Tag Archives: recessions

Powell Channels Bernanke: “Subprime Debt Is Contained”

I recently discussed one of the biggest potential “flash points” for the financial markets today – corporate debt.

What I find most fascinating is how quickly many dismiss the issue of corporate debt with the simple assumption of “it’s not the subprime mortgage market.”

Correct, it’s not the subprime mortgage market. As I noted previously:

“Combined, there is about $1.15 trillion in outstanding U.S. leveraged loans (this is effectively “subprime” corporate debt) — a record that is double the level five years ago — and, as noted, these loans increasingly are being made with less protection for lenders and investors. Just to put this into some context, the amount of sub-prime mortgages peaked slightly above $600 billion or about 50% less than the current leveraged loan market.”

Every bubble has its own characteristics. The current bubble is no different, and I would suggest that it has the potential to have more severe consequences than seen previously. The reasoning is that the fallout from the sub-prime directly impacted both lenders and the homeowners. This time a “corporate debt bust” will impact a much broader spectrum of companies which will lead to a surge in bankruptcies, mass job losses, and the subsequent contraction in consumption.

Same effect. Different characteristics.

Remember, in 2007, Ben Bernanke gave two speeches in which he made a critical assessment of the “sub-prime” mortgage market.

“At this juncture, however, the impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained.” – Ben Bernanke, March 2008

“Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited.” – Ben Bernanke, May 2007

Of course, the sub-prime issue was not “contained,” and all it required was the right catalyst to effectively “burn the house down.” That catalyst was Lehman Brothers which, when it declared bankruptcy, froze the credit markets because buyers for debt evaporated and liquidity was non-existent.

It was interesting to see Federal Reserve Chairman Jerome Powell, during an address to the Fernandina Beach banking conference, channel Ben Bernanke during his speech on corporate “sub-prime” debt (aka leverage loans.)

“Many commentators have observed with a sense of déjà vu the buildup of risky business debt over the past few years. The acronyms have changed a bit—”CLOs” (collateralized loan obligations) instead of “CDOs” (collateralized debt obligations), for example—but once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards.Likewise, much of the borrowing is financed opaquely, outside the banking system. Many are asking whether these developments pose a new threat to financial stability.

In public discussion of this issue, views seem to range from “This is a rerun of the subprime mortgage crisis” to “Nothing to worry about here.” At the moment, the truth is likely somewhere in the middle. To preview my conclusions, as of now, business debt does not present the kind of elevated risks to the stability of the financial system that would lead to broad harm to households and businesses should conditions deteriorate.” – Jerome Powell, May 2019

In other words, corporate debt is “contained.”

The reality is that the corporate debt issue is likely not contained. Here are some stats from our previous report on this issue:

“Currently, the same explosion in low-quality debt is happening in another corner of the US debt market as well. In just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion—an all-time high.

To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder. And there’s a reason BBB-rated debt is so plentiful. Ultra-low interest rates have seduced companies to pile into the bond market and corporate debt has surged to heights not seen since the global financial crisis.”

Let’s put that into context with the sub-prime crisis for a moment.

As Michael Lebowitz wrote for our RIA PRO subscribers. (Try FREE for 30-days)

“The graph shows the implied ratings of all BBB companies based solely on the amount of leverage employed on their respective balance sheets. Bear in mind, the rating agencies use several metrics and not just leverage. The graph shows that 50% of BBB companies, based solely on leverage, are at levels typically associated with lower rated companies.”

“If 50% of BBB-rated bonds were to get downgraded, it would entail a shift of $1.30 trillion bonds to junk status. To put that into perspective, the entire junk market today is less than $1.25 trillion, and the sub-prime mortgage market that caused so many problems in 2008 peaked at $1.30 trillion. Keep in mind, the sub-prime mortgage crisis and the ensuing financial crisis was sparked by investor concerns about defaults and resulting losses.

As mentioned, if only a quarter or even less of this amount were downgraded we would still harbor grave concerns for corporate bond prices, as the supply could not easily be absorbed by traditional buyers of junk.”

Think about that for a moment. If all of a sudden there is a massive slide in ratings quality, many institutions, pension, and mutual funds, which are required to hold “investment grade” bonds will become forced sellers. If there are no “buyers,” you have a liquidity problem.

Let me just remind you that such an event will not happen in a vacuum. It will occur coincident with a recessionary backdrop where assets are being wholesale liquidated. Which is the problem with Powell’s comments which are all predicated on just one thing – no recession.

“To preview my conclusions, as of now, business debt does not present the kind of elevated risks to the stability of the financial system that would lead to broad harm to households and businesses should conditions deteriorate. At the same time, the level of debt certainly could stress borrowers if the economy weakens.”

