Tag Archives: tax cuts

Strongest Economy Ever? I Warned You About Negative Revisions

Over the last 18-months, there has been a continual drone of political punditry touting the success of “Trumponomics” as measured by various economic data points. Even the President himself has several times taken the opportunity to tweet about the “strongest economy ever.”

But if it is the “strongest economy ever,” then why the need for aggressive rate cuts which are “emergency measures” to be utilized to offset recessionary conditions?

First, it is hard to have an “aggressive rate-cutting cycle” when you only have 2.4% to work with.

Secondly, I am not sure we want to be like China or Europe economically speaking, and running a $1.5 Trillion deficit during an expansion, suspending the debt ceiling, and expanding spending isn’t that much different.

Nonetheless, I have repeatedly cautioned about the risk of taking credit for the economic bump, or the stock market, as a measure of fiscal policy success. Such is particularly the case when you are a decade into the current economic cycle.

Economic growth is more than just a reported number. The economy has been “in motion” following the last recession due to massive liquidity injections, zero interest rates, and a contraction in the labor force. Much like a “snowball rolling downhill,” the continuation of economic momentum should have been of little surprise.

As an example, we can look at full-time employment (as a percentage of 16-54  which removes the “retiring baby boomer” argument) by President. The rise in full-time employment has been on a steady trend higher following the financial crisis as the economic and financial systems repaired themselves.

As discussed previously, economic data is little more than a “wild @$$ guess” when it is initially reported. However, one-year and three-years later, the data is revised to reveal a more accurate measure of the “real” economy.

Unfortunately, we pay little attention to the revisions.

While there are many in the media touting “the strongest economy ever” since Trump took office, a quick look at a chart should quickly put that claim to rest.

Yes, there was a spurt in economic growth during 2018, which did seem to support the claims that Trump’s policies were working. As I warned then, there were factors at play which were obfuscating the data.

“Lastly, government spending has been very supportive to the markets in particular over the last few quarters as economic growth has picked up. However, that “sugar-high” was created by 3-massive Hurricanes in 2017 which has required billions in monetary stimulus which created jobs in manufacturing and construction and led to a temporary economic lift. We saw the same following the Hurricanes in 2012 as well.”

“These “sugar highs” are temporary in nature. The problem is the massive surge in unbridled deficit spending only provides a temporary illusion of economic growth.”

The importance is that economic “estimates” become skewed by these exogenous factors, and I have warned these over-estimations would be reversed when annual revisions are made.

Last week, the annual revisions to the economic data were indeed negative. The chart below shows “real GDP” pre- and post-revisions.

This outcome was something I discussed previously:

With the Fed Funds rate running at near 2%, if the Fed now believes such is close to a ‘neutral rate,’ it would suggest that expectations of economic growth will slow in the quarters ahead from nearly 6.0% in Q2 of 2018 to roughly 2.5% in 2019.”

However, there is further evidence that actual, organic, economic growth is weaker than the current negative revisions suggest. More importantly, the revisions to the 2019 data, in 2020, will very likely be as negative as well.

This is also the case with the employment data which I discussed previously:

“Months from now, the Establishment Survey will undergo its annual retrospective benchmark revision, based almost entirely on the Quarterly Census of Employment and Wages conducted by the Labor Department. That’s because the QCEW is not just a sample-based survey, but a census that counts jobs at every establishment, meaning that the data are definitive but take time to collect.”

“The Establishment Survey’s nonfarm jobs figures will clearly be revised down as the QCEW data show job growth averaging only 177,000 a month in 2018. That means the Establishment Survey may be overstating the real numbers by more than 25%.”

There is nothing nefarious going on here.

It is the problem with collecting data from limited samples, applying various seasonal adjustment factors to it, and “guesstimating” what isn’t known. During expansions, the data is always overstated and during recessions it is understated. This is why using lagging economic data as a measure of certainty is always erroneous.

Debt-Driven Growth

I recently discussed the “death of fiscal conservatism” as Washington passed another spending bill.

“In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues, and $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in.”

The “good news” is, if you want to call it that, is that Government spending does show up in economic growth. The “bad news” is that government spending has a negative “multiplier” effect since the bulk of all spending goes to non-productive investments. (Read this)

Nonetheless, the President suggests we are “winning.”

The problem is that economic growth less government spending is actually “recessionary.” 

As shown in the chart below, since 2010 it has taken continually increases in Federal expenditures just to maintain economic growth at the same level it was nearly a decade ago. Such a “fiscal feat” is hardly indicative of “winning.”

As Mike Shedlock noted, part of the issue with current economic estimates is simply in how it is calculated.

In GDP accounting, consumption is the largest component. Naturally, it is not possible to consume oneself to prosperity. The ability to consume more is the result of growing prosperity, not its cause. But this is the kind of deranged economic reasoning that is par for the course for today.

In addition to what Tenebrarum states, please note that government transfer payments including Medicaid, Medicare, disability payments, and SNAP (previously called food stamps), all contribute to GDP.

Nothing is “produced” by those transfer payments. They are not even funded. As a result, national debt rises every year. And that debt adds to GDP.”

This is critically important to understand.

While government spending, a function of continually increasing debt, does appear to have an economic benefit, corporate profits tell a very different story.

The Real Economy

I have been noting for a while the divergence between “operating earnings” (or rather “earnings fantasy”) versus corporate profits which are what companies actually report for tax purposes. From “Earnings Growth Much Weaker Than Advertised:”

“The benefit of a reduction in tax rates is extremely short-lived since we compare earnings and profit growth on a year-over-year basis.

In the U.S., the story remains much the same as near-term economic growth has been driven by artificial stimulus, government spending, and fiscal policy which provides an illusion of prosperity.”

Since consumption makes up roughly 70% of the economy, then corporate profits pre-tax profits should be growing if the economy was indeed growing substantially above 2%.”

We now know the economy wasn’t growing well above 2% and, as a consequence, corporate profits have been revised sharply lower on a pre-tax basis.

The reason we are looking at PRE-tax, rather than post-tax, profits is because we can see more clearly what is actually happening at the corporate level.

Since corporate revenues come for the sale of goods and services, if the economy was growing strongly then corporate profits should be reflective of that. However, since 2014, profits have actually been declining. If we take the first chart above and adjust it for the 2019-revisions we find that corporate profits (both pre- and post-tax) are the same level as in 2012 and have been declining for the last three-years in particular.

Again, this hardly indicates the “strongest economy in history.”

These negative revisions to corporate profits also highlight the over-valuation investors are currently paying for asset prices.  Historically, such premiums have had rather horrific “paybacks” as markets eventually “reprice” for reality.

Trump’s Political Risk

While the media is quick to attribute the current economic strength, or weakness, to the person who occupies the White House, the reality is quite different.

Most fiscal, and monetary, policy changes can take up to a year before the impact shows in the economic data. While changes to “tax rates” can have a more immediate impact, “interest rate” changes take longer to filter through.

The political risk for President Trump is taking too much credit for an economic cycle which was already well into recovery before he took office. Rather than touting the economic numbers and taking credit for liquidity-driven financial markets, he should be using that strength to begin the process of returning the country to a path of fiscal discipline rather than a “drunken binge” of spending.

With the economy, and the financial markets, sporting the longest-duration in history, simple logic should suggest time is running out.

This isn’t doom and gloom, it is just a fact.

Politicians, over the last decade, failed to use $33 trillion in liquidity injections, near zero interest rates, and surging asset prices to refinance the welfare system, balance the budget, and build surpluses for the next downturn.

