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NFIB Survey Trips Economic Alarms

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

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

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

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

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

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

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

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

That point of “exuberance” was the peak.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Fantasy Vs. Reality

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

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

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

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

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

Customers Are Cash Constrained

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

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

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

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

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

No Recession In Sight

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

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


Don’t ignore the data.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Minimum-Wage-Workers

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

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

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

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

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

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

Let that soak in for a minute.

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

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

Not A Magic Bullet

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

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

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

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

A separate NBER study revealed some other issues:

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

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

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

Here is the point that is often overlooked.

Your Minimum Wage Is Zero

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

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

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

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

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

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

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

The Trickle Up Effect:

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

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

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

A report from the Manhattan Institute concluded:

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

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

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

The CBO Study Findings

Overall

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

Employment

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

Effects Across Employers.

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

Macroeconomic Effects.

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

Don’t misunderstand me.

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

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

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

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

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

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

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

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

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

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

“The answer is yes.”

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

Hypocritical?

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

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

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

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

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

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

The Liquidity Trap

Here is the definition:

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

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

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

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

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

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

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

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

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

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

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

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

Lack Of Velocity

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

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

Poor Judy.

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

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

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

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

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

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

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

No Escape From The Trap

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

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

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

It is the only “trick” they know.

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

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

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

3 Things: Fake News, Net Positioning, Buying Panic

 

#FakeNews In Investing

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

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

Dalbar-2016-Performance-060616

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

Dalbar-2016-ReturnComparision-060616

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

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

Dalbar-2016-Psychology-060616

So, why am I bringing this up?

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

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

Actually, no, that is not my argument.

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

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

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

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

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

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

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

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

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

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

Net Positioning

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

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

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

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

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

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

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

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

Buying Panic

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

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

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

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

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

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

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

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

Just some things I am thinking about.

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

A Better Way To Use P/E’s

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bank Loans Issue Warning

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

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

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

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

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

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

It’s Been Quiet – What Happens Next?

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

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

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

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

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

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

sp500-marketupdate-090816-1

Let me remind you how that ended.

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

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

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

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

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

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

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

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

Just some things I am thinking about.

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

February Bumps

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

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

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

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

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

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

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

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

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

Another View On The Inflation Argument

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

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

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

That would be the good.

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

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

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

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

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

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

1999

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

If you were around then, you will remember.

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

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

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

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

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

Stock/Bond Ratio Confirms Breakout

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

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

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

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

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

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

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

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

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

“Breaking even is not an investment strategy.”

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

Everyone’s A Genius

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

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

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

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

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

As Michael stated:

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

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

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

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

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

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

Just some things I am thinking about.

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

What Drives Returns

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Nothing But “Net”

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

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

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

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

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

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

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

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

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

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

Too Optimistic

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

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

However, there are two main problems with that statement:

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

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

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

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

2) Net, Net, Net Returns Are Even Worse

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

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

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

Wait? What?

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

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

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

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

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

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

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

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

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

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

Just something to think about.

3 Things: Consumer Debt, NFIB Optimism & Policy Uncertainty

 

Consumer Debt Surges In November

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

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

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

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

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

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

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

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

And as the astute Greg S. pointed out yesterday:

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

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

NFIB Optimism Explodes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

So Does Policy Uncertainty

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

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

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

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

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

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

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

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

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

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

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

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

But there is also the risk it won’t.

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

Just some things I am thinking about.

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3 Things: Policy Hopes, Puppies & Rainbows

Tax Cut Rainbows

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

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

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

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

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

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

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

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

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

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

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

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

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

Consumer Spending Puppies

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

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

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

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

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

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

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

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

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

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

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

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

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

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

wealth-distribution10-15

Hopefully Hopeful

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

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

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

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

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

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

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

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

1982-today

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

As Michael concludes:

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

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

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

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

Just some things I am thinking about.

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3 Things: Records Are Records For A Reason

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

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

4-panel-recession-watch

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

Consumer Confidence

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

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

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

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

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

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

ECRI Leading vs. Lagging

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

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

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

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

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

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

10-Year Treasury Net Longs Suggest Retracement

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

This may be a bit premature.

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

As discussed previously:

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

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

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

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

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

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

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

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

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

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

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

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

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

Just some things I am thinking about.

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2016 Year-End Bull/Bear Debate

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

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

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

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

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

sp500-marketupdate-121216-5

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

Let’s examine both arguments.

The Bullish Bias

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Bearish Perspective

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

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

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

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

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

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

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

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

Managing Past The Noise

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

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

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

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

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

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

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

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

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

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

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

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

These rules are hard to follow because:

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

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

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

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

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

fantasy-girl

Rates Are Rising Because Of China, Not Inflation

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

interest-rates-then-and-now-121316

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

bonds-foreign-holdings-121316

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

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

china-holdings-bonds-exchangerate-121316-2

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

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

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

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

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

china-chginholdings-rates-121316

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

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

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

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

tbond-short-squeeze

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

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

china-shanghai-index-sp500-121316

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


Trade Doesn’t Suggest Strong Levels Of Inflation Or Growth

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

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

imports-exports-prices-gdp-121316

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

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

capacity-utilization-production-121416

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

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

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


Rate Hike A Vote Of Confidence? Really?