Jerome Powell is basing his risk assessment on the assumption of a “Goldilocks Economy” that will presumably persist indefinitely. In other words, “the only risk is a recession.” 

Of course, Ben Bernanke’s mistaken assumption about “sub-prime” was also the belief in a “Goldilocks” scenario.

“We have spent a bit of time evaluating the financial implications of the sub-prime issues, tried to assess the magnitude of losses, and tried to determine how concentrated they are. There is a sense that, although there is always a possibility for some kind of disruption, the financial system will absorb the losses from the sub-prime mortgage problems without serious problems.” – Ben Bernanke, May 2007

Of course, the risk of recession has risen markedly in recent months and the resurgence of the trade war may be just enough to push the economy over the edge. But importantly, as Michael noted above, the real risk is when the recession does come. That risk was also highlighted by TheStreet.com

“Joseph Otting, who heads the U.S. Office of the Comptroller of the Currency, said in written testimony to the Senate Banking Committee that underwriting standards have declined on these junky loans, meaning investors will likely get less of their money back in the event of a default. That could spell big losses in an economic downturn, since many of the borrowers likely would suffer a sales decline.   

Banks bear ‘indirect risk’ from the junk-lending frenzy because they lend to companies and investors who buy the loans once they’re made, according to Otting.

‘Although less transparent to the federal banking agencies, we will continue to monitor nonbank leveraged lending activity and its potential impacts to the extent possible,’ Otting said. The banks also lend to companies ‘that may have critical suppliers or vendors that are highly leveraged.’ Regulators and banking executives often use the delicate term ‘leveraged’ to describe a company that is highly indebted.”

The risk is also particularly exposed in the ETF market where investors have been crowding over the last several years.

We have previously pointed out the risk of the “passive investing” craze. To wit:

“’There is no such thing as passive investing. While it is believed that ETF investors have become ‘passive,’ the reality is they have simply become ‘active’ investors in a different form. As the markets decline, there will be a slow realization ‘this decline’ is something more than a ‘buy the dip’ opportunity. As losses mount, the anxiety of those ‘losses’ mounts until individuals seek to ‘avert further loss’ by selling.”

However, that “liquidity” risk is magnified when it comes to junk bonds because those instruments can be particularly illiquid and thinly traded. This was recently noted by Evergreen Capital

“While it’s well known that flows into stock ETFs have gone postal during this bull market, less top-of-mind is that the same thing has happened with bond ETFs. Per the charts below, most of the inflows have been into equity ETFs but corporate bond ETFs have increased by 1000% over the past decade.

Moody’s has also observed that ETF investors ‘may be in for a shock during the next sustained market rout’. They opine that this is especially the case with ETFs that hold lightly-traded securities such as corporate bonds and loans. This could lead to a potentially jarring collision between perceptions and reality. ETF investors think they can get out of even junk bond and sub-investment grade bank loan ETFs on a moment’s notice. To a point that’s true. If they hit the sell button at their on-line broker, they’ll be out instantly. But if they do so during another period of mass liquidation, they’ll get a horrible execution price. In my opinion, this is almost certain to happen in the not too distant future, particularly given that corporate bond volumes have contracted so dramatically in recent years. For example, since 2014 junk bond trading volumes have vaporized by 80%. Thus, the bond market is dangerously illiquid these days.

Unfortunately, while Jerome Powell may be currently channeling Ben Bernanke to keep markets stabilized momentarily, the real risk is some unforeseen exogenous event, such as Deutsche Bank going bankrupt, that triggers a global credit contagion.

The problem for the Fed is that they aren’t starting with a $900 billion balance sheet but rather one over $4 Trillion. Fed funds aren’t at 5% but rather 2.4%, and GDP is running at half the levels of periods preceding previous recessions. In other words, when the next recession comes, which will trigger not on a credit contagion but a mean reverting correction in asset prices, the Fed will have very little to work with.

Of course, this all reminds me of movie “Speed” with Howard Payne talking to Jerome Powell:

“Pop quiz, hotshot. There’s a ‘corporate junk bond’ bomb on a bus. Once the economy slides toward 0%, the bomb is armed. If Deutsche Bank goes bust, it blows up. What do you do? What do you do?”

For our clients, we have already gotten off the bus. We have eliminated our credit risk, shortened our duration and moved substantially higher on the credit quality scale.

What are you doing?

Strike Three: The Next Bear Market Ends The Game

At the beginning of this year, I was at dinner with my wife. Sitting at the table next to us, was a young financial advisor, who was probably in his mid-30’s, meeting with his client who appeared to be in his 60’s. Of course, the market had just experienced a 20% correction from the previous peak and the client was obviously concerned about his portfolio.