Instead, they only made the deficits worse and the U.S. economy will enter the next recession pushing a $2 Trillion deficit, $24 Trillion in debt, and a $6 Trillion pension gap which will devastate many in their retirement years.

While Donald Trump talked about “Yellen’s big fat ugly bubble” before he took office, he has now pegged the success of his entire Presidency on the stock market.

It will likely be something he eventually regrets.

“Then said Jesus unto him, Put up again thy sword into his place: for all they that take the sword shall perish with the sword.” – Matthew 26, 26:52

You Have A “Trading” Problem – 10 Steps To Fix It

In April of 2018, I wrote an article entitled “10-Reasons The Bull Market Ended In 2018” in which I concluded:

“There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a ‘panic selling’ situation.)

If I am wrong, and the bull market resumes, we simply remove hedges and reallocate equity exposure.

‘There is little risk, in managing risk.’

The end of bull markets can only be verified well after the fact, but therein lies the biggest problem. Waiting for verification requires a greater destruction of capital than we are willing to endure.”

It is important to remember, that “Risk” is simply the function of how much you will lose when you are wrong in your assumptions.

2018 has been a year of predictions gone horribly wrong.

Not surprisingly, after a decade-long bull market, individuals who were betting on a more positive outcome this year are now clinging to “hope.”

Do you remember all of the analysis about how:

  • Rate hikes won’t matter
  • Surging earnings due to tax cuts will power the market higher
  • Valuations are reasonable

These were all issues which we have heavily questioned over the last couple of years.

And the majority of our warnings “fell on deaf ears” as just being simply “bearish.” 

Of course, you really can’t blame the average investor for ignoring fundamental realities considering they have been repeatedly told the stock market is a “sure thing.” Just “buy and hold” and the market will return 10% a year just as it has over the last 100 years.

This fallacy has been so repeatedly espoused by pundits, brokers, financial advisors, and the media that it has become accepted as “truth.”

But, if it were true, then explain why roughly 80% of Americans, according to numerous surveys, have less than one years salary saved up on average? Furthermore, no one who simply bought and held the S&P 500 has ever lost money over a 10- or 20-year time span. Right? 

Not exactly.

Here is the problem.

No matter how resolute people think they are about buying and holding, they usually fall into the same old emotional pattern of “buying high” and “selling low.”

Investors are human beings. As such, we gravitate towards what feels good and we seek to avoid pain. When things are euphoric in the market, typically at the top of a long bull market, we buy when we should be selling. When things are painful, at the end of a bear market, we sell when we should be buying.

In fact, it’s usually the final capitulation of the last remaining “holders” that sets up the end of the bear market and the start of a new bull market. As Sy Harding says in his excellent book “Riding The Bear:” 

“No such creature as a ‘buy and hold’ investor ever emerged from the other side of the subsequent bear market.”

Statistics compiled by Ned Davis Research back up Harding’s assertion. Every time the market declines more than 10%, (and “real” bear markets don’t even officially begin until the decline is 20%), mutual funds experience net outflows of investor money. To wit:

“Lipper also found the largest outflows on record from stocks ($46BN)the largest outflows since December 2015 from taxable bond ($13.4BN) and Investment Grade bond ($3.7BN) funds, and the 4th consecutive week of outflows from high yield bonds ($2.1BN), offset by a panic rush into cash as money market funds attracted over $81BN in inflows, the largest inflow on record.”

“Fear is a stronger emotion than greed.”

Most bear markets last for months (the norm), or even years (both the 1929 and 1966 bear markets), and one can see how the torture of losing money week after week, month after month, would wear down even the most determined “buy and hold” investor.

But the average investor’s pain threshold is a lot lower than that. The research shows that it doesn’t matter if the bear market lasts less than 3 months (like the 1990 bear) or less than 3 days (like the 1987 bear). People will still sell out, usually at the very bottom, and almost always at a loss.

So THAT is how it happens.

And the only way to avoid it – is to avoid owning stocks during bear markets. If you try to ride them out, odds are you’ll fail. And if you believe that we are in a “New Era,” and that bear markets are a thing of the past, your next of kin will have our sympathies.

But you can do something about it.

Just like any “detox” program, these are the steps to follow to becoming a better long-term investor.

10-Step Process To Curing The Addiction

STEP 1: Admitting there is a problem 

The first step in solving any problem is to realize that you have a “trading” problem. Be willing to take the steps necessary to remedy the situation

STEP 2: You are where you are

It doesn’t matter what your portfolio was in March of 2000, March of 2009, or last Friday.  Your portfolio value is exactly what it is, rather it is realized or unrealized. The loss is already lost, and understanding that will help you come to grips with needing to make a change. Open those statements and look at them – shock therapy is usually effective in bringing about awareness.

STEP 3:  You are not a loser

Most people have a tendency to believe that if they “sell a loser,” then they are a “loser” by extension. They try to ignore the situation, or hide the fact they lost money, which in turn causes more mistakes. This only exacerbates the entire problem until they then try to assign blame to anyone and anything else.

You are not a loser. You made an investment mistake. You lost money. 

It has happened to every person that has ever invested in the stock market, and there are many others who lost more than you.

STEP 4:  Accept responsibility

In order to begin the repair process, you must accept responsibility for your situation. It is not the market’s fault. It is not your advisor’s or money manager’s fault, nor is it the fault of Wall Street. 

It is your fault.

Once you accept that it is your fault and begin fixing the problem, rather than postponing the inevitable and suffering further consequences of inaction, only then can you begin to move forward.

STEP 5:  Understand that markets change

Markets change due to a huge variety of factors from interest rates to currency risks, political events, to geo-economic challenges.

If this is a true statement, then how does it make sense to buy and hold?

If markets are in a constant state of flux, and your portfolio remains in a constant state, then the law of change must apply: 

The law of change:  Change will occur and the elements in the environment will adapt or become extinct and that extinction in and of itself is a consequence of change. 

Therefore, if you are a buy and hold investor then you have to modify and adapt to an ever-changing environment or you will become extinct.

STEP 6:  Ask for help

This market has baffled, and confused, even the best of investors and will likely continue to do so for a while. So, what chance do you have doing it on your own?

Don’t be afraid to ask, or get help, if you need it. This is no longer a market which will forgive mistakes easily and while you may pay a little for getting help, a helping hand may keep you from making more costly investment mistakes in the future.

STEP 7:  Make change gradually

No one said that change was going to easy or painless. Going against every age-old philosophy and piece of advice you have ever been given about investing is tough, confusing and froth with doubt.

However, make changes gradually at first – test the waters and measure the results. For example, sell the positions that are smallest in size with the greatest loss. You will make no noticeable change in the portfolio right away, but it will make you realize that you can actually execute a sell order without suffering a negative consequence.

Gradually work your way through the portfolio on rallies and cleanse the portfolio of the evil seeds of greed that now populate it, and replace them with a garden of investments that will flourish over time.

STEP 8:  Develop a strategy 

Now that you have cleaned everything up you should be feeling a lot more in control of your portfolio and your investments. Now you are ready to start moving forward in the development of a goal-based investment strategy.

If your portfolio is a hodge-podge of investments, then how do you know whether or not your portfolio will generate the return you need to meet your goals. A goal-based investment strategy builds the portfolio to match investments, and investment vehicles, in an orderly structure to deliver the returns necessary with the least amount of risk possible. Ditch the benchmark index and measure your progress against your investment destination instead.