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

  • YELLEN: EXPECT ECONOMY WILL CONTINUE TO PERFORM WELL
  • YELLEN: CURRENT FFR ONLY MODESTLY BELOW NEUTRAL RATE
  • YELLEN: ECON OUTLOOK ‘IS HIGHLY UNCERTAIN’
  • YELLEN: UNEMPL RATE ‘TOUCH LOWER’ THAN SEEN IN PROJECTIONS
  • YELLEN: RATE HIKE ‘IS A VOTE OF CONFIDENCE IN THE ECONOMY

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

fomc-economic-forecasts-12141616

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

  • YELLEN: LABOR MKT LOOKS LIKE IT DID BEFORE RECESSION

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

lmci-12mth-avg-employment-121416

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

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

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

eoci-lei-121416-2

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

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

Just some things I am thinking about.

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Carrier & The Broken Window Narrative

broken-window

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

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

Well, that is what is hoped for.

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

The Art Of The Deal

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

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

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

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

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

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

JIM CRAMER: Versus America?

GREG HAYES: Much higher.

JIM CRAMER: Much higher.

GREG HAYES: Much higher. And I think that’s just part of these — the jobs, again, are not jobs on an assembly line that people really find all that attractive over the long term. Now I’ve got some very long service employees who do a wonderful job for us. And we like the fact that they’re dedicated to UTC, but I would tell you the key here, Jim, is not to be trained for the job today. Our focus is how do you train people for the jobs of tomorrow?

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

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

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

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

 

Offsetting Higher Costs

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

That is where the $16 million investment comes in.

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

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

JIM CRAMER: Right.

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

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

The Broken Window

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

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

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

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

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

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

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

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

There is no free lunch.

It’s Structural

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

Let’s use a simple example.

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

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

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

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

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

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

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

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

pce-fixedinvestment-120716-2

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

debt-gdp-incomes-120716-2

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

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

As noted by Scott Sumner:

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

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

manufacturing-output-jobs-120816

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

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

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

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

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

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

3 Things: Exuberance, Small Caps, 6% Realities

Bull Market Exuberance

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

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

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

sp500-vix-113016

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

sp500-vix-113016

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

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

aaii-invi-bullratio-112916

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

aaii-invi-netbullish-112916

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

sp500-marketupdate-113016

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

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

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

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

But then again, as John Maynard Keynes once quipped:

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

We do live in interesting times.

 

Small Caps Surge On “Trumpectations”

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

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

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

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

small-caps-vs-rates-112916

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

small-caps-vs-usd-112916

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

small-caps-vs-rate-usd-ratio-112916

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

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

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

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

 

Forecasts For 6% GDP Somewhat Unrealistic

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

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

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

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

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

gdp-interestrates-inflation-112916

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

laborforce-productivity-growth-113016

As Dr. Ed Yardeni noted:

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

And from Harvard Business Review:

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

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

But beyond the productivity problem is simply debt.

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

gdp-totaldebt-112916

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

gdp-deficit-113016

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

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

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

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

Just some things I am thinking about.

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3 Things: Retail Sales, Ignorance & Return Reality

Turning To Debt To Sustain Living Standard

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

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

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

retail-sales-12mth-avg-111616

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

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

retail-sales-credit-dpi-111616

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

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

retail-inventory-sales-ratio-111616

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

nfib-retail-sales-111616

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

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

nfib-retail-vs-retailsales-111616

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

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

 

You Should Really Ignore This Chart…Really!

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

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

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

Retirement-Savings-JPM-031416

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

Saving Is Problem

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

incomes-national-bottom80-111616-2

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

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

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

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

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

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

18-34-Living-Home-031416

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

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

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

wage-growth-nonsupervisory-vs-supervisory-111116

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

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

 

Stocks Do Not Deliver Compound Rates Of Return

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

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

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

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

Math-Of-Loss-10pct-Compound-011916

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

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

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

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

SP500-Promised-vs-Real-012516

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

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

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

SP500-Real-RollingReturns-20-Years-031416

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

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

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

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

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

Just some things I am thinking about.

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3 Things: Distortions, Earnings Missed, You’re Crazy

Distortions Of Investing

One of the most important readings I have done as of late was from Horizon Kinetics on investing and modeling. It’s a bit long, but worth a read particularly if you are of the “buy and hold” type mentality.

While the whole piece is worth reading, here was the important point as it relates to the market environment we are in currently.

“Attention to these two issues, liquidity and securities with idiosyncratic characteristics will become increasingly important. Particularly for people who believe they are appropriately diversified and in defensive equity sectors in the manner now generally practiced. 