“Don’t worry, there is always volatility in the market, but as you can see, even bear markets are mild and on average the market returns 8% a year over the long-term.” 

Here is the chart which shows the PERCENTAGE return of each bull and bear market going back to 1900. (The chart is the S&P 500 Total Return Inflation-Adjusted index.)

Here is the narrative used with this chart.

“The average bear market lasts 1.4 years on average and falls 41% on average.-The average bull market (when the market is rising) lasts 9.1 years on average and rises 476% on average.”

While the statement is not false, it is a false narrative.

“Lies, Damned Lies, and Statistics.”– Mark Twain

Here are the basics of math.

  • If the index goes from 100 to 200 it is indeed a 100% gain.
  • If the index goes from 200 back to 100, it is only a 50% loss.
  • Mathematically it would seem as if an investor is still 50% ahead, however, the net return is actually ZERO.

This is the error of measuring returns in terms of percentages as it masks the real damage done to portfolios during a decline. To understand the real impact of bull and bear markets on a portfolio, it must be measured in POINTS rather than percentages.

The chart above exposes the basic realities of math, loss, and time. What becomes much more apparent is that bear markets tend to destroy most or all of the previous advance and has done so repeatedly throughout history.

Importantly, what was not being discussed between the advisor and his 60-something client was simply the risk of “time.”

There are many financial advisors, commentators, experts, and social media gurus who have never actually “been invested” during a real “bear market.” While the “theory of ‘buy and hold'” sounds good, kind of like MMT, in practice it is an entirely different issue. The emotional stress of loss leads to selling even by the most “die hard” of individuals. The combined destruction of capital and the loss of time is the biggest issue when it comes to individuals meeting their retirement goals.

The following chart the real, inflation-adjusted, total return of the S&P 500 index.

Note: The green lines denote the number of years required to get back to even following a bear market. It is worth noting the entirety of the markets return over the last 118-years occurred in only 4-periods: 1925-1929, 1959-1968, 1990-2000, and 2016-present)

That comment corresponds to the next chart. As noted, there have currently been four, going on five, periods of low returns over a 20-year period.

As discussed last week:

“Unless you have contracted ‘vampirism,’ then you do NOT have 90, 100, or more, years to invest to gain “average historical returns.” Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have about 30-35 years to reach their goals. If that period happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are severely diminished.

What drives those 12-15 year periods of flat to little return? Valuations.

Just remember, a 20-year period of one-percent returns is indistinguishable from ZERO with respect to meeting savings goals.”

In other words, the most important component of your investment success depends more on WHEN you start rather than IF you start.

That brings me to my second point of that nagging problem of “time.” 

Time Is An Unkind Companion

While it is nostalgic to use 100+ years of market data to try and prove a point about the benefits of “buy and hold” investing, the reality is that we “mere mortals” do not have the life-span required to achieve those returns.

“Despite the best of intentions, a vast majority of the ‘bullish’ crowd today have never lived through a real bear market.”

I have been managing money for people for a very long time. The one simple truth is that once an individual has lost a large chunk of their savings, they are very reluctant to go through such an experience a second time. This is particularly the case as individuals get ever closer to their retirement age.

Let’s remember that our purpose of investing is to:

 “Grow savings at a rate which maintains the same purchasing power parity in the future and provides a stream of living income.” 

Nowhere in that statement is a requirement to “beat a benchmark index.” 

For most people, a $1 million account sounds like a lot of money. It’s a big, fat round number. The problem is that the end number is much less important than what it can generate. The table below shows $1,000,000 and what it can generate at varying interest rate levels.

30-years ago, when prevailing rates were substantially higher, and living standards were considerably cheaper, a $1,000,000 nest egg was substantial enough to support retirement when combined with social security, pensions, etc.

Today,  that is no longer the case.

Since most investors only have 20 to 30-years to reach their goals, if that period begins when valuations are elevated, the odds of success falls dramatically.

This is why “time” becomes such an important determinate of success.

In all of the analysis that is done by Wall Street, “life expectancy” is never factored into the equations used when presenting the bullish case for investing. Therefore, in order to estimate future inflation-adjusted total returns, we must adjust the formula to include “life expectancy.” 

RTR =((1+(Ca + D)/ 1+I)-1)^(Si-Lfe)

Where:

  • Ca = Capital Appreciation
  • D = Dividends
  • I = Inflation
  • Si = Starting Investment Age
  • Lfe = Life Expectancy

For consistency, we will assume the average starting investment age is 35. We will also assume the holding period for stocks is equal to the life expectancy less the starting age. The chart below shows the calculation of total life expectancy (based on the average of males and females) from 1900-present, the average starting age of 35, and the resulting years until death. I have also overlaid the rolling average of the 20-year total, real returns and valuations.