STEP 9:  Learn it. Live it. Love it.

Once you have designed the strategy, including monthly contributions to the plan, it is time to implement it. This is where the work truly begins.

  • You must learn the plan inside and out so every move you make has a reason and a purpose. 
  • You must live the plan so that adjustments are made to the plan, and the investments, to match performance, time and value horizons.
  • Finally, you must love the plan so that you believe in it and will not deviate from it. 

It must become a part of your daily life, otherwise, it will be sacrificed for whims and moments of weakness.

STEP 10:  Live your life 

That’s it.

You are in control of your situation rather than the situation controlling you.

The markets will continue to remain volatile as a more important “bear market” takes hold in the next year or so.

The good news is that there will be lots of opportunities to make money along the way.

But that is just how it works. As long as you work your plan, the plan will work for you, and you will reach your goals…eventually.

There is no “get rich quick” plan.

So, live your life, enjoy your family, and do whatever it is that you do best. Most importantly, make your portfolio work as hard for you as you did for the money you put into it.

Did The Market Miss Powell’s Real Message?

Last week, I discussed the recent message from Fed Chairman Jerome Powell which sent the markets surging higher.

“During his speech, Powell took to a different tone than seen previously and specifically when he stated that current rates are ‘just below’ the range of estimates for a ‘neutral rate.’ This is a sharply different tone than seen previously when he suggested that a “neutral rate” was still a long way off.

Importantly, while the market surged higher after the comments on the suggestion the Fed was close to ‘being done’ hiking rates, it also suggests the outlook for inflation and economic growth has fallen. With the Fed Funds rate running at near 2%, if the Fed now believes such is close to a ‘neutral rate,’ it would suggest that expectations of economic growth will slow in the quarters ahead from nearly 6.0% in Q2 of 2018 to roughly 2.5% in 2019.”

Since then, the bond market has picked up on that realization as the yield has flattened considerably over the last few days as the 10-year interest rate broke back below the 3% mark. The chart below shows the difference between the 2-year and the 10-year interest rate.

Now, there are many who continue to suggest “this time is different” and an inverted yield curve is not signaling a recession, and Jerome Powell’s recent comments are “in line” with a “Goldilocks economy.”


But historically speaking, while an inversion of the yield curve may not “immediately” coincide with a recessionary onset, given its relationship to economic activity it is likely a “foolish bet” to suggest it won’t. A quick trip though the Fed’s rate hiking history and “soft landing” scenarios give you some clue as to their success.

While the Fed has been acting on previously strong inflationary data due to surging oil prices, the real long-term drivers of inflation pressures weren’t present. I have commented on this previously, but Kevin Giddis from Raymond James had a good note on this:

“We have always known that the bond market wasn’t as worried about inflation as the Fed, but it really needed the Fed to come out and indicate a ‘shift’ in that way of thought to seal the deal.”

This is exactly correct, and despite the many arguments to the contrary we have repeatedly stated the rise in interest rates was a temporary phenomenon as “rates impact real economic activity.” The “real economy,” due to a surge in debt-financed activity, was not nearly strong enough to withstand substantially higher rates. Of course, such has become readily apparent in the recent housing and auto sales data.

Flat As A Pancake

All of sudden, the bond market has woken up to reality after a year-long slumber. The current spread between the 2-year note and the 10-year note is as tight as it has been in many years and has rarely occurred when the economic fundamentals were as strong as many believe.

The reality, of course, is much of the current strength in economic activity is not from organic inputs in a consumer-driven economy, but rather from one-off impacts of several natural disasters, a surge in consumer debt, and a massive surge in deficit spending. To wit:

“The problem is the massive surge in unbridled deficit spending only provides a temporary illusion of economic growth. Over the long-term, debt leads to economic suppression. Currently, the deficit is rapidly approaching $1 Trillion, and will exceed that level in 2019, which will require further increases in the national debt.”

“There is a limited ability to issue debt to pay for excess spending. The problem with running a $1 Trillion deficit during an economic expansion is that it reduces the effectiveness of that tool during the next recession.”

Our assessment of Powell’s change in tone comes from the message the bond market is sending about the risk to the economy. Since economic data is revised in arrears, the onset of a recession will likely surprise most economists when they learn about it “after the fact.”  Let’s go back to Kevin:

“Here is what we know right now:

1) The U.S. economy seems to be slowing, falling under the weight of higher borrowing costs. What’s hard to predict is whether this is a trend change or a temporary pause.

2) The Fed appeared to blink last week, but we won’t know for sure until December 19th when they release their Rate Decision and ‘tell’ the market what the forward-looking path looks like to them.

3) Inflation is well-contained. For all of you who left town riding on the ‘inflation train,’ welcome back.

4) Global economies are weakening and could get weaker.

5) Friday’s release of the Employment Report should give the market guidance on wages, but not much else.

Kevin is correct, take a look at inflation breakeven rates.

It is quite likely these are not temporary stumbles, but rather a more important change in the previous trends. More importantly, the “global weakness” has continued to accelerate and given that roughly 40% of corporate profits are driven by exports, this does not bode well for extremely lofty earnings forecasts going into 2019.

What Powell Really Said

Caroline Baum had an interesting comment on MarketWatch on Tuesday morning:

“I read with interest the articles last week about the Federal Reserve’s new “unpredictable” and “flexible” approach to monetary policy. No longer can financial markets rely on the gradual, premeditated and practically pre-announced adjustments to the benchmark overnight interest rate, according to these analyses. From now on, the Fed will be ‘data dependent.’”

The whole article is worth a read, but the point being made is that the Fed has always been “data dependent” even if their ability to read and interpret the data has been somewhat flawed. The table below is the average range of their predictions for GDP they publish each quarter versus what really happened.

As Caroline noted, the September projections pegged the “neutral rate” range at 2.5-3.5% with a median estimate of 3%. If Powell is indeed suggesting that the neutral rate has fallen to the low-end of that range, he is likely only confirming what the “yield curve” has been telling us for months. As I quoted previously:

“The yield curve itself does not present a threat to the U.S. economy, but it does reflect a change in bond investor expectations about Federal Reserve actions and about the durability of our current economic expansion.”

Importantly, yield curves, like valuations, are “terrible” with respect to the “timing” of the economic slowdown and/or the impact to the financial markets. So, the longer the economy and markets continue to grow without an event, or sign of weakness, investors begin to dismiss the indicator under the premise “this time is different.” 

The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting that Powell may have “woken up to smell the coffee.” While the curve is not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker much of the mainstream economists suggests. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q4.)

Mr. Powell most likely also realizes that continuing to tighten monetary policy will simply accelerate the time frame to the onset of the next recession. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

The only question is the timing.

There are currently too many indicators already suggesting higher rates are impacting interest rate sensitive, and economically important, areas of the economy. The only issue is when investors recognize the obvious and sell in the anticipation of a market decline.

As I discussed previously, the stock market is a strong leading indicator of economic turns and the turmoil this year may be signaling just that.

Believing that professional investors will simply ignore the weight of evidence to contrary in the “hopes” this “might” be different this time is not a good bet as “risk-based” investors will likely act sooner, rather than later. Of course, the contraction in liquidity causes the decline in asset prices which will contribute to the economic contraction as consumer confidence is shattered. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become “obvious” the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the “yield curve” as a “market timing” tool, it is just as unwise to completely dismiss the message it is currently sending.

