash. Most recently, Sarbanes-Oxley and Dodd-Frank legislations were passed following the market crashes of 2000 and 2008.

But legislation isn’t the cure for what causes markets to crash. Legislation only addresses the visible byproduct of the underlying ingredients. For example, Sarbanes-Oxley addressed the faulty accounting and reporting by companies like Enron, WorldCom, and Global Crossing. Dodd-Frank legislation primarily addressed the “bad behavior” by banks (which has now been mostly repealed).

While faulty accounting and “bad behavior” certainly contributed to the end result, those issues were not the cause of the crash.

Recently, John Mauldin addressed this issue:

“In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

While the idea is correct, this assumes that at some point the markets collapse under their own weight when something gives.

I think it is actually a little different. In my view, ingredients like nitrogen, glycerol, sand, and shell are mostly innocuous things and pose little real danger by themselves. However, when they are combined together, and a process is applied to bind them, you make dynamite. But even dynamite, while dangerous, does not immediately explode as long as it is handled properly. It is only when dynamite comes into contact with the appropriate catalyst that it becomes a problem. 

“Mean reverting events,” bear markets, and financial crisis, are all the result of a combined set of ingredients to which a catalyst was applied. Looking back through history we find similar ingredients each and every time.

The Ingredients


Throughout the entire monetary ecosystem, there is a consensus that “debt doesn’t matter” as long as interest rates remain low. Of course, the ultra-low interest rate policy administered by the Federal Reserve is responsible for the “yield chase” and has fostered a massive surge in debt in the U.S. since the “financial crisis.”  

Importantly, debt and leverage, by itself is not a danger. Actually, leverage is supportive of higher asset prices as long as rates remain low and the demand for, rates of return on, other assets remains high.


Likewise, high valuations are also “inert” as long as everything asset prices are rising. In fact, rising valuations supports the “bullish” thesis as higher valuations represent a rising optimism about future growth. In other words, investors are willing to “pay up” today for expected further growth.

While valuations are a horrible “timing indicator” for managing a portfolio in the short-term, valuations are the “great predictor” of future investment returns over the long-term.


Of course, one of the critical drivers of the financial markets in the “short-term” is investor psychology. As asset prices rise, investors become increasingly confident and are willing to commit increasing levels of capital to risk assets. The chart below shows the level of assets dedicated to cash, bear market funds, and bull market funds. Currently, the level of “bullish optimism” as represented by investor allocations is at the highest level on record.

Again, as long as nothing adversely changes, “bullish sentiment begets bullish sentiment” which is supportive of higher asset prices.


Of course, the key ingredient is ownership. High valuations, bullish sentiment, and leverage are completely meaningless if there is no ownership of the underlying equities. The two charts below show both household and corporate levels of equity ownership relative to previous points in history.

Once again, we find rising levels of ownership are a good thing as long as prices are rising. As prices rise, individuals continue to increase ownership in appreciating assets which, in turn, increases the price of the assets being purchased.


Another key ingredient to rising asset prices is momentum. As prices rice, demand for rising assets also rises which creates a further demand on a limited supply of assets increasing prices of those assets at a faster pace. Rising momentum is supportive of higher asset prices in the short-term.

The chart below shows the real price of the S&P 500 index versus its long-term bollinger-bands, valuations, relative-strength, and its deviation above the 3-year moving average. The red vertical lines show where the peaks in these measures were historically located.

The Formulation

Like dynamite, the individual ingredients are relatively harmless. However, when the ingredients are combined they become potentially dangerous.

Leverage + Valuations + Psychology + Ownership + Momentum = “Mean Reverting Event”

Importantly, in the short-term, this particular formula does indeed remain supportive for higher asset prices. Of course, the more prices rise, the more optimistic the investing becomes as it becomes common to believe “this time is different.”

While the combination of ingredients is indeed dangerous, they remain “inert” until exposed to the right catalyst.

These same ingredients were present during every crash throughout history.

All they needed was the right catalyst.

The catalyst, or rather the “match that lit the fuse,” was the same each time.

The Catalyst

In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became “active,” monetarily policy-wise. As shown in the chart below, when the Fed has embarked upon a rate hiking campaign, bad “stuff” has historically followed.

With the Fed expected to hike rates 2-more times in 2018, and even further in 2019, it is likely the Fed has already “lit the fuse” on the next financially-related event.

Yes, the correction will begin as it has in the past, slowly, quietly, and many investors will presume it is simply another “buy the dip” opportunity.

Then suddenly, without reason, the increase in interest rates will trigger a credit-related event. The sell-off will gain traction, sentiment will reverse, and as prices decline the selling will accelerate.

Then a secondary explosion occurs as margin-calls are triggered. Once this occurs, a forced liquidation cycle begins. As assets are sold, prices decline as buyers simply disappear. As prices drop further, more margin calls are triggered requiring further liquidation. The liquidation cycle continues until margin is exhausted.

But the risk to investors is NOT just a market decline of 40-50%.

While such a decline, in and of itself, would devastate the already underfunded 80% of the population that is currently woefully under-prepared for retirement, it would also unleash a host of related collapses throughout the economy as a rush to liquidate holdings accelerates.

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.

But it doesn’t end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

As debts and deficits swell in coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

All the ingredients for the next market crash are currently present. All that is current missing is the “catalyst” which ignites it all.

There are many who currently believe “bear markets” and “crashes” are a relic of the past. Central banks globally now have the financial markets under their control and they will never allow another crash to occur. Maybe that is indeed the case. However, it is worth remembering that such beliefs were always present when, to quote Irving Fisher, “stocks are at a permanently high plateau.” 

3 Things: Fake News, Net Positioning, Buying Panic


#FakeNews In Investing

I regularly push back on the “buy and hold” investing meme because while it works in “theory,” reality has a far different outcome. This is not my opinion, it is the reality of human emotion and psychology as it impacts portfolio management over time. The annual Dalbar Investor survey shows the massive performance lag of individuals not only in the short-term but in the long-term as well. To wit:

  • In 2015, the 20-year annualized S&P return was 8.19% while the 20-year annualized return for the average equity mutual fund investor was only 4.67%, a gap of 3.52%.


Here is a visual of the lag between expectations and reality.


Importantly, THERE IS NO evidence linking investment recommendations to average investor underperformance. Analysis of the underperformance shows that investor behavior is the number one cause, with fees being the second leading cause.

There are THREE reasons why “buy and hold” investment strategies DO NOT WORK according to the Dalbar study:


So, why am I bringing this up?

After recently pinging on the fallacy of “passive investing,” because you are not passive, I invariably receive push back from advisors who cling to the hope that markets will continue to rise indefinitely. Such as this one:

“Just caught up with your latest effort in the fake news category. The thrust of your argument seems to be, wrongly as usual, that active outperforms passive in bear markets.”  – Brent

Actually, no, that is not my argument.

My consistent argument is individuals, like Brent, mislead themselves, or their clients, by suggesting they will get average rates of return over time. They won’t and they don’t.

Markets do NOT compound returns, you do not get average returns, and you do not have 100-plus years to reach your goal.

Investing without a discipline or skill set is easy when the “bull market” is running. It is when the next “bear market” growls where individuals will be decimated as the mean reverting event takes its toll. As history proves, everyone has a threshold of pain – and bear markets always exert the pain required to force investors out near the bottom. 

This is just reality and why protecting capital during market declines is much more critical that chasing returns during market advances.

Furthermore, there is substantial evidence that a good manager with the right skill set can outperform over time. It took me about 5-minutes with a screener to find mutual funds that have outperformed the Vanguard S&P Index fund over the last 20-years.

Take the best performing fund over the last 20-years out of our group above. Sequoia has had a rough couple of years and is severely underperforming the market in the short-term. According to the current mentality, you should sell that fund and buy a passive index ETF. Why pay a fee for an underperforming fund. Right?

That decision would have cost you dearly coming out of the financial crisis.

As is always the case, a ramping bull market hides investor mistakes – it is the bear market that reveals them. However, it is psychology and fees that are the leading causes of underperformance during a bull market advance.

Investors need to be cognizant of, and understand why, the chorus of arguments in favor of short-sighted and flawed strategies are so prevalent. The meteoric rise in passive investing is one such “strategy” sending an important and timely warning.

Just remember, everyone is “passive” until the selling begins.

Net Positioning

Prior to 1991, the Commodity Futures Trading Commission (CFTC) compiled the Commitments of Traders Report (COT Report) once a month. This data reflected the three major trading groups positions as of the last trading day of the month and was released to the public 3-5 days later electronically and 10-15 days later by printed report. Then, from 1/91 to 10/92, the CFTC compiled the COT Report twice a month reflecting the holdings on the 15th of the month and the last trading day of the month. Again, the data was released days later to the public.

Beginning on 10/16/92 to the present, the CFTC compiles the data weekly reflecting the holdings as of the close of each Tuesday.  This data is released electronically to the public every Friday at 3:30 P.M and covers the holdings as of the previous Tuesday.

COT data is exceptionally important data as it is the sole source of the actual holdings of the three key commodity-trading groups, namely:

  • Commercial Traders: this group consists of traders that use futures contracts for hedging purposes and whose positions exceed the reporting levels of the CFTC. These traders are usually involved with the production and/or processing of the underlying commodity.
  • Non-Commercial Traders: this group consists of traders that don’t use futures contracts for hedging and whose positions exceed the CFTC reporting levels They are typically large traders such as clearinghouses, futures commission merchants, foreign brokers, etc.
  • Small Traders: the positions of these traders do not exceed the CFTC reporting levels, and as the name implies, these are usually small traders.

The data we are interested in is the second group of Non-Commercial Traders. This is the group that speculates on where they believe the market is headed. While you would expect these individuals to be “smarter” than retail investors, we find they are just as subject to human fallacy and “herd mentality” as everyone else.

Therefore, as shown in the series of charts below, we can take a look at their current net positioning (long contracts minus short contracts) to gauge excessive bullishness or bearishness on the S&P 500, VIX, Crude Oil, US Dollar and 10-Year Treasury Bonds. With the exception of the 10-Year Treasury which I have compared to interest rates, the others have been compared to the S&P 500.

With the exception of the S&P 500, which is currently building a net short position which has usually denoted short-term market tops, the speculative positioning in the other major categories are extremely “crowded trades” currently. Historically, when the herd is eventually flushed in the opposite direction, the selling becomes a “stampede” to reverse positioning. 

The only question is “what” will be the trigger.

Buying Panic

The market has been surging higher since the beginning of the month based on the “hopes” of a “terrific” tax reform package from the Trump administration. As investors “rush to get in,” the issue of “risk” has now become an antiquated notion.

With the market currently trading almost 8% above the 200-dma, the risk of a “reversion” to the mean is obviously nothing to worry about, right?

Maybe not so fast. The chart below shows the very similar technical setup of the market going into the peak of the market in 2007.

I don’t need to remind you what happened next.

Even if tax cuts come through, they won’t impact the market until 2018. And according to Credit Suisse, there is still a problem:

“Investors have been asking how valuations look on 2018 EPS, when it is becoming more likely … that stock market friendly policy changes in Washington could materialize. On current 2018 expectations, US stocks still look highly overvalued.”

The charts below trace forward-looking price-to-earnings ratios all the way back to the mid-1980s:

Given that Wall Street has given up the difficult work of picking stocks and making models, of calling experts and building theories, and are now just trading on “Trump Tweets,” what could possibly go wrong?

Just some things I am thinking about.

3 Things: Better Use Of P/E, Loans & Too Quiet

A Better Way To Use P/E’s

There has been an ongoing debate about market valuations and the current state of the financial markets. On one hand, the “bulls” use forward price-earnings ratios to justify current valuation levels while the the “bears” cite trailing valuations based on reported earnings per share. The problem with both measures is that valuations, at any specific point in time, are horrible portfolio management tools.

[Note: One of the most egregious fabrications used by Wall Street to try and sell individuals investment products is using forward P/E ratios based operating earnings (earnings before reality) as compared to historical trailing P/E ratios based on reported earnings]

One of the primary problems with fundamental measures, such as P/E ratios, is the “duration mismatch.”