Importantly, notice the level of VALUATIONS when you start investing has everything to do with the achievement of higher rates of return over the investable life expectancy of an individual. 

There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.

As shown in the chart box below, I have taken a $1000 investment for each period and assumed a real, total return holding period until death. No withdrawals were ever made. (Note: the periods from 1983 forward are still running as the investable life expectancy span is 40-plus years.)

The gold sloping line is the “promise” of 6% annualized compound returns. The blue line is what actually happened with invested capital from 35 years of age until death, with the bar chart at the bottom of each period showing the surplus or shortfall of the goal of 6% annualized returns.

In every single case, at the point of death, the invested capital is short of the promised goal.

The difference between “close” to goal, and not, was the starting valuation level when investments were made.

This is why, as I discussed in “The Fatal Flaws In Your Retirement Plan,” that you must compensate for both starting period valuations and variability in returns when making future return assumptions. If you calculate your retirement plan using a 6% compounded growth rates (much less 8% or 10%) you WILL fall short of your goals. 

The Next Bear Market Will Be The Last

After two major bear markets since the turn of the century, a vast majority of “baby boomers” are woefully unprepared for retirement. Dependency on social welfare is at record highs, individuals are working far longer into retirement than at any other point in history, and after a decade long bull market many investors have only just recently gotten back to where they were 10-years ago.

It is from this point, given valuations are once again pushing 30x earnings, that we review the expectations that individuals facing retirement should consider.

  • Expectations for future returns and withdrawal rates should be downwardly adjusted due to current valuation levels.
  • The potential for front-loaded returns going forward is unlikely.
  • Your personal life expectancy plays a huge role in future outcomes. 
  • The impact of taxation must be considered.
  • Future inflation expectations must be carefully considered.
  • Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • The yield chase over the last 10-years, and low interest rate environment, has created an extremely risky environment for investors. Caution is advised.
  • Expectations for compounded annual rates of returns should be dismissed in lieu of variable rates of return based on current valuation levels.

Importantly, chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely realize.

For the majority of individuals today facing, or in, retirement the two previous bear markets have left many further away from retirement than they ever imagined.

The next one will destroy those goals entirely.

Investing for retirement, should be done conservatively, and cautiously, with the goal of outpacing inflation, not the market, over time. Trying to beat some random, arbitrary index that has nothing in common with your financial goals, objectives, and most importantly, your life span, has tended to end badly for individuals.

You can do better.

What Could Go Wrong? The Fed Warns On Corporate Debt

“So, if the housing market isn’t going to affect the economy, and low interest rates are now a permanent fixture in our society, and there is NO risk in doing anything because we can financially engineer our way out it – then why are all these companies building up departments betting on what could be the biggest crash the world has ever seen?

What is more evident is what isn’t being said. Banks aren’t saying “we are gearing up just in case something bad happens.” Quite the contrary – they are gearing up for WHEN it happens.

When the turn does come, it will be unlike anything we have ever seen before. The scale of it could be considerable because of the size of some of these leveraged deals.”Lance Roberts, June 2007

It is often said that no one saw the crash coming. Many did, but since it was “bearish” to discuss such things, the warnings were readily dismissed.

Of course, what came next was the worst financial crisis since the “Great Depression.”

But that was a decade ago, the pain is a relic of history, and the surging asset prices due to monetary policies has once again lured both Wall Street and Main Street into the warm bath of complacency.

It should not be surprising warnings are once again falling on “deaf ears.”

The latest warning came from the Federal Reserve who identified rising sales of risky corporate debt as a top vulnerability facing the U.S. financial system in their latest financial stability report. Via WSJ:

Officials, for the second time in six months, cited potential risks tied to nonfinancial corporate borrowing, particularly leveraged loans—a $1.1 trillion market that the Fed said grew by 20% last year amid declining credit standards. They also flagged possible concerns in elevated asset prices and historically high debt owned by U.S. businesses.

Monday’s report also identified potential economic shocks that could test the stability of the U.S. financial system, including trade tensions, potential spillover effects to the U.S. from a messy exit of Britain from the European Union and slowing economic growth globally.

Specifically, the Fed warned a downturn could expose vulnerabilities in U.S. corporate debt markets, ‘including the rapid growth of less-regulated private credit and a weakening of underwriting standards for leveraged loans.’”

It has become quite commonplace to dismiss the current environment under the thesis of “this time is different.” This was also the case in 2007 where the general beliefs were exactly the same:

  1. Low interest rates are expected to persist indefinitely into the future, 
  2. A pervasive belief that Central Banks have everything under control, and;
  3. The economy is strong and there is “no recession” in sight.

Remember, even though no one knew it at the time, the recessions officially started just 5-months later.