Don’t Fear The Yield Curve?

In July of this year, James McCusker penned an article entitled “Don’t Fear The Yield Curve” in which he stated:

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.”

I didn’t think much of the article at the time as it was an outlier. However, now, given the yield curve continues to trail lower, despite the many calls of “bond bears” swearing rates are going to rise, the number of voices in the “this time is different” camp has grown.

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,”Ryan Detrick, LPL

“In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

First, the yield curve is simply the difference in the yields of different maturities of bonds. However, in this particular case, we are discussing the difference between the 2-year and the 10-year rate on U.S. Treasury bonds.

Historically speaking, the yield curve has been a consistent predictor of weaker economic times in the U.S. As James noted:

“The yield curve itself does not present a threat to the U.S. economy, but it does reflect a change in bond investor expectations about Federal Reserve actions and about the durability of our current economic expansion.”

Importantly, yield curves, like valuations, are “terrible” with respect to the “timing” of the economic slowdown and/or the impact to the financial markets. So, the longer the economy and markets continue to grow without an event, or sign of weakness, investors begin to dismiss the indicator under the premise “this time is different.” 

James did hit on an important point but misses the mark.

“Much of our economy relies on debt, and the so-called ‘entitlement’ sector of government spending is dependent on investors parting with cash to purchase trillions of dollars of the federal government’s debt. That means that the investor expectations reflected in the yield curve have some weight. However, it is good to remember that the negative yield curve may simply be the result of a delayed reaction of long-term interest rates to the economy’s expansion. If long-term rates were to rise, the inversion of the yield curve would disappear.”

He is right that we are in a debt-driven economy. Corporate, household, margin, student, and government debt are at all- time highs. That debt has a cost. It must be serviced. Therefore, as rates rise, the cost of servicing rises commensurately. This is particularly the case with variable rate, credit card, and other debt which are tied directly to short-term rates which is impacted by changes in the overnight lending rates (aka Fed monetary policy).

As rates rise on the short-end, and as expected rates of future returns fall, money is shifted toward the “safety” of longer-dated U.S. Treasuries not only by domestic investors, but also foreign investors which are seeking safety from a stronger dollar, weaker economic growth, or reduced financial market expectations.

While there are many calls to ignore the yield curve, some of the most economically sensitive commodities. like Copper, are providing a cause for concern. Per Jesse Colombo: 

“Copper, which is known as “the metal with a PhD in economics” due to its historic tendency to lead the global economy, is down nearly 4 percent today alone and 22 percent since early-June. Copper’s bear market of the past couple of months is worrisome because it signals that a global economic slowdown is likely ahead.”

Copper Daily Chart

Even exports from South Korea, which acts as a leading indicator of economic activity has turned sharply lower as well.

While “sentiment” data was previously extremely elevated over “hopes” that “Trumponics” would create an broad-based economic surge, as noted recently, such has not been the case and “sentiment” is now catching “down” with reality.

Of course, one really needs to look no further than the bond market which is also screaming the Fed is once again, as they always have, making a monetary policy mistake. The chart below shows, GDP as compared to both the 5- and 10-year inflation “breakeven” rates. As noted, there was a significant boost to economic activity following three massive hurricanes and two major wildfires in 2017. That bump to activity only served to “pull forward” future economic activity, increasing short-term inflationary pressures, which are now beginning to subside.

The message is quite simple.

The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q3)

Furthermore, the AAA-Junk yield curve is also beginning to suggest problems for companies which have binged on debt issuance to support share buybacks over the last decade.

The annual rate of change for bank loans and leases as well has residential homes loans have all started declined as higher rates are crimping demand.

While none of this suggests a problem is imminent, nor does it RULE OUT higher highs in the markets first, there is mounting evidence the Fed is headed towards making another mistake in their long line of creating “boom/bust” cycles.

Looking back through history, the evidence is quite compelling that from the time the first rate hike is induced into the system, it has started the countdown to the next recession.

The Federal Reserve is quickly becoming trapped by its own “data-dependent” analysis. Despite ongoing commentary of improving labor markets and economic growth, their own indicators have been suggesting something very different. This is why the scrapped their Labor Market Conditions Index and are now trying to come up with a “new and improved” yield curve to support their narrative. 

Tightening monetary policy further will simply accelerate the time frame to the onset of the next recession. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

The only question is the timing.

It is unlikely this time is different. There are too many indicators already suggesting higher rates are impacting interest rate sensitive, and economically important, areas of the economy. The only issue is when investors recognize the obvious and sell in the anticipation of a market decline.

Believing that investors will simply ignore the weight of evidence to contrary in the “hopes” this “might” be different this time is not a good bet. The yield curve is clearly sending a message that shouldn’t be ignored and it is a good bet that “risk-based” investors will likely act sooner rather than later. Of course, it is simply the contraction in liquidity that causes the decline which will eventually exacerbate the economic contraction. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become “obvious” the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the “yield curve” as a “market timing” tool, it is just as unwise to completely dismiss the message it is currently sending.

Boiling A Turkey

There is an age old fable describing a frog being slowly boiled alive. The premise is that if a frog is put suddenly into boiling water, it will try and save itself. However, if the frog is put in tepid water which is then brought to a boil slowly, it will not perceive the danger and will be cooked to death. The metaphor is often ascribed to the inability, or unwillingness, of people to react to or be aware of threats which arise gradually rather than suddenly.

This metaphor was brought to mind as I was writing last weekend’s newsletter discussing the issue of Turkey and the potential threat posed to the global economy. Specifically, I was intrigued by the following points from Daniel Lacalle:

“The collapse of Turkey was an accident waiting to happen and is fully self-inflicted.”

It is yet another evidence of the train wreck that monetarists cause in economies. Those that say that ‘a country with monetary sovereignty can issue all the currency it wants without risk of default’ are wrong yet again. Like in Argentina, Brazil, Iran, Venezuela, monetary sovereignty means nothing without strong fundamentals to back the currency.

Turkey took all the actions that MMT lovers applaud. The Erdogan government seized control of the central bank, and decided to print and keep extremely low rates to ‘boost the economy’ without any measure or control.

Turkey’s Money Supply tripled in seven years, and rates were brought down massively to 4,5%.

However, the lira depreciation was something that was not just accepted by the government but encouraged.  Handouts in fresh-printed liras were given to pensioners in order to increase votes for the current government, subsidies in rapidly devaluing lira soared by more than 20% (agriculture, fuel, tourism industry) as the government tried to compensate the loss of tourism revenues due to security concerns with subsidies and grants.

Loss of foreign currency reserves ensued, but the government soldiered on promoting excessive debt and borrowing. Fiscal deficits soared, and the rapidly devaluing lira led to a rising amount of loans in US dollars.

This is the typical flaw of monetarists, they believe monetary sovereignty shields the country from external shocks and loans in foreign currencies soar because no one wants to lend in a constantly-debased currency at affordable rates. Then the central bank raises rates but the monetary hole keeps rising as the money supply continues to grow to pay for handouts in local currency.”

Frog Meets Water 

If any of Daniel’s commentary sounds familiar, you shouldn’t be surprised. The U.S. has been doing much of the same for the last several decades under the same faulty Keynesian/MMT set of beliefs.

But, lets make a big distinction, the U.S. is not Turkey.

While the U.S. may be vastly different than Turkey in many respects, such doesn’t mean pursing the same policies will have a different result.