The channeling of the $2+ trillion flood of assets into index funds since the 2007 Financial Crisis forced ETF organizers to focus on the largest companies with the most share trading liquidity. The sheer weight of that much money into the rather limited number of companies large enough to absorb that much demand for their shares has distorted prices to an extreme degree.

It’s simply a matter of supply and demand – no one who has ever visited a Middle-East souk or a farmer’s market or art auction is confused by what moves the prices. Yet in the stock market, the influence of the same forces is still generally unnoticed.”

ici-fundflows-bytype-110816

“So we’ll just focus on how the modernized practice of indexation has distorted “defensive” equity investing. This should be prefaced by an understanding that indexation as originally conceived by the academic founding fathers of indexation involved simply owning the entire market, simply being a participant in the results of all stocks: large, small, fast growing, mature. After making a long-term asset allocation decision, one would decide how much to place in stocks, how much in bonds, how much in cash as a risk balancer. Very little cause for adjustment. The idea of industry sector funds, style funds, country funds, runs counter to the very mechanism they were proposing to avoid the perennial challenge: how does one even begin to understand the risks entailed by the 1,594 different ETFs traded in the U.S. as of year-end 2015 (specifically, 360 broad-based, 266 sector funds, 592 international, 81 commodity, 21 hybrid and 274 bond ETFs). Which do you buy, when do you sell, and why?”

Horizon is correct and the problem is that money is piling into ETF’s and “passive index” investments because they are erroneously being considered safe. The reality is they aren’t. As I stated just recently:

It is effectively the final evolution of ‘bull market psychology’ as investors capitulate to the ‘if you can’t beat’em, join’em’ mentality.

But it is just that. The final evolution of investor psychology that always leads the ‘sheep to the slaughter.’

Let me just clarify the record – ‘There is no such thing as passive investing.’  

While you may be invested in an ‘index,’ when the next bear market correction begins, and the pain of loss becomes large enough, ‘passive indexing’ will turn into ‘active panic.’ 

Sure, you can hang on. But there will be a point where your conviction will eventually be broken. It is just a function of how much loss it takes to get there.”

investor-psychology-100k-103016

It is important to remember, and this is Horizon’s point, that indexing misses the point of proper investing which is comprised of specific asset selection and risk management. What “Robo-Advisors,” and their unwitting participants, will find out in fairly short order is that correlated markets are great on the way up, but not so much on the way down. The chart below is the performance of the Betterment equity model portfolio selections.

betterment-chart1-equties-110816

Importantly, notice what happens during market declines particularly during 2007-2008.

Furthermore, despite all of the effort to model an allocation that should provide for a “smoother ride,” you would have been much better off simply buying a total market index fund.

Sure, we can all hope this time will be different, but “hope” has never been much of an investment strategy.

 

Without Slashing Estimates, Earnings Missed.

On Monday, Charlie Bilello from Pension Partners tweeted out an interesting point.

sp500-earnings-growth-110816

It is an interesting point.

As I have discussed many times previously, the biggest issue with earnings is the consistent revising of estimates downward (33% on average historically) in order for companies to “win” the “beat the estimate” game. To wit:

“But even those estimates are a likely a fantasy. Throughout history, earnings are consistently overstated by roughly 33%. This overstatement of estimates can be clearly seen in the chart below.”

sp500-forward-estimates-100116

“If we held Wall Street analysts to their estimates at the beginning of this year, much less the beginning of the previous quarter, 100% of companies would have missed earnings during the second quarter of this year. In fact, in just the past three months, analysts have now ratcheted down their estimates for the third quarter to their lowest levels yet.”

Here is what I mean. With 85% of companies reporting, we have a fairly good idea of where earnings are going to end up for the third quarter. So, using the current earnings for the third quarter, let’s compare that to where estimates were for this quarter previously.

earnings-estimates-110816

As you will note, while earnings have indeed beaten estimates in the current quarter, it would have been a substantially different picture if we held analysts to their previous estimates.

Here is the point. If you based your investment analysis on a particular company’s estimated earnings even one quarter ago, your analysis was grossly flawed despite the company eventually beating much-lowered estimates. Furthermore, despite there being a rise in earnings growth rates, there is little real growth actually being seen where it matters – in top line sales.

With earnings “growth” more of a function of bottom line manipulation through share buybacks, accounting gimmicks and cost-cutting, there is little growth in actual sales. Ultimately, it is revenue that matters and with the S&P 500 trading at record prices-to-sales levels, it is only a function of time until top-line reality collides with bottom-line fantasy.

sp500-median-ps-ratio-110816

 

You’re Crazy Buying Here

Jesse Felder penned an excellent piece on Tuesday on the ill-conceived notion pensions and endowments can reduce risk through investing in equities. To wit:

“Here in Oregon, we have a measure on the ballot which would allow public universities to invest in equities. What I find interesting, besides the fact that Oregon is one of the few states that precludes them from doing so, is how the state pitches the ballot measure:

This measure allows investments in equities by public universities to reduce financial risk and increase investments to benefit students. Additional investment income could benefit students by minimizing tuition increases and enhancing student programs.