The issue of “zombie corporations,” or companies that would be bankrupt already if not for ongoing low interest rates and loose lending standards, is not a recent issue. Via Zerohedge:

“As Bloomberg reports, in a particularly striking sign, the Fed said the businesses with the biggest existing debt loads are also the ones taking on the riskiest loans. And protections that lenders include in loan documents in case borrowers default are eroding, the U.S. central bank said in its twice-a-year financial stability report. The Fed board voted unanimously to approve the document.

‘Credit standards for new leveraged loans appear to have deteriorated further over the past six months,’ the Fed said, adding that the loans to firms with especially high debt now exceed earlier peaks in 2007 and 2014.

‘The historically high level of business debt and the recent concentration of debt growth among the riskiest firms could pose a risk to those firms and, potentially, their creditors.’

Leveraged loans are routinely packaged into collateralized loan obligations, or CLOs. Investors in those securities — including insurance companies and banks — face a risk that strains in the underlying loans will deliver ‘unexpected losses,’ the Fed said Monday, adding that the secondary market isn’t very liquid, “even in normal times.”

‘It is hard to know with certainty how today’s CLO structures and investors would fare in a prolonged period of stress,’ the Fed added.”

Yes. CLO’s are back.

And it was the Central Bank’s largesse that led to the latest bubble. As noted by WSJ:

“Financial stability has remained a central focus at the Fed because of the easy-money policies employed to nurse the economy back to health in the years following the financial crisis. Critics have warned that the Fed’s large bond-buying campaigns and years of near-zero interest rates risked new bubbles.”

One of the common misconceptions in the market currently, is that the “subprime mortgage” issue was vastly larger than what we are talking about currently.

Not by a long shot. 

Combined, there is about $1.15 trillion in outstanding U.S. leveraged loans — a record that is double the level five years ago — and, as noted, these loans increasingly are being made with less protection for lenders and investors.

Just to put this into some context, the amount of sub-prime mortgages peaked slightly above $600 billion or about 50% less than the current leveraged loan market.

Of course, that didn’t end so well.

Currently, the same explosion in low-quality debt is happening in another corner of the US debt market as well.

As noted by John Mauldin:

“In just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion—an all-time high.

To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder.

And there’s a reason BBB-rated debt is so plentiful. Ultra-low interest rates have seduced companies to pile into the bond market and corporate debt has surged to heights not seen since the global financial crisis.”

As the Fed noted a downturn in the economy, signs of which we are already seeing, a significant correction in the stock market, or a rise in interest rates could quickly cause problems in the corporate bond market. The biggest risk currently is refinancing the debt. As Frank Holmes noted in a recent Forbes article, the outlook is rather grim.

“Through 2023, as much as $4.88 trillion of this debt is scheduled to mature. And because of higher rates, many companies are increasingly having difficulty making interest payments on their debt, which is growing faster than the U.S. economy, according to the Institute of International Finance (IIF).

“On top of that, the very fastest-growing type of debt is riskier BBB-rated bonds — just one step up from ‘junk.’  This is literally the junkiest corporate bond environment we’ve ever seen.  Combine this with tighter monetary policy, and it could be a recipe for trouble in the coming months.”

Let that sink in for a minute.

Over the next 5-years, more than 50% of the debt is maturing.

As noted, a weaker economy, recession risk, falling asset prices, or rising rates could well lock many corporations out of refinancing their share of this $4.88 trillion debt. Defaults will move significantly higher, and much of this debt will be downgraded to junk.

As noted by James Grant in a recent interview:

“Many companies will get into trouble if the real interest rate on ten-year treasuries rises over 1%. These businesses are so leveraged that they can’t cover their debt payments at levels even as humble and as low as a 1% real interest rate on ten-year treasuries as it translates into corporate borrowing. Just look at the growth in the herd of listed zombies; companies whose average operating income has fallen short of covering the average interest rate expense over three consecutive years. As it turns out, the corporate living dead, as a share of the broad S&P 1500 index, are close to 14%. Former Fed-Chairman Ben Bernanke once tried to reassure everyone that the Fed could raise rates in 15 minutes if it wanted to. Well, it turns out the Fed cannot do that. So, it’s a brave new world we’re living in.”

Not Just Corporate Debt

While subprime and CDO’s blew up the markets in 2008. It isn’t just corporate debt that has ballooned to problematic levels in recent years.

There is another financial risk of epic proportions brewing currently. If you are not familiar with “shadow banking,” you should learn about it quick.

Nonbank lending, an industry that played a central role in the financial crisis, has been expanding rapidly and is still posing risks should credit conditions deteriorate.

Often called ‘shadow banking’ — a term the industry does not embrace — these institutions helped fuel the crisis by providing lending to underqualified borrowers and by financing some of the exotic investment instruments that collapsed when subprime mortgages fell apart.