For example, as Daniel notes, Turkey has provided “handouts” to secure votes. But the U.S. has done, and continues to do the same thing via programs like “paid leave,” “child tax credits,” a smörgåsbord of welfare and entitlement programs. In fact, government assistance programs now make up a record level of disposable personal incomes as 1-in-4 households depend on some form of government program.

This continued push to provide more governmental assistance, and the rise of “socialist” political leanings, should not come as a surprise in an economy where there is an annual deficit of more than $3250 to maintain the standard of living after consumers have exhausted wages, savings and credit.

This is not just about securing votes of the less fortunate. For example, military spending, corporate tax cuts and banking de-regulation to name a few examples, help line the pockets of shareholders and corporate executives and certainly influence their voting patterns.

Since there is simply not enough tax revenue to fund these programs, the government must rely on debt issuance to fund the shortfall. More importantly, since fiscal policies like “tax reform” lower government revenue, when those programs are not offset with real spending cuts, deficits increase more quickly.

Despite assurances from the current Administration that tax reform would lead to higher tax revenues and reduce the deficit – it is actually quite the opposite that has occurred. As shown below, spending has surged while tax receipts have stagnated. As a result the deficit is set to explode and the amount of government debt outstanding will increase by over $1 trillion in each of the next four years.

While most modern economists believe that debt and deficits have little to no consequence, the data suggests otherwise. While deficits continue to be a “talking point” for conservative politicians wanting to win elections, unbridled spending has become the “fiscal policy” of choice. Of course, economic growth has been the ultimate sacrifice. The surge in the deficit in the coming months will reverse the recent spat of economic growth as the boost from a slew of natural disasters last year and tax related boosts fade.

As I stated, in order to fund that spending, the money has to come from either taxpayers or debt issuance. As shown in the next two charts, government debt as percentage of economic growth continues to climb.

The saving grace currently is that interest rates remain at some of the lowest levels on record historically speaking. While that may seem good, lower rates only feed more economic problems as Michael Lebowitz recently discussed in Wicksell’s Elegant Model:

“Where capital is involved, discipline is either applied or neglected through the mechanism of interest rates. To apply a simple analogy, in those places where water is plentiful, cheap, and readily available through pipes and faucets, it is largely taken for granted. It is used for the basic necessities of bathing and drinking but also to wash our cars and dogs. In countries where clean water is not easily accessible, it is regarded as a precious resource and decidedly not taken for granted or wasted for sub-optimal uses. In much the same way, when capital is easily accessible and cheap, how it is used will more often be sub-optimal.”

Those low rates have allowed the government to issue substantial levels of debt without having to “pay” a significant financial consequence as of yet. However, even with the government currently paying some of the lowest effective interest rates in history for the debt outstanding, debt payments have risen to the highest level on record.

At the current run rate, which will massively accelerate if rates do indeed rise, the “debt service” will become on the largest budget items for the U.S. in the not too distant future. Currently, debt service and social welfare consume almost 75% of every tax dollar and in the next decade are slated to consume almost 100%. This leaves all other spending, and there is a lot of it, a function of debt issuance.

Issuing more debt to fund a debt problem is not economically viable long-term as the majority of socialist countries eventually come to realize.

Not unlike Turkey, the U.S. has also engaged in a massively increasing its money supply. The result of which has not been surprising. Beginning in 1980, the surge in the monetary base along with household debt has led to an unsurprising and very predictable outcome.

Of course, with wages and economic growth stagnant, and the purchasing power of the dollar continuing its long-term decline, the need for debt and government assistance will continue to increase.

Given the slowing demographic trends, the structural changes to the economy which continues to erode productivity, and the inevitable increase in debt, the net effect will continue to slow rates of economic growth as deflationary pressures build.

As Jesse Colombo noted earlier this week:

“Turkey’s economy has become reliant on cheap credit, and the recent interest rate hikes mean that the country’s cheap credit era has come to an end. Higher interest rates are going to cause a credit bust in Turkey, leading to a serious economic crisis.

While most commentators believe that Turkey’s current turmoil is the result of U.S. sanctions, the reality is that the country’s crisis was already ‘baked into the cake’ years ago. The recent political clash with the U.S. is simply the catalyst for the coming Turkish economic crisis, but it is not the actual cause. I am also highly concerned that Turkey’s current turmoil will lead to further contagion in emerging markets, which have also similarly thrived due to ultra-loose global monetary conditions that are now coming to an end.”

The U.S. Is Not Turkey.

However, there are many more similarities than most politicians and economists wish to admit. The biggest of which is our current dependence on “cheap debt” to fund everything from Government handouts to corporate buybacks, capital expenditures, and household consumption.

Despite hopes of economic resurgence, the reality is likely quite the opposite. Economic trends are hard to reverse and governmental policy trends are impossible to change.

The good news is that the U.S. will eventually start making meaningful fiscal policy reforms. The bad news, like Turkey, is that those changes will come through “force” rather than “choice.” 

But such has been the case for every empire in history from the Romans, to the Greeks, to the British.

Without real, substantive change, the U.S. will likely face a similar outcome.

We have the time to make the right choices.

The only question is do we have the will?

Or, are we simply the “Turkey” in the pot of water.

Was Q2-GDP Really All That Extraordinary?

Last week, while I was on vacation, I penned a report prior to the release of the second quarter GDP report in which I noted the following:

“Tomorrow, the US Department of Commerce will report its advance estimate of 2Q GDP which will be the long-awaited evidence that “Trumponomics” is working. The current estimates for the initial print run the gamut from 3.9% to over 5% annualized growth. Regardless of the actual number, the White House spokesman will be quick to take credit for success in turning America’s economy around.

But is that really the case? First, there are several things to remember about the initial print on economic growth.

  • The initial estimate is based on the collection of estimates from Wall Street economists.  With no real data in just yet, the initial estimate just a “guess.”
  • The number is annualized. So, a growth of 1% in the economy is reported as 4%. However, as we know from the first quarter, quarterly growth can vary widely in a given year.
  • Lastly, a one-quarter surge in economic growth doesn’t make much difference in the long-term trajectory of economic growth, or in this case, ongoing weakness.  The chart below shows the change in economic growth by decade.”

As noted, the 1% growth rate in the second quarter was multiplied by 4-quarters to reach the proclaimed 4.1% growth rate. However, there is little evidence to support the notion that such mathematical projections have much validity. The chart below shows inflation-adjusted GDP growth on a quarterly basis as compared to economist expectations of sustained growth over the next 3-quarters. Not surprisingly, economic growth tends to vary widely from those expectations. More importantly, spikes in economic growth tend to lead lower rates over subsequent quarters.  

As we now know, the actual first estimate aligned with the 4% assumption made last week along with the expectation the current Administration, and media pundits, would go “all giddy.”

However, from a portfolio management standpoint, I am more interested in the “devil in the details” as economic growth is key to sustained growth in corporate revenue and profits. From an investment standpoint, it is more important to understand the sustainability of economic growth when projecting forward returns and modeling asset allocations around those assumptions. There are also several other important considerations with respect to the most recent GDP report.

Economy Gets A $1 Trillion Boost

With the release of the Q2 GDP report, and not covered by any of the mainstream media, was an adjustment the economic data going all the way back to 1929.

As noted by Wolf Richter:

“What the Bureau of Economic Analysis released Friday as part of its GDP report was a huge pile of revisions and adjustments going back years. It included an adjustment to the tune of nearly $1 trillion in ‘real’ GDP. And it lowered further its already low measure of inflation.