What is truly ironic is that when it comes to buying ‘crap’ we don’t really need, people will spend hours researching brands, specifications, and pricing. However, when it comes to investing our ‘hard earned savings,’ we tend to spend less time researching the underlying investment and more time fantasizing about our future wealth.”

This “mentality” leads to what I call a “duration mismatch” in investing. While valuations give us a fairly good assessment about future returns, such analysis is based on time frames of five years or longer. However, for individuals, average holding periods for investments has fallen from eight years in the 1960’s to just six months currently.

The point to be made here is simple. The time frame required for fundamental valuation measures to be effective in portfolio management are nullified by short-term investment horizons.

It is critical to understand that the current LEVEL of valuations are only useful in determining what the long-term return will be. This is something I have discussed many times previously as it relates to your financial planning specifically. 

More importantly, every bull market in history has ultimately crumbled under the weight of fundamental realities. Despite the many hopes to the contrary, this time will be no different. But rather than arguing absolute valuation levels and future expected returns; P/E ratios can also be used to tell us much about the current trend of the markets as well as major turning points.

The chart below shows the monthly P/E ratio (using Dr. Robert Shiller’s data) going back to 1881.

There is something about P/E ratios that is rarely discussed by the financial media which is whether valuation levels are “expanding” or “contracting.” I have noted the major periods of multiple expansions and contractions. (The green shaded area is the deviation of current multiples from the long-term median.)

I have smoothed the data in the chart above with a 12-month average to better identify the “trend” of valuations as compared to the S&P 500 as shown in the chart below.

Not surprisingly, we find that periods where multiples are “expanding” are correlated to rising asset prices and vice-versa. Therefore, viewing changes in the direction (or trend) of valuations can provide some clue as to changes in market cycles. This is due to the fact that changes in price (“P”) has a much greater near-term impact on valuations than earnings (“E”). While I am NOT suggesting that earnings are unimportant, changes to earnings move at a much slower pace than price and, therefore, has a muted effect on the directional changes to the overall P/E ratio.

Since 2010, almost 2/3rds of the increase in the P/E Ratio has come from price rather than earnings growth. The same is true during declining markets when dramatic changes in price have a much bigger impact on valuation changes.

Importantly, I am NOT suggesting that P/E’s could or should be used as a “market timing” tool. However, it is quite clear that over shorter-term time frames the directional trend of valuations, rather than the absolute level, is much more telling.

Currently, the ongoing multiple expansion remains supportive to overall stock prices. This is one primary reason why my portfolio allocation model remains fully invested. However, this does not mean that you should go “diving” headfirst into the pool either. The low-hanging fruit has already been harvested and, as noted above, future returns on investments made today are likely to be disappointing.

Bank Loans Issue Warning

At the heart of every major economic expansion in history is lending. Not surprisingly, as shown in the chart below, lending tends to lag changes in the overall economic growth rate. This is because, of course, businesses tend to want confirmation of improvement in the economy before taking on extra debt. Conversely, debt is then liquidated through debt reductions, forced payoffs or defaults during an economic decline. This correlation is shown below.

The downturn in commercial loans and leases, while early, should issue a sign of caution to investors about applying too much hope to the current administration to spark an economic rebound in the near term. While tax cuts, repatriations, and tax reform may indeed provide a boost to bottom line earnings, as I have stated previously, there is likely going to be little throughput into the economy unless there is a significant ramp up in consumer demand. But therein lies the problem:

“Here is another problem. While economists, media, and analysts wish to blame those ‘stingy consumers’ for not buying more stuff, the reality is the majority of American consumers have likely reached the limits of their ability to consume. This decline in economic growth over the past 30 years has kept the average American struggling to maintain their standard of living.”

Without the end demand from consumers to push companies to expand production, increase employment and raise prices, there is little impetus for companies to expend capital. The chart below shows the relationship between the extensions of loans and leases as it relates to private fixed investment. Despite hopes that companies would deploy borrowed capital into fixed investment to expand production leading to more job creation, this has not been the case. The ongoing decline in fixed investment continues to suggest an ongoing caution by business owners in deploying capital in productive manners but rather through leverage capital to increase productivity and financial engineering.

The lack of deployment borrowed capital can be clearly seen in the relationship between loans and leases and monetary velocity. While bank loans have increased since 2010, as financial engineering to boost earnings per share to offset weak revenue growth surged, the movement of money through the economic system has continued to plunge. Hence, this is why, despite soaring earnings and stock market prices, the economy has continued to stumble along at 2% annual growth rates as the economy remains starved of monetary flows.

Again, this indicator is very early in its suggestion of weakening demand for credit. However, given the very late stage of economic expansion, this could well be an early warning sign worth paying attention to.

It’s Been Quiet – What Happens Next?

As I was catching up on my reading this morning, this comment from the WSJ caught my attention:

“The S&P 500 hasn’t experienced a daily trading range of 1% or greater for 34 consecutive trading sessions, the longest streak since 1995, according to the Journal’s Market Data Group.

Should the market stay stuck in the doldrums on Monday, it would be the longest streak dating back to at least 1974, according to Thomson Reuters data. And guess what? The S&P 500 has inched down 0.2% in recent trading, putting the record in reach.

The average daily range between a session’s intraday high and low over that stretch, dating back to Dec. 14, is just 0.54%, according to FactSet. That compares to the S&P 500′s average daily trading range in 2016 was 0.96%.”

The reason this was interesting is because of something I was discussing last year during the month of September:

“The bulls and the bears have met at the crossroad. However, neither is ready to commit capital towards their inherent convictions. So, for 43-days, and counting, we remain range bound waiting for what is going to happen next.”


Let me remind you how that ended.

So, here we are once again. Since December the 15th, there has been little volatility in the market. This has lured investors into the same false sense of security seen last year before the rout heading into the November election.

Of course, the problem is we simply don’t know for sure which way this “historically tight trading range” will resolve itself, or when. What is for certain, is that it eventually will. The problem for investors is the “bet wrong” syndrome that occurs in times like this.

I know. It’s boring. We all want to “DO SOMETHING.”  But that is simply your emotions at work.

In investing, sometimes the best thing “TO DO” is to “DO NOTHING.”  This is where having the patience to wait for the “fat pitch” becomes much more difficult, but more often than not, provides the best results.

While we remain in the seasonally strong time of the year, a short-term correction remains likely as I detailed previously in “Buy The Dip?” 

Importantly, I have noted with vertical dashed red lines the buy and sell indications relative to the markets subsequent direction. In each case, a registered sell signal at the top of the chart, and confirmed by a reversal of the bottom indicator, have led to short and intermediate-term corrections in the market. These two signals should not be ignored.”

“In this analysis, the correction could be as small as 2.7% or potentially as large at 13.2%. This is quite a dispersion of outcomes and one we will only know with certainty after the fact. However, recent history has suggested that similar setups have seen deeper corrections so such risk should not be readily dismissed.”

Given the overall optimism of the markets, currently based solely on “hopes” of fiscal policy forcing fundamentals to catch up with price, the most likely outcome is the market finding support between the 4.9% and 6.6% correction levels. This should not be any surprise since the markets have suffered 5% corrections, or more, with regularity over the past couple of years.

Just some things I am thinking about.

3 Things: February Disappointment, Fed & A 50-70% Decline?

February Bumps

With January now behind us, and as the luster of the election begins to fade, the question becomes what will the month of February bring. While it is impossible to predict outcomes with absolute certainly, we can look at historical precedents to discern the risk that we undertake as investors.

If we look at the month of February going back to 1960 we find that there is a slight bias to February ending positively 57% of the time.

Unfortunately, the declines in losing months have wiped out the gains in the positive months leaving the average return for February almost a draw (+.01%)

A look at daily price movements during the month, on average, reveal the 4th trading day of February through the 12th day provide the best opportunity to rebalance portfolio allocations and reduce overall portfolio risk.

Currently, bullish exuberance is once again pushing extremely high levels. As noted yesterday:

Historically, the combination of excessive exuberance, complacency and extensions have not worked out well for investors in the short-term.

Furthermore, Blake Morrow at Forex Analytix made an interesting point as well:

“We have been making higher highs and higher lows (the definition of an uptrend). However, the rate that the higher highs are happening is lower than that of the higher lows. From this, it follows that we may be developing an ascending wedge. Also, the apex is not as tight in price that I typically like for a reversal pattern.

3 Things: Inflation, Stocks Vs. Bonds & Everyone’s A Genius

Another View On The Inflation Argument

There is little evidence that current levels of inflation are stable. As I wrote in “Inflation: The Good & The Bad”, outside of just two areas, rent and health care, there remains a broader deflationary trend currently.

Importantly, as I noted, there are two types of inflation:

“Inflationary pressures can be representative of expanding economic strength if it is reflected in the stronger pricing of both imports and exports. Such increases in prices would suggest stronger consumptive demand, which is 2/3rds of economic growth, and increases in wages allowing for absorption of higher prices.

That would be the good.

The bad would be inflationary pressures in areas which are direct expenses to the household. Such increases curtail consumptive demand, which negatively impacts pricing pressure, by diverting consumer cash flows into non-productive goods or services.”

There is another way to view whether the “good” inflation is manifesting itself within the economy. The chart below shows the three major components that input into creating economically viable inflation – commodity prices (which reflects real economic activity,) wages (which allow for increases in spending and support for higher prices,) and the Velocity Of Money (which shows the demand for money through the economic system.) 

When we combined these three components into a composite inflation index, and compare it to CPI, we find an important outcome.

Currently, there are relatively few “real” inflationary pressures in the economy particularly as monetary velocity continues to plummet. It is also notable that both CPI and the inflation index remain below 2.5% even as interest rates push that level. Ultimately, either inflation will rear its head, or rates will drop back in line with the historic norms of real inflation levels and economic growth. 

There is little argument over the fact that the current economic growth rate has been “sluggish” at best. Growth in the financial markets has been primarily a function of the Federal Reserve’s ongoing balance sheet expansion as economic activity remains fairly subdued. With the Federal Reserve now increasing interest rates over concerns about rising inflationary pressures, the Fed may once again be making the same mistake as they did in 1999. To wit:

If this market rally seems eerily familiar, it’s because it is. If fact, the backdrop of the rally reminds me much of what was happening in 1999.


  • Fed was hiking rates as worries about inflationary pressures were present.
  • Economic growth was improving 
  • Interest and inflation were rising
  • Earnings were rising through the use of “new metrics,” share buybacks and an M&A spree. (Who can forget the market greats of Enron, Worldcom & Global Crossing)
  • The stock market was beginning to go parabolic as exuberance exploded in a “can’t lose market.”

If you were around then, you will remember.

With Yellen, and the Fed, once again chasing an imaginary inflation ‘boogeyman’ (inflation is currently lower than any pre-recessionary period since the 1970’s) the tightening of monetary policy, with already weak economic growth, may once again prove problematic.”

The biggest fear of the Federal Reserve has been the deflationary pressures that have continued to depress the domestic economy. Despite the trillions of dollars of interventions by the Fed, the only real accomplishment has been keeping the economy from slipping back into an outright recession.

Despite many claims to the contrary, the global economy is far from healed which explains the need for ongoing global central bank interventions. However, even these interventions seem to be having a diminished rate of return in spurring real economic activity despite the inflation of asset prices.

What is being realized on a global basis is that injecting the system with liquidity that flows into asset prices, does not create organic economic demand. Both Japan and the Eurozone’s interventions have failed to spark inflationary pressures as the massive debt burden’s carried by these countries continues to sap the ability to stimulate real growth. The U.S. is facing the same pressures as continued stimulative measures have only succeeded in widening the wealth gap but failed to spark inflation or higher levels of economic prosperity for 90% of Americans.

With inflationary pressures impacting the areas that specifically target consumptive spending, there is a real risk of a monetary policy mistake as the Fed once again chases an “inflation boogeyman.” 

Stock/Bond Ratio Confirms Breakout

Following the October swoon, stocks have vaulted to all-time highs following the election of President Trump with the Dow recently breaking above the magical 20,000 level.

As I discussed previously in “Danger Lurks As Extremes Become The Norm” there have only been few occasions where investors have felt so “giddy” about the financial markets. Such periods of exuberance have never ended well for investors as they were deluded by near-term “greed” which blinded them to the building risks. 