In other words, expanding investment options from risk-free securities to risk assets like stocks will ‘reduce financial risk’ for public universities in going forward. While I agree that diversification has historically helped to ‘reduce financial risk,’ what matters most in terms of risk is the price you pay.

The truth is buying equities today is one of the riskiest propositions in the history of these markets. Valuations are extremely high. As Dr. John Hussman points out, the only time the stock market has been more highly valued than it is today was for a few months at the very peak of the dot.com mania.”

wmc161031b

“Because prices are extremely high today, returns going forward will be extremely poor. As Warren Buffett has said time and again, ‘the price you pay determines your rate of return.’ According to GMO points out, high valuations today mean the average annual real return from owning stocks over the next 7 years is a negative 3.1%:”

cvd3r9rueaambop-jpg-large

Of course, this is the same problem that currently plagues pension funds, endowments, and other plans due to inherent flaws of misunderstanding the difference between “average” and “actual” returns. The use of “average” returns has led to a massive underfunded status which keeps pensioners and beneficiaries of these plans at risk of not seeing their full benefits in the future.

Here is the problem. You don’t get “average” returns, and any one year of underperformance, or worse, negative returns, puts you substantially behind the curve in obtaining your goals. For pension funds and endowments, this consistent underperformance has led to irreparable underfunded statuses which are pushing many plans towards insolvency. 

As I discussed previously:

The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe. 

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

SP500-Promised-vs-Real-012516

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

The second point, and probably most important, is that YOU DIED long before you realized the long-term average rate of return.”

This problem also applies to investors being lured in by the myriad of “buy and hold” advice. The use of “average” rates of return are a fantasy that leads to very poor financial outcomes for most.

Just remember, that while long-term charts certainly do make the case for investing for the “long-term,” you simply won’t live long enough to garner those results.

Just some things I am thinking about.

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3 Things: Gross-ly Wrong, Math Of Loss, S&P Warning

Gross-ly Wrong On Fed Rate Hikes

 

I just want to get something on the record as we head into the end of the year.

Yesterday, as I was running sprints with my trainer, and about to pass out, I happen to glance up at one of the multitudes of televisions surrounding the workout out floor to glimpse the following headline:

“[Bill] Gross Sees Three Fed Rate Hikes In 2017”

This almost happened.

Here is my point.

Yesterday, the Fed gave a post-FOMC meeting statement that downgraded consumer spending and inflation expectations while still suggesting they will raise rates in December. Interestingly, they noted that employment remains steady without explaining why their own employment measure fails to agree.

lmci-fedfunds-110216

I understand why the Fed wants to raise rates. However, the likelihood they will be able to do so in 2017 is rapidly approaching zero.

In order for the Fed to raise rates, they need stronger levels of economic growth to support to offset the effects of tighter monetary policy. As I have addressed previously, when economic growth is running below 2% there is very little wiggle room to tighten monetary policy without negative outcomes.  As discussed recently:

“Outside of inflated asset prices, there is little evidence of real economic growth as witnessed by an average annual GDP growth rate of just 1.3% since 2008, which is the lowest in history….ever. The chart and table below compares real, inflation-adjusted, GDP to Federal Reserve interest rate levels. The gold vertical bars denote the quarter of the first rate hike to the beginning of the next rate decrease or onset of a recession.”

fed-rates-vs-gdp-102516-2

“However, note the GREEN arrows. There have only been TWO previous points in history where real economic growth was below 2% at the time of the first quarterly rate hike – 1948 and 1980. In 1948, the recession occurred ONE-quarter later and THREE-quarters following the first hike in 1980.”

The importance of this reflects the point made previously, the Federal Reserve lifts interest rates to slow economic growth and quell inflationary pressures. There is currently little evidence of inflationary pressures outside of financial asset prices and spiraling rent and health care costs. Therefore, rather than lifting rates when average real economic growth was at 3%, the Fed is now considering further rates hikes with growth at less than half that rate.

Think about it this way. If it has historically taken 11 quarters to fall from an economic growth rate of 3% into recession, then it will take just 1/3rd of that time at a rate of 1%, or 3-4 quarters.

However, despite the weight of evidence already present, there is one indicator the Fed should be paying attention to more closely.

wages-compensation-110216

Employee compensation is spiking higher and not because labor is tight, or due to a demand for higher wages (outside of the mandated minimum wage increases in several states) but directly due to the impact of the “Un”-Affordable Care Act. Importantly, rising employment costs impacts have been a precursor to the onset of recessions historically.

As stated in this past weekend’s missive, the risks of a recession have risen markedly in recent months and may arrive in mid-2017. Of course, before we get to that point, the ongoing economic deterioration due to the impact of the stronger dollar and higher interest rates will have already beat the Fed to the “removal of the punch bowl.”