Comprehensive updates of the National Income and Product Accounts (NIPAs), which are carried out about every five years, are an important part of BEA’s regular process for improving and modernizing its accounts to keep pace with the ever-changing U.S. economy. Updates incorporate newly available and more comprehensive source data, as well as improved estimation methodologies. The timespan for this year’s comprehensive update is 1929 through the first quarter 2018.

Where did a bulk of the change come from? A change in the calculation of “real” GDP from using 2009 dollars to 2012 dollars which boosted growth strictly from a lower rate of inflation.  As noted by the BEA:

“For 2012-2017, the average rate of change in the prices paid by U.S. residents, as measured by the gross domestic purchasers’ price index, was 1.2 percent, 0.1 percentage point lower than in the previously published estimates.”

Of course, when you ask the average household about “real inflation,” in terms of healthcare costs, insurance, food, energy, etc., they are likely to give you quite an earful that the cost of living is substantially higher than 1.2%. Nonetheless, the chart below shows “real” GDP both pre- and post-2018 revisions.

Importantly, the entire revision is almost entirely due to a change in the inflation rate. On a nominal basis, there was virtually no real change at all. In other words, stronger economic growth came from a mathematical adjustment rather than increases in actual economic activity.

Population Matters

When the media reports on economic growth, employment gains, retail sales, personal consumption expenditures or a variety of other measures, there is little consideration given to increases in the population.

With respect to economic growth, population increases matter. In an economy that is 70% driven by personal consumption expenditures, adding more consumers to the population will positively impact economic growth. The increase in demand from additional consumers will lead to an increase in retail sales, employment gains, etc. However, as we showed previously, while there is much “hype” about employment gains in the economy, the reality is that employment has failed to keep pace with population growth.

The chart below shows the difference between “real” GDP growth and “real” GDP growth per capita.

As you can see, once you adjust for population, the growth rate of the economy looks very different. However, we can see a clearer representation of the difference when looking at the average growth rate per decade. I have projected the data out, based on current assumptions, through 2025.

There is a significant difference between reported economic growth rates and GDP per capita. Currently, at just a 1.4% annual growth rate in GDP per capita going forward, the expectations for higher returns on investments must be reconsidered. It is unlikely, with debt to GDP ratios elevated, interest rates rising, and wages stagnant that higher rates of growth can be sustained.

It Wasn’t Really 4%

As was quoted previously, the second quarter GDP report was inflated by a number of one-off factors that will dissipate in the quarters ahead.

An unusually large number of one-off factors appear to have boosted 2Q GDP, many of which are directly related to escalating trade concerns. As companies and countries race to secure supplies that may become expensive later on, exports have surged and inventories have swelled. If these trends are one-time adjustments (and our economists believe they are), the ‘payback’ in 2H could be significant. Enjoy the 2Q GDP number, which may be the last best print for a while.”

Our friends at the Committee for a Responsible Federal Budget provided a good piece of commentary showing the impacts of recent legislation and political actions.

Most of this growth comes from the one-time surge in consumption that accompanies deficit-financed legislation. We recently estimated that other deficit-financed bills would generate a further 0.2 percent of growth.

At the same time, many analysts believe the second-quarter growth numbers are artificially inflated by shifts in consumption to avoid the new tariffs announced this quarter. Most significantly, China appears to have accelerated purchases of soybeans, crude oil, and other exports before new tariffs went into effect. Pantheon Macroeconomics estimated the soybean surge alone could account for as much 0.6 percentage points of the growth rate. These accelerated purchases mean faster growth now at the expense of slower growth later.

Assuming CBO’s numbers apply evenly on a quarterly basis and Pantheon’s numbers are correct, these temporary factors alone account for 1.4 percentage points of annual growth – meaning without them the second-quarter growth rate would fall to 2.7 percent. Even this 2.7 percent figure is likely inflated by the accelerated export of other goods, as well as one-time recovery effects.”

“Growth of 4.1 percent is a fast quarterly growth rate, the highest since the third quarter of 2014 (4.9 percent). Nevertheless, it’s notable that this growth rate is based on several temporary and predictable factors. But importantly, growth often fluctuates quarter to quarter – and over the course of the year, economic growth is likely to be significantly slower.”

We concur with that outlook and expect a significant softening of economic growth over the next couple of quarters. Furthermore, while a one-quarter anomaly is certainly good for media sound bytes, it is a far different matter when it comes to investing capital. The recent pop in economic growth did little to change the long-run dynamics of the economy as I showed previously. More importantly, the quality of economic growth continues to deteriorate due to structural shifts in the economic backdrop.

In modeling assumptions for future returns on invested capital, expectations of weaker economic growth rates must be considered. As we discussed in our third chapter of “Myths of Stocks For The Long Run” if:

  • GDP maintains a 2% annualized growth rate, AND
  • There are NO recessions….ever, AND
  • Current market cap/GDP stays flat at 1.25, AND
  • The current dividend yield of roughly 2% remains,

Using Dr. John Hussman’s formula we would get forward returns of:

(1.02)*(.8/1.25)^(1/30)-1+.02 = 2.5%

But there’s a “whole lotta ifs” in that assumption.

More importantly, if we assume that inflation remains stagnant at 2%, as the Fed hopes, this would mean a real rate of return of just 0.5%.

Economic growth matters, and it matters a lot.

As an investor, it is important to remember that in the end corporate earnings and profits are a function of the economy and not the other way around. Historically, GDP growth and revenues have grown at roughly equivalent rates.

Forget the optimism surrounding “Trumpenomics” and focus on longer-term economic trends which have been declining for the past 30+ years. The economic trend is a function of a growing burden of debt, increasing demographic headwinds and, very importantly, declining productivity growth. I see little to make me believe these are changing in a meaningful way.

Lastly, do not forget that interest rates, despite recent increases, are near historical lows and the Feds balance sheet is still 4 times as large as it was before the financial crisis of 2008. Further, the U.S. Treasury will borrow $1.3 trillion this year which will directly feed economic growth. Just ask yourself where would the economy be if this extreme monetary and fiscal policy were not in place.

Still think everything is “hunky dory?”

The Mirage That Will Be Q2-GDP

Tomorrow, the US Department of Commerce will report its advance estimate of 2Q GDP which will be the long-awaited evidence that “Trumponomics” is working. The current estimates for the initial print run the gamut from 3.9% to over 5% annualized growth. Regardless of the actual number, the White House spokesman will be quick to take credit for success in turning America’s economy around.

But is that really the case? First, there are several things to remember about the initial print on economic growth.

  • The initial estimate is based on the collection of estimates from Wall Street economists.  With no real data in just yet, the initial estimate just a “guess.”
  • The number is annualized. So, a growth of 1% in the economy is reported as 4%. However, as we know from the first quarter, quarterly growth can vary widely in a given year.
  • Lastly, a one-quarter surge in economic growth doesn’t make much difference in the long-term trajectory of economic growth, or in this case, ongoing weakness.  The chart below shows the change in economic growth by decade.

  • In both the chart above, and below, I have penciled in a 4% increase in economic growth for the second quarter. Making similar adjustments for wages and productivity, we find the 5-year averages change very little. More importantly, current action is more typical of a late cycle expansion as opposed to the beginning of a new one.