This kind of lending has absolutely exploded all over the globe since the last recession, and it has now become a $52 trillion dollar bubble.

In the years since the crisis, global shadow banks have seen their assets grow to $52 trillion, a 75% jump from the level in 2010, the year after the crisis ended. The asset level is through 2017, according to bond ratings agency DBRS, citing data from the Financial Stability Board.

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, and a $5 trillion dollar funding gap, 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, credit is collapsing, and shadow-banking freezes, the ensuing debacle will make 2008 look like mild recession. 

It is unlikely Central Banks are prepared for, or have the monetary capacity, to substantially deal with the fallout.

As David Rosenberg noted:

“There is no way you ever emerge from eight years of free money without a debt bubble. If it’s not a LatAm cycle, then it’s energy the next, commercial real estate after that, a tech mania years after, and then the mother of all of them, housing over a decade ago. This time there is a huge bubble on corporate balance sheets and a price will be paid. It’s just a matter of when, not if.”

Never before in human history have we seen so much debt.  Government debt, corporate debt, shadow-banking debt, and consumer debt are all at record levels. Not just in the U.S., but all over the world.

If you are thinking this is a “Goldilocks economy,” “there is no recession in sight,” “Central Banks have this under control,” and that “I am just being bearish,” you would be right.

But that is also what everyone thought in 2007.

Has The Fed Done It? No More Recessions?

“Wow!”

That is all I could utter as my brain spun listening to an interview with Chamrath Palihapitiya on CNBC last week.

“I don’t see a world in which we have any form of meaningful contraction nor any form of meaningful expansion. We have completely taken away the toolkit of how normal economies should work when we started with QE. I mean, the odds that there’s a recession anymore in any Western country of the world is almost next to impossible now, save a complete financial externality that we can’t forecast.”

It is a fascinating comment particularly at a time where the Federal Reserve has tried, unsuccessfully, to normalize monetary policy by raising interest rates and reducing their balance sheet.  However, an almost immediate upheaval in the economy, not to mention reprisal from the Trump Administration, brought those efforts to a halt just a scant few months after they began.

A quick Google search on Chamrath revealed a pretty gruesome story about his tenure as CEO of Social Capital which will likely cease existence soon. However, his commentary was interesting because despite an apparent lack of understanding of how economics works, his thesis is simply that economic cycles are no longer relevant.

This is the quintessential uttering of “this time is different.” 

Economists wanting to get rid of recessions is not a new thing.

Emi Nakamura, this years winners of the John Bates Clark Medal honoring economists under 40, stated in an interview that she:

“…wants to tackle some of her fields’ biggest questions such as the causes of recessions and what policy makers can do to avoid them.”

The problem with Central Bankers, economists, and politicians, intervening to eliminate recessions is that while they may successfully extend the normal business cycle for a while, they are most adept at creating a “boom to bust” cycles.

To be sure the last three business cycles (80’s, 90’s and 2000) were extremely long and supported by a massive shift in financial engineering and credit leveraging cycle. The post-Depression recovery and WWII drove the long economic expansion in the 40’s, and the “space race” supported the 60’s.  You can see the length of the economic recoveries in the chart below. I have also shown you the subsequent percentage market decline when they ended.

Currently, employment and wage growth is fragile, 1-in-4 Americans are on Government subsidies, and the majority of American’s living paycheck-to-paycheck. This is why Central Banks, globally, are aggressively monetizing debt in order to keep growth from stalling out.

Despite a surging stock market and an economy tied for the longest economic expansion in history, it is also is running at the weakest rate of growth with the highest debt levels…since “The Great Depression.”  

Recessions Are An Important Part Of The Cycle

I know, I get it.

If you mention the “R” word, you are a pariah from the mainstream proletariat.

This is because people assume if you talk about a “recession” you mean the end of the world is coming.

The reality is that recessions are just a necessary part of the economic cycle and arguably an crucial one. Recessions remove the “excesses” built up during the expansion and “reset” the table for the next leg of economic growth.

Without “recessions,” the build up of excess continues until something breaks. The outcomes of previous attempts to manipulate the cycles have all had devastating consequences.

In the current cycle, the Fed’s interventions and maintenance of low rates for a decade have allowed fundamentally weak companies to stay in business by taking on cheap debt for unproductive purposes like stock buybacks and dividends. Consumers have used low rates to expand their consumption through debt once again. The Government has piled on debts and increased the deficit to levels normally seen during a recession. Such will only serve to compound the problem of the next recession when it comes.

However, it is the Fed’s mentality of constant growth, with no tolerance for recession, has allowed this situation to inflate rather than allowing the natural order of the economy to perform its Darwinian function of “weeding out the weak.”