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

The Fed surely understands that economic cycles do not last forever, and after eight years of a “pull forward expansion,” it is highly likely we are closer to the next recession than not. While raising rates in December will accelerate a potential recession, and a significant market correction, from the Fed’s perspective it might be the “lesser of two evils.” Being caught at the “zero bound” at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline.

For Janet Yellen, the “window” to lift interest rates appears to have closed which is a policy nightmare for the Fed, the economy and you. 

While Bill Gross thinks the Fed will hike rates next year, I suspect we will more likely be talking about rate cuts instead.

The Math Of Loss

 

Over the last several months, as market turmoil has increased, the litany of articles on “passive vs. active” investing have multiplied. My position remains that such musings are symbiotic with late stage bull market advances and the eventual market correction will rapidly remind individuals of the consequences of overly simplistic strategies in extremely complex environments.

As I have often stated, the biggest problem with passive indexing strategies is not the destruction of principal from market downturns, but the loss of “time” getting back to even. While capital can eventually be regained over time, the years spent getting back to your starting point simply cannot be replaced. This reality prompted an email from a colleague earlier this week with respect to “the math of loss.”

During ebullient periods in the stock market “investment risk” is disregarded in the pursuit of gains. It is during these times where markets “only seem to go up” that statements such as “investing is about ‘time-in’ the market rather than ‘timing’ the market” are made. Such statements are generally regretted in the not-so-distant future.

There is a major point of clarification that needs to be made here. I completely agree that investors can not be “all in”or “all out” of the market on a consistently correct basis. However, it is at this point in the discussion that some analyst pulls out a chart showing how poor your investment returns would have been if you had missed the “10-best days in the market.”

While that bit of information is true, what is never discussed is the what happens to investor returns when they capture market losses. The table below shows the damage done to an investor’s portfolio during a market draw down and the subsequent return required to get “back to even.”

Math-Of-Loss-102814

Even a modest 10% correction requires an 11.11% gain just to get back to even. This is why a strategy of “getting back to even” has never been a worthwhile investment discipline. [Let me repeat: The most important commodity lost during such a period is “time.” Time is the one asset in all portfolios that can never be replaced or recovered. Once it is lost, it is gone forever. Read: “Thoughts On Long Term Investing”]

Conversely, being “all in the market all the time” is just as poor of a strategy as bullish prognosticators forget about the importance of capital destruction as it relates to portfolio returns over time.

There are no great investors of our time that “buy and hold” investments. Even the great Warren Buffett occasionally sells investments. True investors buy when they see value, and sell when value no longer exists.

While there are many sophisticated methods of handling risk within a portfolio, even using a basic method of price analysis, such as a moving average crossover, can be a valuable tool over the long term holding periods. Will such a method ALWAYS be right? Absolutely not. However, will such a method keep you from losing large amounts of capital? Absolutely.

Again, I am not implying, suggesting or stating that such signals mean going 100% to cash. What I am suggesting is that when “sell signals” are given that is the time when individuals should perform some basic portfolio risk management such as:

  • Trim back winning positions to original portfolio weights: Investment Rule: Let Winners Run
  • Sell positions that simply are not working (if the position was not working in a rising market, it likely won’t in a declining market.) Investment Rule: Cut Losers Short
  • Hold the cash raised from these activities until the next buying opportunity occurs. Investment Rule: Buy Low

Missing The 10 Worst Days

The reason that portfolio risk management is so crucial is that it is not “missing the 10-best days” that is important, it is “missing the 10-worst days.” The chart below shows the comparison of $100,000 invested in the S&P 500 Index (log scale base 2) and the return when adjusted for missing the 10 best and worst days.

math-of-loss-110216

Clearly, avoiding major draw downs in the market is key to long-term investment success. If I am not spending the bulk of my time making up previous losses in my portfolio, I spend more time compounding my invested dollars towards my long term goals.

S&P Just Did Something Only Seen Three Times Previously

 

Bloomberg had a very interesting note out yesterday stating:

Over the last 20 years, the S&P 500 index has only recorded a seven-day losing streak on three separate occasions. The first was in 2008 after Lehman Brothers collapsed, while the other two were during Europe’s 2011 debt crisis. If the index ends the day lower on Wednesday, it’ll chalk up a fourth.”

Well, it did.

sp500-marketupate-110216

 

Importantly, as I addressed in the latest newsletter, the violation of that crucial support suggests a further correction is likely. However, by the time a break is completed, the market has already become short-term oversold and a “sellable bounce” is very likely. As Bloomberg noted:

The index’s longest-ever run of losses was eight days, matched at the height of the financial crisis in October 2008. The S&P 500 started falling on Monday, September 29 and saw lower closes at the end of every trading day until October 10, in what was its worst week in history.”