Secondly, while the print will undoubtedly be a strong one, and not unexpected following a weak Q1 growth rate, the question is whether it is sustainable? A recent note from Goldman Sachs suggests some caution:

“An unusually large number of one-off factors appear to have boosted 2Q GDP, many of which are directly related to escalating trade concerns. As companies and countries race to secure supplies that may become expensive later on, exports have surged and inventories have swelled. If these trends are one-time adjustments (and our economists believe they are), the ‘payback’ in 2H could be significant. Enjoy the 2Q GDP number, which may be the last best print for a while.”

This is likely correct. As 2018 has seen a steady increase in trade tensions, and trade actions, between the US and its trading partners, we have already begun to see some of the negative impacts from those actions. Just this past week Boeing ($BA), General Motors ($GM) and Whirlpool ($WHR) all had disappointing reports with comments directly related to the negative impact of tariffs on their results. They are surely not going to be the last as the US has slapped tariffs on washing machines and solar panels in January, on steel and aluminum in March, and on US$34 billion of goods from China on July 6. Now, the administration is talking about another 25% tariff on close to $200 billion in foreign-made automobiles later this year.

Morgan Stanley also made very similar comments in their recent analysis about the unusually large number of one-off factors which appear to have boosted 2Q GDP, most of which are directly related to escalating trade concerns.

“As companies and countries race to secure supplies that may become expensive later on, exports have surged and inventories have swelled. If these trends are one-time adjustments (and our economists believe they are), the ‘payback’ in 2H could be significant. Enjoy the 2Q GDP number, which may be the last best print for a while.

The ‘stockpiling’ in exports could be responsible for 1.5 percentage points of our 4.7% 2Q GDP estimate. ‘Stockpiling’ also appears to be at work for US companies, albeit to a more limited extent. The inventory build in 2Q is tracking at +US$38 billion, versus a +US$10 billion rate in the prior two quarters. And what’s more interesting is the areas where those inventories are building, which have material overlaps with trade: electrical goods, machinery equipment, motor vehicles and parts.”

In other words, the contribution to Q2 GDP from inventories alone would be roughly 2.2%, or roughly 50%, of the total increase. Such would be the single biggest combined contribution since 4Q11 when the U.S. was restocking auto inventories following the tsunami-related shutdown of Japan. 

These one-off adjustments are unsustainable and simply represent the pull-forward of demand that will be given back over the subsequent quarters. Following the economic reboot in Q4 of 2011, as Japan’s manufacturing came back online, the next five quarters averaged just 1.6%.

Another reason, the second quarter economic growth print may be a “one-time” bonanza, is that tariffs are not only impacting U.S. companies and their profitability, it is also filtering through the rest of the economy as recently noted by ECRI:

“As the chart shows, real personal income and consumer spending growth are both in cyclical downturns.”

“Contrary to the notion of a ‘strengthening’ economy, consumer spending growth has fallen to a 4 ¼-year low, as personal income growth continues to undershoot spending growth.

The consumer — which makes up about 70% of the economy — is getting hit with a six-year highs in inflation, so real wages are actually lower than a year ago.

The chart also shows that the income shortfall relative to spending is increasing, and since 2015 the cumulative shortfall is over 1% of GDP. Necessarily, that gap is financed by consumers taking on more debt.

Away from the trade war rhetoric, which hasn’t really made a big impact yet, the lack of real income gains is why many are having a harder time making ends meet.

The expected strength in Q2 GDP growth comes in large part from energy production and a temporary fiscal boost, which are both non-cyclical events. Of course, higher gas prices also hurt the consumer.”

With wage growth stagnant, corporations struggling to pass through rising commodity and tariff related costs and debt service requirements on the rise as the Fed continues to hike rates, the drag from the consumption side of the economic equation will likely dwarf the current boosts in the next two quarters.

Furthermore, as I noted previously, tax cuts and reform, tariffs and other fiscal remedies promoted by the current administration fail to address the main drag to economic growth over time. The debt.

“It now requires $3.71 of debt to create $1 of economic growth which will only worsen as the debt continues to expand at the expense of stronger rates of growth.”

In fact, as recently noted by our friends at the Committee for a Responsible Federal Budget, the U.S. deficit is set to surge. To wit:

“The White House Office of Management and Budget recently released its annual mid-session review which updated deficit projections in its fiscal year 2019 budget request. The report projected deficits will reach $1.085 trillion in FY 2019 under their budget, which is double the $526 billion called for in the FY 2018 budget.”

The report specifically addresses the biggest point of concern:

“The last time the nation experienced trillion-dollar deficits was during a serious economic downturn, no less – lawmakers took the issue seriouly. PAYGO laws were established, a fiscal commission was formed, new discretionary spending caps were implemented and policymakers entered a multi-year debate on how best to bring down long-term debt levels.

This time around, with the emergence of trillion-dollar deficits during a period of economic strength – when we should be saving for future downturns – few seem to even take notice. On our current course, debt will overtake the size of the entire economy in about a decade, and interest will be the largest government program in three decades or less. This will weaken both our economy and our role in the world.”

Of course, the debt commission failed, what few spending cuts that were put in place have been fully repealed and unsurprisingly surging debt levels continue to surge as economic growth remains weak.

Furthermore, while many in the current administration like to use the Congressional Budget Office (CBO) projections as they are always overly optimistic, it is important to note the CBO gives no weight to the structural changes which continue to plague economic assumptions. The combination of tariffs and tax cuts combined with the major headwinds to economic growth are daunting.

  • Spending hikes
  • Demographics
  • Surging health care costs
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Financialization 
  • Global debt

These factors will continue to send the debt to GDP ratios to record levels. The debt, combined with these numerous challenges, will continue to weigh on economic growth, wages and standards of living into the foreseeable future.

So, while the economic report on Friday will be a “rosy” picture in the short-term, it is likely going to be the best print we see between now and the onset of the next recession.

The Data Is In: Tax Cuts And The Failure To Trickle Down

Back in February, I discussed some of the early indications of what we were seeing following the passage of “tax cut” bill last December. To wit:

“The same is true for the myth that tax cuts lead to higher wages. Again, as with economic growth, there is no evidence that cutting taxes increases wage growth for average Americans. This is particularly the case currently as companies are sourcing every accounting gimmick, share repurchase or productivity increasing enhancement possible to increase profit growth.

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

‘How have U.S. corporations been deploying their new influx of capital? Unlike in prior cycles – when corporations favored long-term business investments and expansions – corporations have largely focused on juicing their stock prices via share buybacks, dividends, and mergers & acquisitions. While this pleases shareholders and boosts executive compensation, this short-term approach is detrimental to the long-term success of American corporations. The chart below shows the surge in share buybacks and dividends paid, which is a direct byproduct of the current artificially low interest rate environment. Even more alarming is the fact that share buybacks are expected to exceed $1 trillion this year, which would blow all prior records out of the water. The passing of President Donald Trump’s tax reform plan was the primary catalyst that encouraged corporations to dramatically ramp up their share buyback plans.'”

SP500 Buybacks & Dividends By Year

“What is even more unwise about the current share buyback mania is the fact that it is occurring at extremely high valuations, which is tantamount to ‘throwing good money after bad.’”

And, in the time since that writing, there is scant evidence that wages, or employment, are improving for the masses versus those in the executive “C-suite.” 

Nonetheless, while the markets have been rising, investors continue to bank on strong earnings going forward, but should they?

Jamie Powell tackles that question for the Financial Times:

Zion Research Group, an independent consultancy focused on Accountancy and Tax based in New York City, have combed over last quarter’s earnings- sifting out the organic growth from the accountancy and tax shenanigans. Yet the degree to which it boosted profits may come as a surprise, particularly when broken down by sector.