Surprisingly, investors are currently more exuberant than just about at any other time on record.”

One of the things that I pay close attention to is the ratio of the S&P 500 compared to longer duration bonds. The theory is that when investors are willing to take on more risk, money flows out of “safe haven” like bonds to equities as portfolio allocations become more aggressively tilted. The opposite occurs as investors began to reduce “risk exposure” in portfolios and focus more on “safety.”

As you can see in the chart below, there is a very high level of correlation between the rise and fall of the stock/bond ratio and the very broad Wilshire 5000 index.

Since the Fed began extracting liquidity from the markets, beginning with the end of QE 3 and now the hiking of interest rates, the stock-bond ratio deviated from its normal correlation. However, post the election in November, that correlation has now rejoined the market as exuberance thrives and the ratio is pushing higher extremes. 

Of course, with seemingly everyone in the “bullish camp,” and a good degree of history forgotten, Bob Farrell’s rule #9 comes to mind:

“When everyone agrees; something else is bound to happen.”

With the markets hitting all-time highs, this is an event that has only occurred during very short periods of our long market history. Of course, this only makes sense that when considering that the market spends the majority of its time making up previous losses. As my father often told me:

“Breaking even is not an investment strategy.”

But for now – it’s “Party On, Garth.” 

Everyone’s A Genius

The last point brings me to something Michael Sincere’s once penned:

“At market tops, it is common to see what I call the ‘high-five effect’ — that is, investors giving high-fives to each other because they are making so much paper money. It is happening now. I am also suspicious when amateurs come out of the woodwork to insult other investors.”

Michael’s point is very apropos, particularly today. It is interesting that prior to the election the majority of analysts, media and investors were “certain” the market would crash if Trump was elected. Since the election, it’s “high-fives and pats on the back.” 

While nothing has changed, the confidence of individuals and investors has surged. Of course, as the markets continue their relentless rise, investors begin to feel “bullet proof” as investment success breeds over-confidence.

The reality is that strongly rising asset prices, particularly when driven by emotional exuberance, “hides” investment mistakes in the short term. Poor, or deteriorating, fundamentals, excessive valuations and/or rising credit risk is often ignored as prices increase. Unfortunately, it is only after the damage is done that the realization of those “risks” occurs.

As Michael stated:

“Most investors believe the Fed will protect their investments from any and all harm, but that cannot go on forever. When the Fed attempts to extricate itself from the market one day, that is when the music stops, and the blame game begins.”

In the end, it is crucially important to understand that markets run in full cycles (up and down). While the bullish “up” cycle last twice as long as the bearish “down” cycle, the damage to investors is not a result of lagging markets as they rise, but in capturing the inevitable reversion. This is something I discussed in “Bulls And Bears Are Both Broken Clocks:”

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’  The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.

The markets are indeed in a liquidity-driven up cycle currently. With margin debt near peaks, stock prices in a near vertical rise and “junk bond yields” near record lows, the bullish media continues to suggest there is no reason for concern.

The support of liquidity is being extracted by the Federal Reserve as they simultaneously tighten monetary policy by raising interest rates. Those combined actions, combined with excessive exuberance and risk taking, have NEVER been good for investors over the long term.

At market peaks – everyone’s a “Genius.”

Just some things I am thinking about.

3 Things: Returns, Nothing But “Net”, Overly Optimistic

What Drives Returns

A little over a year ago, John Coumarianos penned a very interesting note with respect to the view that it is just “volatility” is driving prices.

“The great economist John Maynard Keynes once said: ‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.'”

The point of his article was debunking the idea investors who have the fortitude to withstand volatility in the markets will eventually be rewarded assuming increased volatility pushes asset prices higher.

The problem, which I addressed in Tuesday’s post entitled the “The Psychological Impact Of Loss,” is the repeated emotional mistakes made by investors which are ultimately driven by the very volatility investors are supposed to withstand.

But more importantly, while the idea of “efficient markets” and “random walk” theories play out well on paper, they don’t in actual practice.

What drives stock prices (long-term) is the value of what you pay today for a future share of the company’s earnings in the future. Simply put – “it’s valuation, stupid.” As John aptly points out:

“Stocks are not magical pieces of paper that automatically deliver gut-wrenching volatility over the short run and superior returns over the long run. In fact, we’ve just had a six-year period with 15%-plus annualized returns and little volatility, but also a 15-year period of lousy (less than 5% annualized) returns.

It’s not just volatility; it’s valuation.

Instead of magical lottery tickets that automatically and necessarily reward those who wait, stocks are ownership units of businesses. That’s banal, I know, but everyone seems to forget it. And it means equity returns depend on how much you pay for their future profits, not on how much price volatility you can endure.”

“And stocks are not so efficiently priced that they are always poised to deliver satisfying returns even over a decade or more, as we’ve just witnessed for 15 years. A glance at future 10-year real returns based on the starting Shiller PE (price relative to past 10 years’ average, inflation-adjusted earnings) in the chart above tells the story. Buying high locks in low returns and vice versa.

Generally, if you pay a lot for profits, you’ll lock in lousy returns for a long time.”

Volatility is simply the short-term dynamics of “fear” and “greed” at play. However, in the long-term, as stated, it is simply valuation. As I discussed in last weekend’s newsletter, valuations are already pushing historic extremes which suggest lower future forward returns.

With valuations at levels that have historically been coincident with the end, rather than the beginning, of bull markets, the expectation of future returns should be adjusted lower. This expectation is supported in the chart below which compares valuations to forward 10-year market returns.”

“The function of math is pretty simple – the more you pay, the less you get.”

As a long-term investor, we experience short-term price volatility as “opportunity,” and high prices as “risk.” With earnings growth weak, and valuation expansion elevated, the risk of high prices has risen sharply.

Nothing But “Net”

One of the biggest myths perpetrated by Wall Street on investors is showing individuals the following chart and telling them over the “long-term” the stock market has generated a 10% annualized total return.

The statement is not entirely false. Since 1900, stock market appreciation plus dividends have provided investors with an AVERAGE return of 10% per year. Historically, 4%, or 40% of the total return, came from dividends alone. The other 60% came from capital appreciation that averaged 6% and equated to the long-term growth rate of the economy.

However, there are several fallacies with the notion the markets will compound over the long-term at 10% annually.

1) The market does not return 10% every year. There are many years where market returns have been sharply higher and significantly lower.

2) The analysis does not include the real world effects of inflation, taxes, fees and other expenses that subtract from total returns over the long-term.

3) You don’t have 145 years to invest and save.

The chart below shows what happens to a $1000 investment from 1871 to present including the effects of inflation, taxes, and fees. (Assumptions: I have used a 15% tax rate on years the portfolio advanced in value, CPI as the benchmark for inflation and a 1% annual expense ratio. In reality, all of these assumptions are quite likely on the low side.)

As you can see, there is a dramatic difference in outcomes over the long-term.

From 1871 to present the total nominal return was 9.15% versus just 6.93% on a “real” basis. While the percentages may not seem like much, over such a long period the ending value of the original $1000 investment was lower by millions of dollars.

Importantly, the return that investors receive from the financial markets is more dependent on “WHEN” you begin investing with respect to “valuations” and your personal “life-span”.

Too Optimistic

Following on with the point above, with valuations currently at the second highest level on record, forward returns are very likely going to be substantially lower for an extended period. Yet, listen to the media, and the majority of the bullish analysts, and they are still suggesting that markets should compound at 8% annually going forward as stated by BofA:

“Based on current valuations, a regression analysis suggests compounded annual returns of 8% over the next 10 years with a 90% confidence interval of 4-12%. While this is below the average returns of 10% over the last 50 years, asset allocation is a zero-sum game. Against a backdrop of slow growth and shrinking liquidity, 8% is compelling in our view. With a 2% dividend yield, we think the S&P 500 will reach 3500 over the next 10 years, implying annual price returns of 6% per year.”

However, there are two main problems with that statement:

1) The Markets Have NEVER Returned 8-10% EVERY SINGLE Year.

Annualized rates of return and real rates of return are VASTLY different things. The destruction of capital during market downturns destroys years of previous capital appreciation. Furthermore, while the markets have indeed AVERAGED an 8% return over the last 115 years, you will NOT LIVE LONG ENOUGH to receive the same.

The chart below shows the real return of capital over time versus what was promised.

The shortfall in REAL returns is a very REAL PROBLEM for people planning their retirement.

2) Net, Net, Net Returns Are Even Worse

Okay, for a moment let’s just assume the Wall Street “world of fantasy” actually does exist and you can somehow achieve a stagnant rate of return over the next 10-years.

As discussed above, the “other” problem with the analysis is that it excludes the effects of fees, taxes, and inflation. Here is another way to look at it. Let’s start with the fantastical idea of 8% annualized rates of return.

8% – Inflation (historically 3%) – Taxes (roughly 1.5%) – Fees (avg. 1%) = 3.5%

Wait? What?

Hold on…it gets worse. Let’s look forward rather than backward.

Let’s assume that you started planning your retirement at the turn of the century (this gives us 15 years plus 15 years forward for a total of 30 years)

Based on current valuation levels future expected returns from stocks will be roughly 2% (which is what it has been for the last 15 years as well – which means the math works.)

Let’s also assume that inflation remains constant at the current average of 1.5% and include taxes and fees.

2% – Inflation (1.5%) – Taxes (1.5%) – Fees (1%) = -2.0%

A negative rate of real NET, NET return over the next 15 years is a very real problem. If I just held cash, I would, in theory, be better off.

However, this is why capital preservation and portfolio management is so critically important going forward.

There is no doubt that another major market reversion is coming. The only question is the timing of such an event which will wipe out the majority of the gains accrued during the first half of the current full market cycle. Assuming that you agree with that statement, here is the question:

“If you were offered cash for your portfolio today, would you sell it?”

This is the “dilemma” that all investors face today – including me.

Just something to think about.

3 Things: Consumer Debt, NFIB Optimism & Policy Uncertainty


Consumer Debt Surges In November

Last week, I addressed the issue with consumer spending and the issue of consumer debt. To wit:

“Given the lack of income growth and rising costs of living, it is unlikely that Americans are actually saving more. The reality is consumers are likely saving less and may even be pushing a negative savings rate.

I know suggesting such a thing is ridiculous. However, the BEA calculates the saving rate as the difference between incomes and outlays as measured by their own assumptions for interest rates on debt, inflationary pressures on a presumed basket of goods and services and taxes. What it does not measure is what individuals are actually putting into a bank saving or investment account. In other words, the savings rate is an estimate of what is ‘likely’ to be saved each month.

However, as we can surmise, the reality for the majority of American’s is quite the opposite as the daily costs of maintaining the current standard of living absorbs any excess cash flow. This is why I repeatedly wrote early on that falling oil prices would not boost consumption and it didn’t.”

As shown in the chart below, consumer credit has surged in recent months and exploded in November rising $24.5 billion in the month alone.

More importantly, while consumer credit continued to# expand, PCE and Wages remain primarily stagnant.

“Here is another problem. While economists, media, and analysts wish to blame those ‘stingy consumers’ for not buying more stuff, the reality is the majority of American consumers have likely reached the limits of their ability to consume. This decline in economic growth over the past 30 years has kept the average American struggling to maintain their standard of living.”

As more evidence of consumer’s struggling to maintain their standard of living, while consumer credit has continued to climb, retail sales remain weak as shown below.

And as the astute Greg S. pointed out yesterday:

Rising credit and delinquency rates combined with stagnant wage growth and you have a wicked brew being mixed for the economy. Furthermore, once you strip out surging health care related costs the strength witnessed in economic and inflation related reports as of late seem much less optimistic. (This is an issue I have repeatedly warned of over the past several years.)

Despite surges in optimism, with roughly 70% of the economy dependent upon the consumer, the ability of consumers to continue leveraging consumption is limited. As wage growth continues to stagnate, except for the top 20% of those employed, economic growth will likely remain sluggish which suggests the recent surges in optimism, as I will discuss in a minute, will likely fade as “Trump-uberence” reconnects with “economic realities.”