But a bounce and a resumption of a bull-market are two different things. As was seen in both 2008 and 2011, the consecutive 7-day declines led to further selling before a bottom was eventually found.

sp500-marketupate-110216-2

Given that we are very oversold short-term, a bounce back towards previous support levels (now resistance) is likely and will provide a better opportunity to rebalance equity risk in portfolios. A failure to break back above 2125 very soon will likely lead to further losses before the next buying opportunity is found. Caution is advised.

Just some things I am thinking about.

3 Things: GDP – A Grossly Defective Product

GDP – The Problem

 

Paul Wallace recently penned for Reuters an interesting article entitled: “GDP Is A Grossly Defective Product.” In the article he states:

“Yet despite its theoretical appeal, GDP is, in practice, a fallible measure – and increasingly becoming one that could be described as a grossly defective product. 

For one thing, the number shifts as more complete, up-to-date data becomes available. For another, national accountants change their definitions and approaches to better reflect the changing shape of the economy, such as the recent inclusion of research and development as investment.

He is absolutely correct.

Now, for all of you playing the home version of “Nail That GDP Number,” it was in 2013 the BEA decided that the economy was not growing fast enough and “tweaked” the GDP calculation and added in “intellectual property.” Those adjustments boosted GDP by some $500 million.

There are inherent problems when you begin to adjust the “math” to “goal seek” a specific outcome. For example, the problem with adding “intellectual property” is that the cost of a new cancer drug treatment, a Hollywood movie or a new hit song is already included in the value of product brought to market. In other words, since production is what drives economic growth, that value is captured in the quarterly analysis of business investment, spending, etc. Furthermore, how does the BEA value “intellectual property” accurately and fairly across all industries and products? Some products like a cancer treatment have a much different “value” than a song.

However, since those tweaks did not boost the economic growth rate as much as was hoped, the BEA went further in 2015 to adjust the calculation once again. To wit:

“Nicole Mayerhauser, chief of BEA’s national income and wealth division, which oversees the GDP report, said in the statement that the agency has identified several sources of trouble in the data, including federal defense service spending. Mayerhauser said initial research has shown this category of spending to be generally lower in the first and the fourth quarters. The BEA will also be adjusting “certain inventory investment series” that have not previously been seasonally adjusted. In addition, the agency will provide more intensive seasonal adjustment quarterly service spending data.

I am not a conspiracy theorist by any stretch. However, something strikes me as very odd about the frequency of adjusting the calculation to obtain better outcomes. 

The Federal Reserve understands, as we push into the eighth year of the current economic expansion, that we are likely closer to the next recession than not. The problem is the Fed has remained stuck at the zero bound for interest rates for far too long.

gdp-historical-recoveries-102016

While QE programs have NOT been effective at creating organic economic growth, they were effective at boosting asset prices and providing an illusory wealth effect. This would have provided cover for the Federal Reserve to raise interest rates off of the zero bound giving them access to a more effective monetary policy tool in the future. The chart below shows the trajectory of rate increases the Fed should have undertaken given the support the expansion of their balance sheet would have provided.

yield-spreads-economic-growth-102016

Of course, the offset of using the liquidity push to raise rates and normalization of monetary policy early on would have limited asset price inflation to about one-half of its previous advance. Certainly not nearly as much fun for Wall Street.

But alas, the Fed failed to use the recalculated and adjusted economic numbers, massive liquidity flows and rising asset prices to reload their policy tools. After two years of promises to hike rates in the face of stronger economic growth, each attempt has been consistently met with “weaker than expected” economic data.

As we approach the end of the year, the Fed is once again determined to raise interest rates. However, is economic growth strengthening enough to support the hike? We can look at some alternative measures of the economy to answer that question.

Alternative Measures Of Economic Growth

 

While the BEA is suggesting that it is simply “residual adjustments” lingering in the inventory and production-related data, that does not really explain the economic weakness in other areas of the economy.

The chart collection below is from a recent Harvard study entitled “Problems Unsolved and a Nation Divided”  which came to a couple of key conclusions (via ZeroHedge)

“America’s economic performance peaked in the late 1990s, and erosion in crucial economic indicators such as the rate of economic growth, productivity growth, job growth, and investment began well before the Great Recession.

Workforce participation, the proportion of Americans in the productive workforce, peaked in 1997. With fewer working-age men and women in the workforce, per-capita income for the U.S. is reduced.

Median real household income has declined since 1999, with incomes stagnating across virtually all income levels. Despite a welcome jump in 2015, median household income remains below the peak attained in 1999, 17 years ago. Moreover, stagnating income and limited job prospects have disproportionately affected lower-income and lower-skilled Americans, leading inequality to rise.

Pessimism about the trajectory of U.S. competitiveness deepened in 2016, for the first time since we started surveying alumni in 2011. Fifty percent of the business leaders surveyed expect U.S. competitiveness to decline in the coming three years, while 30% foresee improvement and 20% no change.

The U.S. lacks an economic strategy, especially at the federal level. The implicit strategy has been to trust the Federal Reserve to solve our problems through monetary policy.”