The two charts below show both corporate debt as a percentage of economic growth and total system leverage versus the market.

Do you see the issue?

The fact that over the past few decades the system has not been allowed to reset has led to a resultant increase in debt to the point it has impaired the economy to grow. It is more than just a coincidence that the Fed’s “not-so-invisible hand” has left fingerprints on previous financial unravellings.

Given the years of “ultra-accommodative” policies following the financial crisis, the majority of the ability to “pull-forward” consumption appears to have run its course. This is an issue that can’t, and won’t be, fixed by simply issuing more debt which, for last 40 years, has been the preferred remedy of each Administration. In reality, most of the aggregate growth in the economy has been financed by deficit spending, credit creation, and a reduction in savings.

In turn, this surge in debt reduced both productive investments into, and the output from, the economy. As the economy slowed, and wages fell, the consumer was forced to take on more leverage which continued to decrease the savings rate. As a result, of the increased leverage, more of their income was needed to service the debt.

Since most of the government spending programs redistribute income from workers to the unemployed, this, Keynesians argue, increases the welfare of many hurt by the recession. What their models ignore, however, is the reduced productivity that follows a shift of resources from productive investment to redistribution.

All of these issues have weighed on the overall prosperity of the economy and what has obviously gone clearly awry is the inability for the current economists, who maintain our monetary and fiscal policies, to realize what downturns encompass.

The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the result, is clearly wrong. It has not happened in four decades. What is missed is that things like temporary tax cuts, or one time injections, do not create economic growth but merely reschedules it. The average American may fall for a near-term increase in their take-home pay and any increased consumption in the present will be matched by a decrease later on when the tax cut is revoked.

This is, of course, assuming the balance sheet at home is not broken. As we saw during the period of the “Great Depression” most economists thought that the simple solution was just more stimulus. Work programs, lower interest rates, government spending, etc. did nothing to stem the tide of the depression era.

The problem currently is that the Fed’s actions halted the “balance sheet” deleveraging process keeping consumers indebted and forcing more income to pay off the debt which detracts from their ability to consume. This is the one facet that Keynesian economics does not factor in. More importantly, it also impacts the production side of the equation since no act of saving ever detracts from demand. Consumption delayed, is merely a shift of consumptive ability to other individuals, and even better, money saved is often capital supplied to entrepreneurs and businesses that will use it to expand, and hire new workers.

The continued misuse of capital and continued erroneous monetary policies have instigated not only the recent downturn but actually 40-years of an insidious slow moving infection that has destroyed the American legacy.

Here is the most important point.

“Recessions” should be embraced and utilized to clear the “excesses” that accrue in the economic system during the first half of the economic growth cycle.

Trying to delay the inevitable, only makes the inevitable that much worse in the end.

The “R” Word

Despite hopes to the contrary, the U.S., and the globe, will experience another recession. The only question is the timing.

As I quoted in much more detail in this past weekend’s newsletter, Doug Kass suggests there is plenty of “gasoline” awaiting a spark.

  • Slowing Domestic Economic Growth
  • Slowing Non-U.S. Economic Growth
  • The Earnings Recession
  • The Last Two Times the Fed Ended Its Rate Hike Cycle, a Recession and Bear Market Followed
  • The Strengthening U.S. Dollar
  • Message of the Bond Market
  • Untenable Debt Levels
  • Credit Is Already Weakening
  • The Abundance of Uncertainties
  • Political Uncertainties and Policy Concerns
  • Valuation
  • Positioning Is to the Bullish Extreme
  • Rising Bullish Sentiment (and The Bull Market in Complacency)
  • Non-Conformation of Transports

But herein lies the most important point about recessions, market reversions, and systemic problems.

What Chamrath Palihapitiya said was both correct and naive.

He is naive to believe the Fed has “everything” under control and recessions are a relic of the past. Central Banks globally have engaged in a monetary experiment hereto never before seen in history. Therefore, the outcome of such an experiment is also indeterminable.

Secondly, when Central Banks launched their emergency measures, the global economies were emerging from a financial crisis not at the end of a decade long growth cycle. The efficacy of their programs going forward is highly questionable.

But what Chamrath does have right were his final words, even though he dismisses the probability of occurrence.

“…save a complete financial externality that we can’t forecast.”

Every financial crisis, market upheaval, major correction, recession, etc. all came from one thing – an exogenous event that was not forecast or expected.

This is why bear markets are always vicious, brutal, devastating, and fast. It is the exogenous event, usually credit related, which sucks the liquidity out of the market causing prices to plunge. As prices fall, investors begin to panic sell driving prices lower which forces more selling in the market until, ultimately, sellers are exhausted.