NFIB Optimism Explodes

Besides the surge in consumer debt, optimism has also exploded since the Presidential election. In the latest NFIB Small Business Survey, respondent’s confidence surged to levels only seen twice before in history. Interestingly, this surge comes nearer the end of a long economic cycle versus a more expected post-recessionary rise seen previously. (In many cases, as noted by the vertical dashed lines, sharp spikes in confidence have coincided with short to intermediate-term market peaks.)

However, while the spike in confidence is certainly encouraging there are a couple of aspects about the survey that should be considered.

  1. Small business owners TEND to be more conservatively biased politically speaking. Therefore, it is not surprising the “Trump win” has lifted their spirits.
  2. Given that regulations, taxes and the Affordable Care Act have weighed heavily on small business owners, the “hope” for any relief is certainly reason for a rise in expectations.
  3. The survey sample was the smallest of the entire year consisting of just a little more than 600 respondents.

Furthermore, if we use a 12-month average of the survey to smooth out the volatility, a very different picture emerges and one that is likely far more consistent with the current state of the economy.

Importantly, “expectations” have tended to run well ahead of reality. As shown below while spikes in expectations have corresponded to short-term rises in economic activity, such increases have generally been very short-lived. This time around a much stronger dollar, rising interest rates, and plenty of potential policy missteps could quickly reverse “exuberance” back to “reality.” 

Increases in confidence are one thing, but actually committing capital to projects, expenditures, equipment and further employment are based on actual increases in demand, not hope.

For evidence of demand, we can look at sales “expectations” versus actual “sales.” Not surprisingly, since the election, “expectations” of increased sales have surged. However, “actual sales” have been on the decline for several months due to the constriction of consumer demand due to increased debt and weak wage growth as noted above. 

This also shows up in actual real, inflation adjusted, retail sales data which shows little momentum.

While the surge in “optimism” is certainly welcome, there is a function of an economic cycle that must be dealt with. As I discussed previously:

“It is not just tighter monetary policy weighing on fiscal policy changes but the economic challenges as well. As my partner Michael Lebowitz recently pointed out – ‘this ain’t the 1980’s.’

‘Many investors are suddenly comparing Trump’s economic policy proposals to those of Ronald Reagan. For those that deem that bullish, we remind you that the economic environment and potential growth of 1982 was vastly different than it is today.’

This also isn’t 2009 where economic activity and consumption is extremely depressed which gives tax cuts, incentives and regulatory reforms have a much bigger impact on economic and earnings growth.

Will “Trumponomics” change the course of the U.S. economy? I certainly hope so.

However, as investors, we must understand the difference between a “narrative-driven” advance and one driven by strengthening fundamentals. The first is short-term and leads to bad outcomes. The other isn’t, and doesn’t.”

So Does Policy Uncertainty

While optimism and confidence has certainly surged over the last couple of months, something else has as well – policy uncertainty.

As I stated above, the surge in optimism from consumers, investors, and business owners has certainly lifted spirits, it hasn’t translated into fuel for economic growth as of yet. Interestingly, as Nick Timiraos from the WSJ notes, with free-trade adversaries on one side of his economic team and market-oriented advisers from the Washington and Wall Street establishments on the other, Donald Trump has charted an unpredictable course.

A flat organizational structure could set these and other individuals against each other as they compete for Mr. Trump’s support. Uncertainty about his economic agenda is heightened by how Mr. Trump, who has never held public office, has changed his mind on some policy issues while saying little about others.

Tensions are already surfacing now that Mr. Trump must translate campaign promises into a governing agenda. Mr. Trump, and other Republican lawmakers, are voicing concerns over how quickly to advance a repeal of Mr. Obama’s health-care overhaul, which could boost deficits and leave millions without health insurance. The new administration also may ask for billions of dollars for border security after Mr. Trump repeatedly promised to make Mexico shoulder the cost of new security measures.

The nucleus of Mr. Trump’s economic team consists of two financiers, Mr. Cohn and Treasury secretary-designate Steven Mnuchin, who in 1994 both became partners at Goldman. They haven’t weighed in on the pitched partisan policy battles of the past decade, making them more of a tabula rasa who advisers say can translate into policy Mr. Trump’s fusion of traditional GOP support for lower taxes and fewer regulations with his calls to brand China as a currency manipulator and spend more on infrastructure.

The elevation of Goldman Sachs alums also stands in contrast to Mr. Trump’s pointed attacks on the investment bank in last fall’s campaign. In addition to Messrs. Cohn and Mnuchin, the transition team is considering Jim Donovan, a senior Goldman executive, to serve as undersecretary of domestic finance, a top Treasury Department post.

Perhaps the starkest example of policy idiosyncrasy comes with Mr. Trump’s pick for budget director, Rep. Mick Mulvaney (R., S.C.), a committed deficit hawk. He has been deeply critical of Republicans who have sought higher spending and spoke skeptically of Mr. Trump’s infrastructure-spending push just weeks after the November election.

Throughout the campaign, Mr. Trump championed more spending on everything from the military to infrastructure, veterans’ health care and border security while he also brushed aside calls to address to long-run solvency of popular benefit programs such as Medicare and Social Security.

One question now is whether Mr. Mulvaney will prevail on Mr. Trump to rein in his big-spending agenda, or whether he might be tasked by Mr. Trump to sell a short-term boost in federal outlays to his fellow, skeptical House conservatives.

The organizational structure ‘may leave everyone guessing about who holds ultimate sway,’ said Jeb Mason, a Treasury Department official in the George W. Bush administration.”

Importantly, with economic growth anemic, consumers stretched and an economy heading into one of the longest post-recessionary expansions on record, there is little room for a policy misstep at this juncture.

Maybe Trump will be wildly successful and the economy will come roaring back. That is a possibility.

But there is also the risk it won’t.

Optimism is one thing. Your personal capital and financial health is quite another.

Just some things I am thinking about.






3 Things: Policy Hopes, Puppies & Rainbows

Tax Cut Rainbows

Can we slow down for just a minute and let a little bit of logic prevail. The exuberance by Wall Street over the election of Trump, which is ironic because these were the same guys saying his election would crash the market, has gotten a little heated. In particular, is the repeated impact of tax cuts on earnings over the next year as recently reiterated by Bob Pisani:

“Even before the election, analysts were anticipating a roughly 9 percent increase in earnings for the S&P 500, from roughly $118 in 2016 to $131 in 2017. But I noted back on Dec. 1 that Thomson Reuters estimated that every 1 percentage point reduction in the corporate tax rate could “hypothetically” add $1.31 to 2017 earnings. So with a full 20 percentage point reduction in the tax rate (from 35 percent to 15 percent), that’s $1.31 x 20 = $26.20.

That implies an increase in earnings of close to 20 percent, or $157. Of course, this is a hypothetical and because most corporations do not pay the top rate, we won’t get this kind of boost. No matter: Even a modest boost to, say, $140, would bring the S&P to 2400 at the current 17 multiple, nearly 7 percent above where it is now.”

There is a raft of issues with this analysis which investors have taken to heart since Reuters first trotted this idea a little over a month ago.

First, as noted by the Government Accountability Office, the average tax rate paid by U.S. corporations is not 35% but closer to 12.5%.

“Large, profitable U.S. corporations paid an average effective federal tax rate of 12.6% in 2010, the Government Accountability Office said Monday.

The federal corporate tax rate stands at 35%, and jumps to 39.2% when state rates are taken into account. But thanks to things like tax credits, exemptions and offshore tax havens, the actual tax burden of American companies is much lower.

Even when foreign, state and local taxes were taken into account, the companies paid only 16.9% of their worldwide income in taxes in 2010.”

Therefore, the reduction in the legislative tax rates to 15-20% is likely to be far less impactful to earnings growth than what is currently estimated by Reuters.

Secondly, the expectations of a $1.31 boost to earnings for each percentage point of reduction in tax rates is also a bit “squishy.”

The premise is based on the currently expected earnings in 2017 of $131.00 for the entirety of the S&P 500. The $1.31 increase is simply 1% of $131.00 in total operating earnings. However, given the fact that earnings are consistently overestimated historically by roughly 33%, as shown in the chart below, and are grossly affected by “one-time” repeating write-offs, accounting gimmickry, and a variety of other issues, the assumption of effective impact of a tax rate change of 1% of face value of earnings is awfully presumptive.

Given the strong rise in the U.S. Dollar as of late, along with the incremental increase in borrowing costs from higher Treasury rates, it is quite likely the drag on earnings from the reduction in exports will offset much of the impact of any tax rate changes that come about. With the Federal Reserve once again chasing an “inflation monster,” much as they did in 1999, the tightening of monetary policy will also further offset much of the benefit of tax rate changes.

As we saw with the Bush tax cuts in 2001, and the repatriation holiday in 2004, the impacts from policy changes are more “psychological” short-term boosts which are quickly absorbed by economic realities.

Consumer Spending Puppies

Keeping the tax cut meme going for a minute, it is hoped tax reform for individuals, along with the recent surge in optimism, will lead to a sharp increase in consumer spending. Maybe it will.

It is also important to remember that “Revenue” is a function of consumption. Therefore, while lowering taxes is certainly beneficial to the bottom line of corporations, it is ultimately what happens at the “top line” where decisions are made to increase employment, increase production and make investments.

In other words, it remains a spending and debt problem.

“Given the lack of income growth and rising costs of living, it is unlikely that Americans are actually saving more. The reality is consumers are likely saving less and may even be pushing a negative savings rate.

I know suggesting such a thing is ridiculous. However, the BEA calculates the saving rate as the difference between incomes and outlays as measured by their own assumptions for interest rates on debt, inflationary pressures on a presumed basket of goods and services and taxes. What it does not measure is what individuals are actually putting into a bank saving or investment account. In other words, the savings rate is an estimate of what is ‘likely’ to be saved each month.

However, as we can surmise, the reality for the majority of American’s is quite the opposite as the daily costs of maintaining the current standard of living absorbs any excess cash flow. This is why I repeatedly wrote early on that falling oil prices would not boost consumption and it didn’t.”

As shown in the chart below, consumer credit has surged in recent months.

Here is another problem. While economists, media, and analysts wish to blame those “stingy consumers” for not buying more stuff, the reality is the majority of American consumers have likely reached the limits of their ability to consume. This decline in economic growth over the past 30 years has kept the average American struggling to maintain their standard of living.

As shown above, consumer credit as a percentage of total personal consumption expenditures has risen from an average of 20% prior to 1980 to almost 30% today. As wage growth continues to stagnate, the dependency on credit to foster further consumption will continue to rise. Unfortunately, as I discussed previously, this is not a good thing as it relates to economic growth in the future.

“The massive indulgence in debt, what the Austrians refer to as a “credit induced boom,” has likely reached its inevitable conclusion. The unsustainable credit-sourced boom, which led to artificially stimulated borrowing, has continued to seek out ever diminishing investment opportunities.”

While lower tax rates will certainly boost bottom line earnings, particularly as share buybacks increase from increased retention, as noted there are huge differences between the economic and debt related backdrops between today and the early 80’s. 

The true burden on taxpayers is government spending, because the debt requires future interest payments out of future taxes. As debt levels, and subsequently deficits, increase, economic growth is burdened by the diversion of revenue from productive investments into debt service. 

This is the same problem that many households in America face today. Many families are struggling to meet the service requirements of the debt they have accumulated over the last couple of decades with the income that is available to them. They can only increase that income marginally by taking on second jobs. However, the biggest ability to service the debt at home is to reduce spending in other areas.

While lowering corporate tax rates will certainly help businesses potentially increase their bottom line earnings, there is a high probability that it will not “trickle down” to middle-class America.


Hopefully Hopeful

While I am certainly hopeful for meaningful changes in tax reform, deregulation and a move back towards a middle-right political agenda, from an investment standpoint there are many economic challenges that are not policy driven.

  • Demographics
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Financialization 
  • Global debt

“In the latest report from the Institute for International Finance released on Wednesday, total debt as of Q3 2016 once again rose sharply, increasing by $11 trillion in the first 9 months of the year, hitting a new all-time high of $217 trillion. As a result, late in 2016, global debt levels are now roughly 325% of the world’s gross domestic product.”

All of these challenges, and particularly the debt, will continue to weigh on economic growth, wages and standards of living into the foreseeable future.  As a result, incremental tax and policy changes will have a more muted effect on the economy as well. 