20160915-harvard-13_tjb

However, most importantly, the following chart is the best overall indicator of economic activity in the domestic economy. The Economic Output Composite Index (EOCI) is a compilation of broad economic inputs from manufacturing to small business to leading economic indicators. (read more on construction here)

eoci-102516

Importantly, all of these indicators confirm that economic weakness is pervasive across a broad swath of the economy, and weakness in GDP growth in Q1 was likely more than just a “statistical anomaly.” 

Furthermore, despite the recent bounce in some of the economic data, it is important to note the entire complex of indicators still operate at levels more normally associated with weak economic environments versus expansionary ones.

But it is here, as suggested above, that the Federal Reserve finds itself trapped. The Federal Reserve needs stronger economic growth to justify raising interest rates. After all, the reason the Fed tightens monetary policy to is SLOW economic growth to mitigate the potential of surging inflationary pressures. The problem currently, is that the Fed is discussing raising interest rates into an environment of low growth and inflation.

So, what has happened historically when the Fed has raised interest rates in such an environment?

Interest Rates Versus Economic Growth

 

Currently, employment and wage growth is extremely weak, 1-in-4 Americans are on Government subsidies, and the majority of American’s are living paycheck-to-paycheck. This is why Central Banks, globally, are aggressively monetizing debt to keep growth from stalling out. However, currently, many analysts and economist have increased the odds of the Fed hiking rates in December. The belief is that economic growth can continue to accelerate despite tighter monetary policy.

The problem is most of the analysis overlooks the level of economic growth at the beginning of interest rate hikes. The Federal Reserve uses monetary policy tools to slow economic growth and ease inflationary pressures by tightening monetary supply. For the last eight years, the Federal Reserve has flooded the financial system to boost asset prices in hopes of spurring economic growth and inflation.

As stated, outside of inflated asset prices, there is little evidence of real economic growth as witnessed by an average annual GDP growth rate of just 1.3% since 2008, which is the lowest in history….ever. The chart and table below compares real, inflation-adjusted, GDP to Federal Reserve interest rate levels. The gold vertical bars denote the quarter of the first rate hike to the beginning of the next rate decrease or onset of a recession.

fed-rates-vs-gdp-102516-2

If I look at the underlying data, which dates back to 1943, and calculate both the average and median for the entire span, I find:

  • The average number of quarters from the first rate hike to the next recession is 11, or 33 months.
  • The average 5-year real economic growth rate was 3.08%
  • The median number of quarters from the first rate hike to the next recession is 10, or 30 months.
  • The median 5-year real economic growth rate was 3.10%

However, note the GREEN arrows. There have only been TWO previous points in history where real economic growth was below 2% at the time of the first quarterly rate hike – 1948 and 1980. In 1948, the recession occurred ONE-quarter later and THREE-quarters following the first hike in 1980.The importance of this reflects the point made previously, the Federal Reserve lifts interest rates to slow economic growth and quell inflationary pressures. There is currently little evidence of inflationary pressures outside of financial asset prices and spiraling rent and health care costs. Therefore, rather than lifting rates when average real economic growth was at 3%, the Fed is now considering further rates hikes with growth at less than half that rate.

Think about it this way. If it has historically taken 11 quarters to fall from an economic growth rate of 3% into recession, then it will take just 1/3rd of that time at a rate of 1%, or 3-4 quarters. This is historically consistent with previous economic cycles, as shown in the table to the left. This suggests there is much less wiggle room between the first rate hike, and the next recession, than currently believed.

But then again, if you can just keep changing the data calculation to goal seek a better economic picture, then surely that is enough. Right? Might want to ask those 100 million on government welfare what they think.

Just some things I am thinking about.

3 Things: The Howard Marks Problem, Reversions & Rates

The Howard Marks Problem

Howard Marks once stated that being a “contrarian” is tough, lonely and generally right. To wit:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, particularly when momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

The problem with being a contrarian is the determination of where in a market cycle the “herd mentality” is operating. The collective wisdom of market participants is generally “right” during the middle of a market advance but “wrong” at market peaks and troughs.

This is why technical analysis, which is nothing more than the study of “herd psychology,” can be useful at determining the point in the market cycle where betting against the “crowd” can be effective. Being too early, or late, as Howard Marks stated, is the same as being wrong.

The chart below is a historical chart of the S&P 500 index based on QUARTERLY data. Such long-term data is NOT useful for short-term market timing BUT is critically important in not only determining the current price trends of the market but potentially the turning points as well. 

sp500-marketupdate-101816

While valuation risk is certainly concerning, it is the bottom to parts of the chart above that are the most concerning. When the long-term indicators have previously been this overbought, further gains in the market have been hard to achieve. However, the problem comes, as identified by the vertical dashed lines, is when these indicators reverse course. The subsequent corrections have not been forgiving.