It is the same every time.

While investors insist the markets are currently NOT in a bubble, it would be wise to remember the same belief was held in 1999 and 2007. Throughout history, financial bubbles have only been recognized in hindsight when their existence becomes “apparently obvious” to everyone. Of course, by that point is was far too late to be of any use to investors and the subsequent destruction of invested capital.

This time will not be different. Only the catalyst, magnitude, and duration will be.

My advice to Emi Nakamura would be instead of studying how economists can avoid recessions, focus on the implications, costs, and outcomes of previous attempts and why “recessions” are actually a “healthy thing.” 

Here Are The Most Important Stock Charts To Watch This Week

After the sharp 12 percent stock market rout over the past two weeks, the big question on everyone’s mind is “where are we heading next?” In addition, as someone who is known for warning that we’re in a gigantic bubble, many people are asking me “is this the peak of the bubble?” Though I rely on fundamental information such as valuations to help determine if a market or asset is experiencing a bubble, I believe that technical or chart analysis is necessary when dealing with market timing-related questions. In this piece, I will show the most important stock charts that I’m watching to help determine if a bounce is ahead or if another leg down is likely.

Starting in September 2017, the U.S. stock indices went parabolic and climbed a succession of steepening uptrend lines. The correction of the past two weeks caused the Dow to slice below the two most recent uptrend lines that formed in September and November 2017, respectively. This represents a notable technical breakdown that investors and traders should be mindful of. At the same time, the longer-term uptrend line remains unbroken, which means that the longer-term trend is still intact for now. In the near future, the Dow is likely to bounce around and form a consolidation pattern between the most recently broken uptrend line and the unbroken longer-term uptrend line as it works off its oversold condition.

Dow Daily

Source: StockCharts.com

The weekly Dow chart shows how the most recent uptrend line was broken, but the other two uptrend lines are unbroken. My level of concern will rise proportionately with each major uptrend line that is broken.

Dow Weekly

Source: StockCharts.com

After plunging below the two most recent uptrend lines, the SP500 found support at the longer-term trendline on Friday. There is a very high likelihood that the SP500 will bounce around in between these trendlines for now as traders digest the implications of the recent downdraft.

SP500 Daily

Source: StockCharts.com

The weekly SP500 chart shows that the longer-term uptrend line that started in early-2016 is still intact. If this were to break, it would give another bearish confirmation signal.

Source: StockCharts.com

The tech-heavy Nasdaq Composite Index also broke below its most recent uptrend line, but found support at its longer-term uptrend line.

Nasdaq Daily

Source: StockCharts.com

The weekly Nasdaq chart shows that the uptrend line that began in early-2016 is still intact.

Nasdaq Weekly

Source: StockCharts.com

After a brief breakout above the 1,550 level that I was watching in January, the small cap Russell 2000 cut right below that level and the uptrend line that started in August 2017.

Russell 2000 Daily

Source: StockCharts.com

The weekly Russell 2000 chart shows that the index has been rising within a channel over the past two years and that the uptrend is still intact as long as it stays within this pattern. The index briefly fell below the bottom of this channel on Friday, but was able to regain this level by the close of trading.

Russell 2000 Weekly

Source: StockCharts.com

For now, there is a high probability that the major U.S. stock indices will consolidate after such a powerful downward move. Once the current oversold conditions are worked off, the next directional move made will be very important from a technical signal standpoint. If the market breaks below the longer-term trendlines discussed in this piece, it would be quite worrisome. On the other hand, if the indices are able to rally back above their broken trendlines, it would negate the recent bearish signals.

(Disclaimer: All information is provided for educational purposes only and should not be relied on for making any investment decisions. These chart analysis blog posts are simply market “play by plays” and color commentaries, not hard predictions, as the author is an agnostic on short-term market movements.)

RIA Economic & Investment Summit (Q1-2016)

Just recently, I hosted an Economic & Investment summit in Houston to discuss the markets, economy and the outlook heading into the end of the year.

Importantly, the point of the presentation was to discuss the data and the current detachment of the fundamental backdrop from current realities. As I have stated many times, this is not the first time such a detachment has occurred. Unfortunately, the reversions of these detachments have tended to be rather nasty.

I have broken down the summit into the five basic sections for easier consumption. The slide presentation is presented in PDF at the end.

I hope you enjoy and find the information helpful.


2007 vs 2016 – What I Saw Then That Suggested A Recession Was Coming

The Stock Market – Was Was Promised Vs. What Actually Happens

10 Warning Signs

Managing For Certainty In An Uncertain Market

Oil, Interest Rates & Gold

The Slide Presentation

RIA Economic & Investment Summit 2016 by streettalk700


Lance Roberts

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Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter and Linked-In