This was also noted by the Fed in their most recent release of the December meeting minutes:

However, the staff noted that the impact of easier fiscal policy was ‘substantially counterbalanced by the restraint from the higher assumed paths for longer-term interest rates and the foreign exchange value of the dollar.’ The offset from tighter financial conditions may also explain why median forecasts for GDP growth were little changed in participants’ Summary of Economic Projections (SEP).”

It is not just tighter monetary policy weighing on fiscal policy changes but the economic challenges as well. As my partner Michael Lebowitz recently pointed out“this ain’t the 1980’s.”

“Many investors are suddenly comparing Trump’s economic policy proposals to those of Ronald Reagan. For those that deem that bullish, we remind you that the economic environment and potential growth of 1982 was vastly different than it is today.


This also isn’t 2009 where economic activity and consumption is extremely depressed which gives tax cuts, incentives and regulatory reforms have a much bigger impact on economic and earnings growth.

As Michael concludes:

“As investors, we must understand the popular narrative and respect it as it is a formidable short-term force driving the market. That said, we also must understand whether there is logic and truth behind the narrative. In the late 1990’s, investors bought into the new economy narrative. By 2002, the market reminded them that the narrative was born of greed, not reality. Similarly, in the early to mid-2000’s real estate investors were lead to believe that real-estate prices never decline.

The bottom line is that one should respect the narrative and its ability to propel the market higher.

Will “Trumponomics” change the course of the U.S. economy? I certainly hope so as any improvement that filters down to the bottom 80% of the country will be beneficial.

However, as investors, we must understand the difference between a “narrative-driven” advance and one driven by strengthening fundamentals. The first is short-term and leads to bad outcomes. The other isn’t, and doesn’t. 

Just some things I am thinking about.






3 Things: Records Are Records For A Reason

I recently penned a post discussing various data points which were hitting record levels. To wit:

“First, “record levels” of anything are records for a reason. It is where the point where previous limits were reached. Therefore, when a ‘record level’ is reached, it is NOT THE BEGINNING, but rather an indication of the MATURITY of a cycle. While the media has focused on employment, record stock market levels, etc. as a sign of an ongoing economic recovery, history suggests caution.  The 4-panel chart below suggests that current levels should be a sign of caution rather than exuberance.”


I want to add to the list above with 3-more indicators which are hitting historically high levels as well. Once again, while the mainstream media is touting exuberance over these high levels, my contention is they should be eliciting a sign of caution.

Consumer Confidence

There are many measures of consumer confidence but two of the most widely watched are the University of Michigan (UofM) and Conference Board (CB) surveys. Since the election both measures have independently soared sharply as “hope” has emerged that President-elect Trump can cause real economic change through tax reform, infrastructure spending and the return of jobs back to America. It’s a tall order to fill and there is much room for disappointment, but for now, “hope” is in the driver’s seat and according to the latest readings consumer sentiment has reached levels not seen since the turn of the century.

The chart below is a composite index of the average of the UofM and CB survey readings for consumer confidence, consumer expectations, and current conditions. The horizontal dashed lines show the current readings of each composite back to 1957.

Importantly, as noted above, high readings of the index are not unusual. It is also worth noting that high readings are historically more coincident with a late stage expansion, and a leading indicator of an upcoming recession, rather than a start of an economic expansion.

The next chart shows the same analysis as compared to the S&P 500 index. The dashed vertical lines denote peaks in the consumer composite index.

Again, not surprisingly, when consumer confidence has previously reached such lofty levels, it was towards the end of an expansion and preceded either a notable correction or a bear market.

Importantly, corrections did not always follow immediately after high levels were reached and that is not the point to be made. What is important to understand is all cycles have a beginning and an end and by the time any previous record has been broken, it has always marked the beginning of the end of the current cycle.

ECRI Leading vs. Lagging

A colleague and friend of mine is an avid follower of the Economic Cycle Research Institute (ECRI) data as it relates to economic cycles. While I don’t ascribe to the data as closely as he does, only because I use several other data sets that tell me roughly the same thing, I did note the ECRI Weekly Leading Index (WLI) just spiked to a peak not seen since 2007.

There is a very close correlation between the ECRI WLI and GDP as shown in the chart below. I have also included the Chicago Fed National Activity Index (CFNAI) which is a very broad measure of economic activity consisting of roughly 85 subcomponents.

Importantly, there is currently a rather significant divergence between the WLI and CFNAI measures. Historically, such divergences tend to correct themselves over the next several months with the WLI correcting back towards the CFNAI.

Furthermore, there is also a significant divergence in the ECRI leading and lagging data sets. These two data sets were very closely correlated until the turn of the century where they have become increasingly more detached. This is one reason, I suspect, the ECRI has struggled in recent years with its economic forecasts to some degree.

We can take these two indices and create an effective “book-to-bill” ratio by subtracting the lagging index (what actually happened) from the leading index (what we expect to happen). What we find is very interesting. The current level of the leading-lagging index has plummeted to the lowest levels on record with historical spikes lower associated with recessionary economic periods.

Of course, ongoing Central Bank interventions have seemingly prevented the onset of an economic recession in the U.S. currently. While this “time may be different,” I would remain exceedingly cautious betting on such an outcome.

10-Year Treasury Net Longs Suggest Retracement

Speaking of “contrarian” indications, there is an overwhelming consensus following the election the replacement of monetary with fiscal policy is the “cure to economic growth” which has been missing. As such, interest rates have risen giving rise to the belief the “30-year bond bull market” is finally dead.

This may be a bit premature.

First, the policies currently being proposed from tax repatriation (Bush, 2004), tax cuts (Bush, 2001, 2003. Obama, 2010, 2012) and infrastructure spending (Obama, 2009) have, as noted, all been done before. While these actions did lead to short-term increases in rates, these policies were more beneficial to corporate bottom lines than actual economic growth.

As discussed previously:

With global rates near zero or negative, money will continue to chase U.S. Treasuries for the higher yield. This will continue to push yields lower as the global economy continues to slow. What would cause this to reverse? It would require either an economic rebound as last seen in 50’s and 60’s, or a complete loss of faith in the U.S. to pay its debts through either default or the onset of the ‘zombie apocalypse.'” 

Secondly, and from a pure investment standpoint, the positioning in 10-year Treasuries has returned to more extreme levels. As noted by the vertical dashed lines, when the 4-week moving average of net positioning rises sharply it has typically denoted a short-term peak in rates.

Not surprisingly, with everyone on the “same side of the trade,” any exogenous event which triggers a movement in the opposite direction tends to result in a stampede. 

Furthermore, as I addressed in detail recently, a bulk of the rate rise since the lows has been directly related to rebalancing of holdings following Brexit and a fight by China to stabilize the collapse of the Yuan. To wit:

“It is important to understand that foreign countries “sanitize” transactions with the U.S. by buying treasuries to keep currency exchange rates stable. As of late, China has been dumping U.S Treasuries and converting the proceeds back into Yuan in an attempt to stop the current decline. The stronger dollar and weaker yuan increase the costs of imports into China from the U.S. which negatively impacts their economy. This relationship between the currency exchange rate and U.S. Treasuries is shown below. “

When this rebalancing ends, a potential reversal in rates back towards 2% would not be surprising. This will particularly be the case as deflationary pressures from the expected Trump policies take root over the next several quarters.

The next chart shows the weekly number of net contracts on the 10-year Treasury currently outstanding compared to the S&P 500.  At the second highest level on record, such a contrarian positioning should provide some pause. Peaks in net positioning have often been associated with short to intermediate-term corrections, or worse, in the markets. 

These are only a few of the indicators currently hitting more extreme levels. There are many more and they should not be dismissed in “hopes” things could be different this time. Maybe they will be, and the markets will rise indefinitely into the future. Since portfolios are already allocated to the markets, such an outcome will be welcome.

But, what if “this time is not different?”

Do you have the savings and investment time horizon to once again get back to even?

Do you have a plan of action to manage the unexpected?

“Hope” isn’t a plan to effectively deal with risks.

“It is always easier to regain a lost opportunity than trying to regain lost capital.” 

Just some things I am thinking about.






2016 Year-End Bull/Bear Debate

I have written over the last couple of months the market was likely to rally into the end of the year as portfolio managers, hedge, and pension funds chased performance and “window dressed” portfolios for year-end reporting purposes. As I noted in this past weekend’s missive:

“I still suspect there is enough bullish exuberance currently to push the Dow to 20,000 and the S&P to 2,300 by the end of the year. However, I am more concerned about what I believe may occur after the inauguration in January.

I have discussed previously the importance of ‘price’ as an indicator of the market ‘herd’ mentality. One of the major problems with the fundamental and macro-economic analysis is the psychology of the ‘herd’ can defy logical analysis for quite some time. As Keynes once stated:

‘The markets can remain irrational longer than you can remain solvent.’

Many an investor have learned that lesson the hard way over time and may be taught again in the not so distant future. As shown in the chart below, the momentum of the market has decidedly changed for the negative. Furthermore, these changes have only occurred near market peaks in the past. Some of these corrections were more minor; some were extremely negative. Given the current negative divergences in the markets from RSI to Momentum, the latter is rising possibility.”


Despite this technical deterioration and excessive price extension, the “bullish vs. bearish” argument continues.

Let’s examine both arguments.

The Bullish Bias

The bulls currently have the “wind at their backs” as the exuberance mounts the new administration will foster in an age of deregulation, infrastructure spending and tax cuts that will be boost corporate earnings in the future. As Jack Bouroudjian via CNBC wrote:

“Let’s be clear, this market run up to the 20K level has a much more solid foundation for valuation. We are not looking at a P/E which has been stretched beyond historic norms as was the case in 1999, nor are we looking at a dot com bubble ready to implode. On the contrary, between digestible valuations and the prospects of real pro-growth policies, we have the foundation for a run up in equities over the course of the next few years which could leave 20K in the dust.

One of the great lessons in the market is that when ‘Animal Spirits’ take control, one must simply go with it. It’s not easy to recognize a paradigm shift, in fact many can only realize the phenomenon after the fact. The Trump victory coupled with the sweep in congress makes this a classic paradigm shift and the financial world needs to embrace it.

The dark days of wasted revenue and liberal tax and spend policies is giving way to an era of fiscal stimulus and pro-growth legislation not seen in 30 years. All this is coming at a time when corporate America, sitting on mountains of cash both domestically and overseas, find itself on the brink of a digital revolution.

Over the course of the next few years, corporations should see top line growth and expanding operating margins. With the understanding that equity prices move on expectations, one must conclude that the rally we have experienced over the last few weeks might be the ‘tip of the iceberg’ when it comes to the move we will see in the coming years.”

This, of course, is just the latest iteration of the “bull argument.”  Previously it was Federal Reserve liquidity, low interest rates, and low inflation were good for stocks. Now, it is higher interest rates and inflation is good for stocks. In other words, there is apparently no environment that is bad for stocks. Right?

As shown below, the bullish trend has remained firmly intact since the onset of QE1 which brings two Wall Street axioms into play:

1) Don’t Fight The Fed
2) The Trend Is Your Friend

Since the primary goal of the Federal Reserve’s monetary interventions was to boost asset prices, in order to stimulate economic growth, employment, inflationary pressures and consumer confidence, there is little argument the Fed achieved its goal of inflating asset prices. The “bulls” drank deeply from the proverbial “punch bowl.”

The continuous and uninterrupted surge in asset prices has driven investors into an extreme state of complacency. The common mantra is the “Fed will not let the markets fall” has emboldened investors to take exceptional risks. The chart of volatility shows again that bulls remain clearly in charge of the markets currently with the “fear of a correction” at near historic lows.

We can see the same level of bullishness when looking at the levels of “bearish” ratio of Rydex funds. (Bear Funds + Cash Funds / Bull Funds)

In other words, since investors have little fear of a correction, they have now gone “all in” following the election.

Lastly, since the election, investors confidence has soared as discussed by Evelyn Cheng via CNBC this week:

“Individual investor optimism jumped to a nine-year high in November, according to the Wells Fargo/Gallup Investor and Retirement Optimism Index published Tuesday.

The last time the index approached the November level was before the financial crisis, in May 2007 with a read of 95, the report said. The index was at 103 in January 2007.”