First off, we should note that Zion Research limited its analysis to 351 of the S&P 500’s constituents, removing businesses whose first quarter did not end on March 31, and only keeping those whose effective tax rate was between 0 to 45 per cent as to, in its words, ‘remove whacky outliers’.

Here are the key findings:

‘On average, it appears as if tax rates dropped by 588 bps from 25.7 per cent in 1Q17 to 19.8 per cent in 1Q18 for the S&P 500 companies analyzed. We estimate that lower tax rates boosted GAAP earnings in the aggregate by 9%.

In the aggregate, we estimate that lower tax rates resulted in about $18.3 billion of incremental net income in 1Q18, accounting for nearly half of the $37.0 billion (17.6%) in year-over-year earnings growth for the 351 companies we analyzed.’

In other words, nearly half of the quarter’s earnings growth came from tax cuts for those selected companies. Furthermore, of the 351 companies analyzed, only 273 got a boost to 1Q18 earnings from lower taxes, while 63 companies had a “tax drag” due to write-downs of deferred tax assets.

More from Zion:

“98 companies [of the 258] relied on taxes for more than half of their earnings growth, including 35 where all the growth was tax related. At the other end of the spectrum, 41 companies actually saw a tax-related drag on earnings growth.”

Buyback Bonanza

However, there is more to Zion’s story. While earnings growth was indeed derived from tax cuts, it was also the extensive use of buybacks used to boost bottom lines earnings per share that is important. While the mainstream media, and the Administration, rushed to claim that tax cuts would lead to surging economic growth, wages, and employment, such has yet to be the case. Instead, companies have used their tax windfall to buyback shares instead.

As Matt Egan noted for CNN Money:

“Corporate America threw Wall Street a record-shattering party last quarter. Flooded with cash from the Republican tax cut, US public companies announced a whopping $436.6 billion worth of stock buybacks, according to research firm TrimTabs.

Not only is that most ever, it nearly doubles the previous record of $242.1 billion, which was set during the first three months of the year.”

The Heisenberg Report looked at the divisor change in the major indices to confirm the same.

There’s an argument to be made that if you’re looking to explain how it is that U.S. equities held up in Q2 amid all the headline risk, buybacks are a good place to start. I highlighted the following chart from JPMorgan in a previous post, but I’ll use it again here in the interest of backing up that contention:”

“Normative discussions aside, the corporate bid is in place and that’s a form of real-life ‘plunge protection’. You don’t need any conspiracy theories to employ the ‘plunge protection’ characterization. Recall that back in February, amid the equity rout, Goldman’s buyback desk had its second busiest week in history. Here’s a quote from a note dated February:

‘The Goldman Sachs Corporate Trading Desk recently completed the two most active weeks in its history and the desk’s executions have increased by almost 80% YTD vs. 2017.’

The point here, is that when it comes to the ‘who will be the marginal buyer of U.S. equities?’ question, I’m not entirely sure it needs answering in the near term as long as buybacks continue and as long as earnings continue to come in strong. Additionally, you can expect the buyback bid to be even more pronounced in the event there’s a sell off.”

The “buyback bid” not only supports stock prices in the short-term, but as I discussed recently in “Q1-Earnings Review,” there is evidence which suggests the economy is not as fully robust as may appear in headline data.

“Looking back it is interesting to see that much of the rise in ‘profitability’ since the recessionary lows have come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. As shown in the chart below, there has been a stunning surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 336%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which has only increased by a marginal 49% during the same period.”

“Furthermore, while the majority of buybacks have been done with ‘repatriated’ cash, it just goes to show how much cash has been used to boost earnings rather than expanding production, making productive acquisitions or returning cash to shareholders. 

Ultimately, the problem with cost-cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. Eventually, you simply run out of people to fire, costs to cut and the ability to reduce labor costs.” 

When Does The Party End?

While tax cuts have been, and will be, fantastic for bottom line earnings in the first half of this year, the real question becomes who will be the marginal buyer of equities once the “windfall bonanza” for corporations subsides. There are two points of concern which should be considered.

The first is those profit expectations are on the decline already as noted by BofA in a recent report:

“A a net -9% of respondents think global profits will not improve in the next 12 months, down 53ppt from Jan’18 and the lowest since Feb’16. This means that a majority of investors now believe that profits have topped out and will slide in the coming year.

The second is margin expansion. Going forward increasing margins will become tougher as higher labor costs, rising energy prices, higher interest costs, tariffs and a stronger dollar weigh on bottom line profitability. More importantly, the dramatic surge in earnings growth in the first two quarters will dissipate quickly as year-over-year comparisons become more problematic.

As Eric Parnell recently penned:

“Share buyback activity is currently breaking records, perhaps in unsustainable ways. Eventually, this activity will slow. If history and logic is any guide, it will be when the U.S. economy falls back into recession and corporations need to circle the wagons and keep the cash that might otherwise be allocated to buybacks on their balance sheets instead. And if the forecasters along with the Treasury yield curve that are predicting an economic slowdown as soon as 2019 prove to be correct, this scaling back in buyback activity may be coming sooner rather than later once the tax cut sugar high finally wears off.

While the key market trends remain decidedly positive for now, and portfolios should remain tilted toward equity exposure, understand that all cycles end. The only questions are “when” and “what causes it?” 

As we have repeatedly written since last December, tax cuts were destined to only wind up in one place – in the pockets of shareholders and C-suite executives. But in an economy which is nearly 70% driven by the consumption of the bottom 90%, a fiscal policy which specifically targeted corporations (which are major political donors) was not likely the best strategy to promote a long-term increase in economic prosperity.

Unsurprisingly, with the data now in, we once again come to find out that “trickle down” economics never actually trickles.

Quick Take: Bulls Attempt A “Jailbreak”

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

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

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

This is just one day.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“You” ranked “dead last” in importance.

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

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

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

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

The Entire Premise Is Flawed

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I want you to take note of the following.

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

Why 22 years? 

Take a look at the chart below.

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

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

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

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

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

Quick Take: Market Breaks Important Support

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

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

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

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

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

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

Here is what we are wanting to see:

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

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

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

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

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

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

Bull Markets Actually Do Die Of “Old Age”

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

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

Think about this for a moment.

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

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

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

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

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

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

Think about it this way.

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

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

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

The Infections That Kill Old Bull Markets

Infection #1: Interest Rates

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

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

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

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

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

Infection #2: Spiking Input Costs

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

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

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

This shouldn’t be surprising.

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

As I recently discussed with Shawn Langlois at MarketWatch:

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

For investors, that poses huge risks in the market.

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

Infection #3 – Valuations

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

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

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

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

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

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


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

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

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

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

Analysts’ Estimates Go Parabolic – Is The Market Next?

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

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

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

That was so yesterday.

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

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

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

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

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

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

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

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

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

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

But economic growth is set to explode. Right?

Most likely not.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This time will likely be no different.

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

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

Are stocks ready to go parabolic?

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

Tax Cuts & The Failure To Change The Economic Balance

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

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

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

First, the data.

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

See, the “rich” are clearly paying more. 

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

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

This is how “less” equals “more.” 

So, where is the “less?”

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

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

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

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

The 80/20 Rule

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

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

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

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

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

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

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

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

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

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

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

The Corporate Tax Cut Sham

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

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

Why do I say that? Simple.

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

The outcome will be very disappointing.