There is little doubt the “Bulls are back.” With the markets pushing all-time highs heading into the 9th year of a bull market, the belief is the momentum is set to continue. In fact, there isn’t a “bear” in sight:

“The unexpected election last month of Donald J. Trump as president has been a game changer for the 10 investment strategists whose market outlook Barron’s solicits twice each year. As stocks took off on Nov. 9 and thereafter, fueled by investors’ enthusiasm for Trump’s expected pro-growth agenda, even our group’s bears turned bullish.

The Bearish Perspective

While the bulls are pushing a continuation of the market based on “hopes” and “expectations,” the bears are countering with a more rational and pragmatic basis.

Valuations, by all historical measures, are expensive. While high valuations can certainly get higher, it does suggest that future returns will be lower than in the past.

That statement of “lower future returns” is very misunderstood. Based on current valuations the future return of the market over the next decade will be in the neighborhood of 2%. This DOES NOT mean the average return of the market each year will be 2% but rather a volatile series of returns (such as 5%, 6%, 8%, -20%, 15%, 10%, 8%,6%,-20%) which equate to an average of 2%.

Of course, as discussed previously, investor behavior makes forward long-term returns even worse.

The bulls have continually argued that the “retail” investor is going to jump into the markets which will keep the bull market alive. The chart below supports the bear’s case that they are already in. At 30% of total assets, households are committed to the markets at levels only seen near peaks of markets in 1968, 2000, and 2007.  I don’t really need to tell you what happened next.

The dearth of “bears” is a significant problem. With virtually everyone on the “buy” side of the market, there will be few people to eventually “sell to.” The hidden danger is with much of the daily trading volume run by computerized trading, a surge in selling could exacerbate price declines as computers “run wild” looking for vacant buyers.

This thought dovetails into the “hyperextension” of the market currently. Since price is a reflection of investor sentiment, it is not surprising the recent surge in confidence is reflected by a symbiotic surge in asset prices.

The problem, as always, is sharp deviations from the long-term moving average always “reverts to the mean” at some point. The only questions are “when” and “by how much?”

Managing Past The Noise

There are obviously many more arguments for both camps depending on your personal bias. But there is the rub. YOUR personal bias may be leading you astray as “cognitive biases” impair investor returns over time.

“Confirmation bias, also called my side bias, is the tendency to search for, interpret, and remember information in a way that confirms one’s preconceptions or working hypotheses. It is a systematic error of inductive reasoning.”

Therefore, it is important to consider both sides of the current debate in order to make logical, rather than emotional, decisions about current portfolio allocations and risk management.

Currently, the “bulls” are still well in control of the markets which means keeping portfolios tilted towards equity exposure.  However, as David Rosenberg recently penned, the markets may be set up for disappointment. To wit:

“In fact, despite base effects taking the year-over-year trends higher near-term, I think we will close 2017 with consumer inflation, headline and core, below 1.5% (though both will peak in the opening months of the year at 2.6% and 2.3% respectively).

The question is what sort of growth we get, and as we saw with all the promises from ‘hope and change’ in 2008, what you see isn’t always what you get.

There are strong grounds to fade this current rally, which has more to do with sentiment, market positioning and technicals than anything that can be construed as real or fundamental. There is perception, and then there is reality.”

Currently, there is much “hope” things will “change” for the better. The problem facing President-elect Trump, is an aging economic cycle, $20 trillion in debt, an almost $700 billion deficit, unemployment at 4.6%, jobless claims at historical lows, and a tightening of monetary policy and 80% of households heavily leveraged with little free cash flow. Combined,  these issues will likely offset most of the positive effects of tax cuts and deregulations.

Furthermore, while the “bears” concerns are often dismissed when markets are rising, it does not mean they aren’t valid. Unfortunately, by the time the “herd” is alerted to a shift in overall sentiment, the stampede for the exits will already be well underway. 

Importantly, when discussing the “bull/bear” case it is worth remembering that the financial markets only make “record new highs” roughly 5% of the time. In other words, most investors spend a bulk of their time making up lost ground.

The process of “getting back to even” is not an investment strategy that will work over the long term. This is why there are basic investment rules all great investors follow:

  1. Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
  2. Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.
  3. Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

These rules are hard to follow because:

  1. The bulk of financial advice only tells you to “buy”
  2. The vast majority of analysts ratings are “buy”
  3. And Wall Street needs you to “buy” so they have someone to sell their products to.

With everyone telling you to “buy” it is easy to understand why individuals have a such a difficult and poor track record of managing their money.

As we head into 2017, trying to predict the markets is often quite pointless. The risk for investors is “willful blindness” that builds when complacency reaches extremes. It is worth remembering that the bullish mantra we hear today is much the same as it was in both 1999 and 2007.

I don’t need to remind you what happened next.






3 Things: What’s Driving Rates, Trade & Fantasy Girl


Rates Are Rising Because Of China, Not Inflation

There has been a lot of angst in the markets as of late as interest rates have risen back to the levels last seen, oh my gosh, all the way back to last year. Okay, a bit of sarcasm, I know. But from all of the teeth gnashing and rhetoric of the recent rise in rates, you would have thought the world just ended. The chart below puts the recent rise in rates into some perspective. (You have to kind of squint to see it.)


While the bump in rates has been fastened to the recent election of Donald Trump, due to hopes of a deficit expansion program (read: more debt) and infrastructure spending which should foster economic growth and inflation, it doesn’t explain the global selling of U.S. Treasuries.


For that answer, we only need to look at one country – China.

It is important to understand that foreign countries “sanitize” transactions with the U.S. by buying treasuries to keep currency exchange rates stable. As of late, China has been dumping U.S Treasuries and converting the proceeds back into Yuan in an attempt to stop the current decline. The stronger dollar and weaker yuan increase the costs of imports into China from the U.S. which negatively impacts their economy. This relationship between the currency exchange rate and U.S. Treasuries is shown below.  (The exchange rate is inverted for illustrative purposes.)


The selling of Treasuries by China has been the primary culprit in the spike in interest rates in recent months and is likely quickly approaching its nadir. As I will discuss in a moment with respect to the trade deficit, there is little evidence of a sustainable rise in inflationary pressures. The current push has come from a temporary restocking cycle following a very weak first half of the year economically speaking, and pressures from higher oil, health care and rental prices. 

As noted by Horseman Capital in their recent note to investors (Via Zerohedge):

Asia is the source of most global demand for commodities, while also a huge supplier of goods into the US. Asian currencies have followed US bond yields higher and lower since the 1990s, as well as followed commodity prices higher and lower over that time. There has been one time when this relationship has broken down. In 2007 and 2008. 

Today we are seeing the reverse, I believe. The Chinese financial system is showing signs of stress. Corporate bond yields are rising, the Chinese Yuan is weakening, and outflows are continuing. In my view, the Trump election has made a large Chinese devaluation more likely. Mainland Chinese investors are desperately trying to get out of the Yuan, and the People’s Bank of China is trying to defend the value of the Yuan. They are doing this by selling treasuries.”

This is shown, the annual rate of change in U.S. bond holdings by China is rapidly approaching historical lows (axis is inverted).


“The problem with this is that the more treasuries the PBOC sells, the more yields are likely to rise, putting more pressure on the Yuan. It seems to me that the PBOC is stuck in a doom loop. But as I noted in my market view, the PBOC is running out of options.

In my view, the macro model that I have been using to think about markets still looks valid, despite recent moves. The model indicates that it is impossible for countries that have engaged in QE to then normalize interest rates without causing financial crises with their trade partners. Since 2013, we have had the taper tantrum, devaluations in India, Russia, and Brazil, which all helped to drive long dated treasuries to new lows. Now the market is thinking the US will normalize rates, and the second biggest economy in the world is struggling. A rerun of 2007/8 is looking likely to me.”  – Russell Clark, Horseman Global

Then there is simple issue that when virtually everyone is on the same side of trade, in this case short Treasuries, reversions tend to be rather abrupt.  As Edward Harrision penned at Credit Writedowns:

“Jamie McGeever over at Reuters posted a chart from Citigroup that is very important. Citi research shows speculators’ aggregate net short position in US Treasuries now at 5 standard deviations above normal – meaning everyone is now on the same side of the trade – short US Treasuries.”


With everyone piled into a short position on safe assets, all we need is one crisis trigger to create the mother of all short-covering rallies back into safe assets, not just in the US but globally.”

But what kind of crisis might that be? Well, considering the plunge in the Yuan and the pressures on China, you might want to pay attention to the Shanghai index.


“Investors seem to have once again managed to fool themselves that geopolitics won’t matter. Be very careful with this one. Not every problem can be solved with monetary policy. And the response to every tweet won’t always be an editorial.” – Richard Breslow

Trade Doesn’t Suggest Strong Levels Of Inflation Or Growth

I mentioned above that I wanted to discuss the trade deficit and the expectations of rising inflationary pressures. While there are indeed EXPECTATIONS that inflation will be a problem in the future, there is currently no evidence supporting those expectations currently.

While there has been a small bump in prices of imports and exports, which coincides with the bump in oil/energy prices, the trend of pricing power is still sorely negative.


Importantly, declines in import/export prices to such a degree have been indicative of recessions in the past. With the dollar rising, which puts pressure on exports, the recent bounce in pricing power is likely temporary and will push toward lower levels putting downward pressure on corporate earnings and economic growth. 

It is not just import/export prices that are trending weaker but we are seeing the same weakness prevail in industrial production and capacity utilization. While year-over-year rates have improved recently, following an extremely weak 4th-quarter last year, the negative trend in production and utilization suggests little about a resurgence of economic activity which would foster a demand-push inflationary rise.


Just from an anecdotal view, declines of this magnitude and duration have previously been more coincident with the onset of a recession than not.

Inflation can be both good and bad. Inflationary pressures can be representative of expanding economic strength if it is reflected in the stronger pricing of both imports and exports. Such increases in prices would suggest stronger consumptive demand, which is 2/3rds of economic growth, and increases in wages allowing for absorption of higher prices. That would be the good, but unfortunately it is not the case.

The dichotomy of between expectations of inflation and its ultimate reality will likely soon be recognized.

Rate Hike A Vote Of Confidence? Really?

So, the Fed finally, after more than a year of jawboning, hiked interest rates. But it was not the rate hike that was important but the commentary that went along with it. According to Ms. Yellen:


Really? The rate hike was a vote of confidence in the economy? This is irony considering the direction of growth since 2011 has been consistently BELOW expectations set by the Fed as shown by the median of their own forecasts versus reality. 


Of course, one of the key comments was her outlook on employment when she stated:


She is right, it does. This according to the Fed’s own Labor Market Conditions Index.


Historically speaking, peaks in the 12-month average of the LMCI index have been coincident with declines in employment and the onset of weaker economic growth.

While the Fed raised it’s longer term interest rate forecast, and projected three more hikes to the Fed Funds Rate in 2017, there is a strong probability this is the same wishful thinking they have had over the last two years.

As shown in all the data above and the EOCI index below (a broad composite of manufacturing, service and leading indicators), the current economic bounce is likely another in a series of temporary restocking cycles. These cycles have been repeatedly witnessed after cyclical slowdowns in economic growth. Furthermore, as shown below, with the broader economy operating at levels more normally associated with recessions than expansions, there is little suggesting an ability to support substantially higher rates or generate inflationary pressures above 2%. 


Which is why interest rates on the 10-year treasury have likely seen their peak currently and will be lower in 2017 as overly exuberant expectations are dragged lower by economic realities. 

Of course, that is why Janet Yellen is my personal “Fantasy Girl.”

Just some things I am thinking about.






Carrier & The Broken Window Narrative


“Trump saves jobs in Indiana before even being President. This is how you make ‘America Great Again.” 

Between promises to cut corporate taxes from 35% to 15%, reduce regulatory burdens and penalize companies who leave the U.S., markets, economists and analysts are all trying to figure out what it means. As I noted on Tuesday, the always bullish analysts are already pushing up corporate earnings to record levels while the mainstream media is fostering the idea of an economic resurgence to levels last seen during the Reagan Administration. In turn, this will result in higher inflation, higher interest rates and an end to the stagflationary environment that has gripped the economy over the last 8-years.

Well, that is what is hoped for.

I thought it might be useful to take a look at the specifics of the deal struck with Carrier and the reality of the current economic backdrop as it relates to fostering future job growth, higher wages and the avoidance of a recessionary outcome.

The Art Of The Deal

Supporters of Donald Trump have praised the president-elect for working out a deal to keep jobs at a manufacturing plant in Indiana from being moved to Mexico.

The deal with Carrier, which makes heating, air conditioning, and refrigerator parts, meant that roughly 1,000 workers will keep their jobs in Indiana. However, in exchange for keeping those jobs in Indiana, Carrier will receive $7 million in tax credits and other incentives which will ultimately be picked up by the taxpayers of Indiana. Carrier also said it will invest $16 million in its Indianapolis plant.

According to Carrier, they would have saved $65 million a year by moving operations to Mexico which begs the question of how tax credits and a company investment of $16 million will equalize the disparity of costs.

For that answer let’s go to Greg Hayes, the CEO of Carrier, who appeared on Monday’s edition of “Mad Money” with Jim Cramer. (Transcript courtesy of Business Insider)

JIM CRAMER: What’s good about Mexico? What’s good about going there? And obviously what’s good about staying here?

GREG HAYES: 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.

JIM CRAMER: Versus America?

GREG HAYES: Much higher.

JIM CRAMER: Much higher.

GREG HAYES: Much higher. 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. Now I’ve got some very long service employees who do a wonderful job for us. And we like the fact that they’re dedicated to UTC, but I would tell you the key here, Jim, is not to be trained for the job today. Our focus is how do you train people for the jobs of tomorrow?

As I have discussed on the “Lance Roberts Show” in the past, and this is important, while foreign countries have cheaper labor (not demanding $15/hr minimum wages to flip burgers) they also have a more dedicated workforce willing to work the kind of low-skilled jobs American’s do not find attractive. To wit:

GREG HAYES: The assembly lines in Indiana — I mean, great people, great people. But the skill set to do those jobs is very different than what it takes to assemble a jet engine.

So, why did Hayes actually decide to cancel the move to Mexico?

GREG HAYES: So, there was a cost as we thought about keeping the Indiana plant open. At the same time, and I’ll tell you this because you and I, we know each other, but I was born at night but not last night. I also know that about 10% of our revenue comes from the US government. And I know that a better regulatory environment, a lower tax rate can eventually help UTC in the long run.


Offsetting Higher Costs

So, as I asked earlier, how to do you equalize the cost of saving $65 million annually by moving to Mexico in exchange for $7 million in one-time tax credit and incentives.

That is where the $16 million investment comes in.

In order to justify keeping the Indiana plant open, the company will inject $16 million to drive down the cost of production to reduce the operating gap between the US and Mexico.

GREG HAYES: Right. Well, and again, if you think about what we talked about last week, we’re going to make a $16 million investment in that factory in Indianapolis to automate to drive the cost down so that we can continue to be competitive. Now is it as cheap as moving to Mexico with a lower cost of labor? No. But we will make that plant competitive just because we’ll make the capital investments there.


GREG HAYES: But what that ultimately means is there will be fewer jobs.

The deal may have saved 1,000 jobs in Indiana today, but that doesn’t solve the structural employment dynamics of a 21st-century economy.

The Broken Window

The interesting thing about the Carrier deal is it is the very essence of the “broken window” narrative of economic creation. A window is destroyed, therefore the window has to be replaced which leads to economic activity throughout the economy.

However, the fallacy of the “broken window” narrative is that economic activity is only changed and not increased. The dollars used to pay for the window can no longer be used for their original intended purpose.

With the Carrier deal, while jobs may be retained, the dollars that would have belonged to the taxpayers are now diverted from their original use into assisting Carrier to keep existing jobs.

In reality, the effect of the Carrier deal is a net negative for Indiana as dollars are diverted from taxpayers which would have created activity elsewhere in the economy. The jobs are still going to be lost at some point as they are displaced by advances in productivity.

The issues surrounding the “Carrier” deal are problematic going forward as well.

On Wednesday, in an interview with Time magazine’s Michael Scherer after being named Time’s Person of the Year, Trump said he wants to speak with the CEO of any company considering shipping jobs overseas. Trump told Reince Priebus, the next White House chief of staff:

“‘Hey, Reince, I want to get a list of companies that have announced they’re leaving,’ he called out. ‘I can call them myself. Five minutes apiece. They won’t be leaving. OK?'”

What deals will have to cut in order to keep these companies from leaving or simply automating their workforces? Who is going to pay for those deals? What is the true economic cost and benefit?

There is no free lunch.

It’s Structural

Yes, reducing taxes, easing regulations and repatriating dollars held offshore which will increase corporate profitability and liquidity. But, will such increase employment, expand production and raise wages?

Let’s use a simple example.

  • Company A manufactures and sells a “widget.” 
  • They sell 10,000 units a year with a domestic manufacturing cost of $15/hr and a net profit of $5 per unit AFTER taxes.
  • Trump reduces taxes from $35 to $15 which increases the net profit per unit to $5.73 per unit.
  • Net profit for the company rises from $50,000 to $57,300 annually.
  • They able to repatriate $10,000 held in offshore facilities. 
  • A specific regulation is eliminated which now reduces operational costs by $5000 annually. 

What does the company do with their new found sources of profits and liquidity?

While the company owners will experience a greater income annually from the tax savings, reduced regulatory costs and repatriation of dollars, there was no increase in the annual demand for their widgets. Since the demand for widgets has not risen in our example, there is no need to expand the production of widgets or increase employment.

Yes, the owners of the company may opt to keep their employees in the U.S. for now because of increased income currently, but eventually, those $15/hr wages will be reduced to $5/hr through outsourcing as competition reduces the profit margins on “widgets.”

Since there was no increase in actual demand from consumers, the best use of capital will return back to shareholder benefits. As Goldman Sachs recently noted about the use of repatriated dollars:

“Buybacks will rise by 30% as companies repatriate cash held overseas. Dividends will rise by 6% in 2017, above the 4% growth rate currently implied by the dividend swap market.”

Last time I checked, stock buybacks do not create jobs.

Without an increase in demand, there is little reason to invest dollars into capacity which has been evident over the last few years. As shown in the chart below, personal consumption expenditures during the Reagan administration were 300% higher than today.


Furthermore, consumer indebtedness was low and just beginning to rise allowing consumption to expand at faster rates versus the high levels of debt today.


It is an interesting conundrum since rising production (jobs) leads to higher levels of consumption. However, it is the demand, real or perceived, for a company’s products or services which drives the need for employment and increased production. With consumers effectively “running on empty,” the ability for a further ramp in consumption to create the needed demand is simply lacking. 

While the Carrier deal did save jobs, for now, what was missed is the need to focus on the structural employment shifts that have occurred since the turn of the century and will continue to occur in the future.

As noted by Scott Sumner:

“The FRED series shows total manufacturing output rising from 69.789 in 1987 to 129.129 in the most recent quarter. That’s an 85% gain.

At the same time, manufacturing employment has fallen, from 17.499 million to 12.275 million. This represents a decline from 17.3% of total employment to only 8.5% of total employment. That’s the figure that has people so upset. But the cause is not trade; it’s automation.”


Think about all of the disruptive technologies currently in play from Amazon, to Uber, to robotics and more. Every industry, business, and employee is under attack from increases in productivity, the drive for lower costs and higher profit margins.

“When people say they are upset about trade, I think that what really bothers them is that automation is allowing us to produce 85% more manufactured goods with far fewer workers. That transition has been painful for many workers, but it’s not about trade—except in one respect.

Trade allows the US to concentrate in industries where we have a comparative advantage (aircraft, chemicals, agricultural products, high tech goods, movies, pharmaceuticals, coal, etc.) We then import cars, toys, sneakers, TVs, clothing, furniture and lots of other goods. It’s likely that our productivity is higher in the industries where we export as compared to the industries where we import. So in that sense, trade may be speeding up the pace by which automation costs jobs. But probably only slightly; in previous posts I’ve shown that even within a given industry, such as steel, the job loss is overwhelmingly about automation, not trade.

There are certain low-skilled jobs being lost to other countries which have lower labor costs. They are also being lost to technology due to the lack of specific skill sets and a work ethic. Technological developments are a bigger threat to American workers than trade which is the trend of the future and the crux of the structural employment change.

As Greg Hayes noted in the interview with Jim Cramer, companies like United Technologies are focused on how to “train people for the jobs of tomorrow.” 

The “Carrier” deal, and future deals like it, only succeed in temporarily keeping the jobs of yesterday with a cost to taxpayers today. 

3 Things: Exuberance, Small Caps, 6% Realities

Bull Market Exuberance

As I addressed on Tuesday, the exuberance in the markets following the election, is getting just a bit overdone. To wit:

“Such an outlook is certainly encouraging, but there is a long way to go between President-elect taking office, drafting bills and getting them passed. There is even a further period of time before any actions actually passed by the Trump administration actually create perceivable effects within the broader economy. In the meantime, there are many concerns, from a technical perspective, that must be recognized within the current market environment.”

The level of “complacency” in the market has simply gotten to an extreme that rarely lasts long. The chart below is the comparison of the S&P 500 to the Volatility Index. As you will note, when the momentum of the VIX has reached current levels, the market has generally stalled out, as we are witnessing now, followed by a more corrective action as volatility increases.”


More to this point, the chart below shows the S&P 500 as compared to the level of volatility as represented by the 6-month average of the Volatility Index (VIX). I have provided three different bands showing levels of investor sentiment as it relates to volatility. Not surprisingly, as markets ping new highs, volatility is headed towards new lows.


This rise in complacency is also correspondent to the level of investor optimism following the recent election. The change in expectations is actually quite a phenomenon considering the rapid change in the narrative from “Trump The Terrible” to “Trump The Great.”

This post-election surge in investor optimism is shown below. The first chart is the bull/bear ratio of both professional investors (as represented by the INVI Index) and individuals (from AAII). Currently, the level of bullishness has surged to levels more normally associated with intermediate term tops in the market.


The net bullishness (bulls minus bears) of both individual and professional investors has likewise surged to levels which again have been more historically representative to intermediate term tops in the market.


As I have noted on Tuesday, with the markets overly extended, bullish and complacent, the risk of a correction has risen markedly. 


As shown in the chart above, the market is currently pushing a 3-standard deviation of the 50-dma which it has not done at any point over the last 3-years. Such extensions can, of course, be resolved by the markets either trending sideways or declining. In either event, the current levels of complacency, bullish optimism and price extension suggest there is little upside in the markets currently.

As I discussed previously, the most likely outcome is some corrective action in the first couple of weeks of December as hedge and mutual funds pay out redemptions and distributions. Such a correction will offer a better opportunity to re-evaluate equity related exposure and adjust accordingly.

Importantly, there is little currently to suggest the markets can withstand higher rates, inflation, US Dollar or tighter monetary policy for long. The impact to exports, corporate earnings, consumption and debt will impact economic growth negatively which is why I am still hedging equity risk exposure in portfolios. Maybe “Trumponomics” will work as planned and economic cycles can be repealed? Maybe stocks have indeed reached a “permanently high plateau?”

However, given the current dynamics of the market from a historical perspective, valuations, debt-to-income ratios, etc., there is little to suggest such long-term bullish outcomes are likely. For now, I suggest remaining patient as the long-term benefits of excessive risk taking are skewed to the downside.

But then again, as John Maynard Keynes once quipped:

“Nothing is more suicidal than a rational investment policy in an irrational world.” 

We do live in interesting times.


Small Caps Surge On “Trumpectations”

On Monday, I listened to an interesting discussion on why investors should jump into “small cap” stocks now as the “Trump Train” was leaving the station. The premise is lower tax rates, and stimulus spending via “infrastructure,” is going to provide an ongoing boost to smaller capitalization stocks.

Of course, small capitalization companies have already experienced a tremendous move since the election chasing this exact premise. However, there may be a problem.

Small capitalization companies, as opposed to the larger brethren, are impacted more quickly by changes in the economic and monetary environment. For companies that do business internationally, changes to the dollar create a bigger impact earnings. Changes in interest rates more quickly impact decisions on borrowing decisions by changing the costs of capital.

The first chart shows the small-cap index relative to the 6-month rate of change of interest rates. The dashed black lines show that when there has been a rapid rise in rates, there has been short to intermediate negative outcomes for small-capitalization stocks.


The same can be seen with the 6-month rate of change in the US Dollar. As the dollar rises, the cost of exports to foreign buyers rise as well.


Currently, small-caps are getting the double whammy of rising rates and stocks simultaneously as shown below. If the media is correct, and the dollar and rates continue to strengthen under “Trumponomics,” the combined impact could effectively derail much of the benefit of the expected policies.


There are also threats that stem from enacting large tax cuts and boosting public spending in an economy already nearing full employment, higher interest rates, and a stronger dollar. As noted by Anatole Kaletsky via Project Syndicate:

“The impact on financial markets will be disruptive, regardless of whether the Fed aggressively tightens monetary policy to pre-empt rising prices or lets the economy ‘run hot’ for a year or two, allowing inflation to accelerate.

With the US economy growing faster than expected and long-term interest rates rising, excessive strengthening of the dollar is a third major risk. Even though the dollar is already overvalued, it could move into a self-reinforcing upward spiral, as it did in the early 1980s and late 1990s, owing to dollar debts accumulated in emerging markets by governments and companies tempted by near-zero interest rates.

Just remember, as has always been the case, rapid changes in monetary variables have inevitability led to an unexpected and exogenous shock that have surprised the markets. This time will likely be no different.


Forecasts For 6% GDP Somewhat Unrealistic

Just recently, Barron’s penned an interview with Jeff Gundlach discussing the recent election of President-elect Trump and his views on interest rates going forward. To wit:

“Trump’s pro-business agenda is inherently ‘unfriendly’ to bonds, as it could to lead to stronger economic growth and renewed inflation. Gundlach expects President-elect Trump to ‘amp up the deficit’ to pay for infrastructure projects and other programs. That could produce an inflation rate of 3% and nominal growth of 4% to 6% in gross domestic product. ‘If nominal GDP pushes toward 4%, 5%, or even 6%, there is no way you are going to get bond yields to stay below 2%,’ he says.”

First, you can’t blame Gundlach for “talking his book” because if he is right, he will lose a LOT of money over the next 5-years as assets flow out of his bond funds and into other asset classes. However, I really don’t think he has much to worry about.

While everyone is certainly exuberant about the hopes for an economic boom under President Trump, let’s step back from the ledge for a moment and look at some realities.

As I have shown previously, there is a very high correlation between economic growth, inflation, interest rates and wages.


The problem for Trump, and for Gundlach’s outlook, is that we no longer reside in the 80’s where a large group of “baby boomers” were entering the workforce and driving a massive wave of innovation and productivity changes.  Today, we are on the wrong side of the demographic trends combined with falling productivity and labor force growth.


As Dr. Ed Yardeni noted:

“In any event, the horses may already be out of the barn. Only 8.5% of payroll employment is now attributable to manufacturing, down from 10.3% 10 years ago, 14.3% 20 years ago, and 17.5% 30 years ago. Bringing factory jobs back to the US may bring them back to automated factories loaded with robots. Even Chinese factories are using more robots.”

And from Harvard Business Review:

“Slow productivity growth is the main cause of slow economic growth, and slow economic growth makes it all but impossible for everyone’s boat to rise. No wonder angry citizens want dramatic change. But while voters may see the problem in a political establishment that is out of touch, the populist politicians who are challenging that establishment are unlikely to fare better.

In the short term, they may be able to medicate the economy with a big tax cut or a dose of deficit spending. When the effects of that treatment wear off, though, the effects of slow productivity growth will linger.”

But beyond the productivity problem is simply debt.

Debt deters consumer spending as the debt must be serviced. Give consumers more money via a tax-cut, as we have seen previously, and it will not necessarily show up in the economy but rather in debt service. The pay down of debt would be good provided interest rates do not rise. However, if Gundlach is right, debt service will explode consuming whatever increases to income may come from tax reductions and infrastructure spending. 


The same goes for the deficit. At $20 Trillion in debt, which will increase by $5 Trillion over the next 4 years at current run rates, an increase in rates towards 6% will send service costs skyrocketing. The deficit will expand sharply towards $2 Trillion completely sapping the economic recovery story.


As opposed to the 1980’s when deficit spending could be used to increase economic growth, with a current $650 billion deficit, the input of an infrastructure spending program will be negligible at best and massively deflationary at worst.

If the Fed increases interest rates, along with the impacts of higher treasury rates, such will choke off the flow of credit available and makes businesses less likely to spend. While it may reign in inflation, it also decreases economic output. This typically leads to a recession.

As stated, the net positive impact to economic growth in the short-run from a Trump plan would be negligible.

“In short, introducing large stimulus plans during cycle peaks — roughly where we are now — doesn’t increase private spending as much as during downturns. So the 4% GDP growth promised by Trump is ‘not going to happen’ even with the plan.”

Just some things I am thinking about.



3 Things: Retail Sales, Ignorance & Return Reality

Turning To Debt To Sustain Living Standard

There was an awful lot of cheering about the recent retail sales report which showed an uptick of 0.8% which beat the analyst’s estimates of 0.6%. Despite the fact, the improvement was driven by a surge in gasoline prices (which is important as consumers did not consume MORE of the product, but just paid more for it) important discretionary areas like restaurants and furniture declined.

However, if we dig deeper behind the headlines more troubling trends emerge for the consumer which begins to erode the narrative of the “economy is doing great” and “there is no recession” in sight.

While there is always a lot of “jiggering” of the economic data with seasonal adjustments, such can be quickly eliminated by using a 12-month average to smooth the non-seasonally adjusted numbers. As shown, the annual percentage change of the 12-month average shows retail sales creeping along levels that have normally been coincident with weak economic environments. 


Despite ongoing prognostications of a “recession nowhere in sight,” it should be remembered that consumption drives roughly 2/3rds of the economy. Of that, retail sales comprise about 40%. Therefore, the ongoing deterioration in retail sales should not be readily dismissed.

More troubling is the rise in consumer credit relative to the decline in retail sales as shown below.


What this suggests is that consumers are struggling just to maintain their current living standard and have resorted to credit to make ends meet. Since the amount of credit extended to any one individual is finite, it should not surprise anyone that such a surge in credit as retail sales decline has been a precursor to previous recessions. 

Further, the weakness of consumption can be seen in the levels of retailers inventory relative to their actual sales.


We can also view this problem with retail sales by looking at the National Federation of Independent Business Small Business Survey. The survey asks respondents about last quarter’s actual sales versus next quarter’s expectations.


Not surprisingly, expectations are always much more optimistic than reality turns out to be. However, what is important is that both actual and expected retail sales are declining from levels that have historically been indicative of a recession.

Also, since the average of expected and actual retail sales from the survey also closely tracks actual inflation-adjusted retail sales, expectations of a strong holiday spending season should likely be curtailed.


With consumer credit surging, without a relevant pickup in spending, to more than 26% of DPI, the economic strain is clearly evident. Given that it took a surge of $11 Trillion in credit to offset a decline in economic growth from 8% in the 70’s to an average of 4% during the 80’s and 90’s, it is unlikely that consumers can repeat that “hat trick” again. 

President-Elect Trump is going to have his work cut out for him.


You Should Really Ignore This Chart…Really!

There are two primary reasons Millennials aren’t saving like they should. The first is the lack of money to save, the second is the lack of trust in Wall Street. A recent post from JP Morgan, via Andy Kiersz, got me to thinking on this issue.

“JPMorgan shows outcomes for four hypothetical investors who invest $10,000 a year at a 6.5% annual rate of return over different periods of their lives:

  • Chloe invests for her entire working life, from 25 to 65.
  • Lyla starts 10 years later, investing from 35 to 65.
  • Quincy puts money away for only 10 years at the start of his career, from ages 25 to 35.
  • Noah saves from 25 to 65 like Chloe, but instead of being moderately aggressive with his investments he simply holds cash at a 2.25% annual return.”


There are two main problems with this entire bit of analysis.

Saving Is Problem

First, while saving $10,000 a year sounds great, the real problem is that median incomes in the U.S. for 80% of wage earners is $44,732 (via the Census Bureau, 2015 most recent data).


The problem, of course, is JP Morgan assumes that these young individuals are able to save an astounding 25% of their annual incomes. This is not a realistic assumption given that many of the Millennial age group are struggling with student loan and credit card debts, car notes, apartment rent, etc.

But it really isn’t just the Millennial age group that are struggling to save money but the entirety of the population in the bottom 80% of income earners. According to a recent McKinsey & Company study, 81% of American’s are now worse off than they were in 2005,

 “Based on market income from wages and capital, the study shows 81% of US citizens are worse off now than a decade ago. In France the figure is 63%, Italy 97%, and Sweden 20%.

Then there is the New York Federal Reserve which also discussed that 15% of American’s have “negative net wealth.”

So, how are Chloe, Lyla, Noah and Quincy to save $10,000 a year when Chole works as a nursing assistant, Lyla waits tables, Noah is a bartender and Quincy works retail? (These are the jobs that have made up a bulk of the employment increases since 2009. They are also in the lower wage paying scales which makes the problem of savings for difficult.)  This is also why Millennials are setting new records for living with their parents.

“Young people started moving out mid-century as they became more economically independent, and by 1960 only 24% of young adults total—men and women—were living with mom and dad. But that number has been rising ever since, and in 2014, the number of young women living with their parents eclipsed 1940s—albeit by less than a percentage point. And last year 43% of young men were living at home, which is the highest rate since 1940.”


“But Lance, wages have been rising recently. That helps, right?”

While we have, at long last, seen an uptick in wages recently, there are two main problems with looking at the headline data.

First, the growth rate of wages remains well behind levels seen prior to the financial crisis and woefully behind levels of rising health care, food and other related living costs that eat up a substantial portion of incomes reducing the ability to save. 


Secondly, wage growth has primarily only occurred in the top-20% of wage earners who are in executive/management/supervisory roles.

So, yes, Millennials SHOULD save more – they just don’t have anything to actually save.


Stocks Do Not Deliver Compound Rates Of Return

The second major problem with JPM’s analysis is the assumption that stocks deliver compounded returns over the long-term. This is one of the biggest fallacies perpetrated by Wall Street on individuals in the effort to entice them to sink their money in “fee-based” investment strategies and forget about them.

Compound returns ONLY occur in investments that have a return of principal function and an interest rate such as CD’s or Bonds (not bond funds.)  This is not the case with stocks as I have explained previously:

While over the long-term (1900-Present) the average rate of return may have been 10% (total return), the markets did not deliver 10% every single year.  As I discussed just recently, a loss in any given year destroys the ‘compounding effect:’

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.”


“The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%.

Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.”

JPM’s assessment shows a nice smooth acceleration of wealth for the four individuals, there is a huge difference that occurs when accounting for the variability of returns during a long-term investment period.  To wit:

“Here is another way to view the difference between what was ‘promised,’ versus what ‘actually’ happened. The chart below takes the average rate of return, and price volatility, of the markets from the 1960’s to present and extrapolates those returns into the future.”


“When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over the long-term.”

Lastly, and probably the most critical point, is valuation level of the market when these individuals began the saving and investing program.

The problem for Chloe and her friends is that valuation levels are currently at some of the highest levels recorded in market history. The chart below shows REAL rolling returns for stock-based investments over 20-year time frames at various valuation levels throughout history.


Of course, none of this even includes the negative impacts to individuals and their savings due to the emotional and psychological impact of market volatility over time. (Read:“Dalbar: Why You Suck At Investing.”)

Unfortunately, for individuals, the ultimate results between what they have been promised, and what actually occurs, continues to be two entirely different things and generally not for the better. 

Don’t misunderstand me. Should individuals invest in the financial markets? Absolutely.

However, depending on the markets to make up for a savings shortfall, combined with unrealistic forward return projections, is a continued recipe for disaster.

But, of course, since pension funds and endowments still have not learned their lessons, why should we expect individuals to have learned any different? The next major bear market/recession will likely finally cure the continued errors of confusing “average” with “actual” annualized returns.

Just some things I am thinking about.