Furthermore, virtually all internal measures of the market are also throwing off warning signals that have only been seen at previous major market peaks.

sp500-marketupdate-101816-2

These “warning” signals suggest the risk of a market correction is on the rise. However, all price trends remain within the confines of a bullish advance. Therefore, while portfolios should remain tilted toward equity exposure “currently,” the risk of a sizable correction has risen markedly in recent months. 

The mistake that most investors make is trying to “guess” at what the market will do next. Yes, the technicals above do suggest that investors should “theoretically” hold more cash. However, as we should all be quite aware of by now, the markets can “irrational” far longer than “logic” would suggest. Trying to “guess” at the next correction has left many far behind the curve over the last few years.

This is the “Howard Mark’s” problem defined. There are plenty of warning signals that suggest that investors should be getting more cautious with portfolio allocations. However, the “herd” is still supporting asset prices at current levels based primarily on the “fear” of missing out on further advances. Becoming too cautious, too soon, leads to“emotionally” based decision making which generally turns out compounding the problem.

As Mr. Marks suggests, being a “contrarian” is a tough and lonely existence.

The Most Powerful Force – Reversion To The Mean

One of the primary issues currently being ignored by the markets is the inherent risk of mean reversions.

Mean reversions are one of the most powerful forces in the financial markets as, like gravity, moving averages provide the gravitational forces around which prices oscillate. The chart below shows the long-term view of the S&P 500 as related to its long-term 6-year moving average.

sp500-longterm-bollingerbands-101816

Not surprisingly, when prices deviate too far from their underlying moving average (2-standard deviations from the mean) there is generally a reversion back to the mean, or worse.

As you will notice, the bear markets in 2000 and 2007 were not just reversions to the mean but rather a massive reversion to 2-standard deviations below the mean. Like stretching a rubber band as far as possible in one direction, the snap-back resulted in large advancing cyclical bull markets.

The problem, is these cyclical bull markets are quickly believed to be the beginning of the next secular multi-decade bull market. However, as discussed on Monday, this is currently unlikely the case given the lack of economic dynamics required to foster such a secular period.

The chart below brings this idea of reversion into a bit clearer focus. I have overlaid the 3-year average annual real return of the S&P 500 against the inflation-adjusted price index itself. 

sp500-3yr-annchg-reversion-101816

Historically, we find that when price extensions have exceeded a 12% deviation from the 3-year average return of the index, the majority of the market cycle had been completed.  Currently, over the last year, the markets have failed to make much of an advance as prices had exceeded 12% historical deviation.

While this analysis does NOT mean the market is set to crash, it does suggest that a reversion in returns is likely. Unfortunately, the historical reversion in returns has often coincided at some juncture with a rather sharp decline in prices.

Stocks On The Wrong Side Of A Rate Hike 

It’s been an interesting few weeks for interest rates. As I discussed this past Tuesday:

“With interest rates extremely overbought, the reflexive bounce in rates following the flight to “safety” for the “Brexit” is now functionally complete. This rise in rates is both a blessing and a curse.”

What is interesting is the main spin from the media is rates are rising in anticipation of a Fed rate hike in November or December. The hike, of course, is predicated on a recovery in economic growth and higher rates of inflation which currently, outside of higher health care costs and rent, is nascent at best. 

Importantly, there has never been a cyclical bull market in the U.S. stock market that has gone this long without the Federal Reserve increasing interest rates. While much of the mainstream media continues to expect valuations to keep rising, one has to wonder if they are asking too much if history is any guide.

The chart below shows the 3-month LIBOR which has already risen sharply in recent months. Unlike the Fed Funds rate, LIBOR actually impacts many variable rate type loans. Higher borrowing costs negatively impact consumer spending and ultimately economic growth. However, in particular, periods of increases in LIBOR have been associated with stock market corrections or worse.

sp500-libor-10yr-101816

Furthermore, if the FOMC begins to raise short-term interest rates further, the current environment is actually worse now than December of 2014 when the first hike was done. Economic growth is weaker, corporate profits have declined, debt and leverage are at or near record levels, the US Dollar is stronger and markets are starved for liquidity. This suggests, that further increases in interest rates may not go so smoothly in terms of the impact on financial asset prices. 

Again, just as a reminder, higher interest rates are a brake on economic growth. Given that “low interest rates” have been a primary argument used to justify high stock valuations, rising rates will nullify that support. 

Sure, this time could be different. But that is probably a bet with very low odds of actually winning.

Just some things I am thinking about.

3 Things: Employment – Obama’s Victory Lap Premature

President Obama Creates 15M Jobs

 

In a recent op-ed by President Obama for the economist wrote that his team has created a “more durable, growing economy” with “15 million new private-sector jobs since early 2010.”

No. Not Really.

But, hey let’s give him, and the mainstream media that recirculated this overly-optimistic spin, an “A” for effort. The chart below shows the total number of jobs created by each President going back to Ronald Reagan. Since the President takes office on January 20th, I have calculated the job gains from February 1st through the end of their Presidency. (Importantly, President Bush only served one term following Reagan.)

employment-president-total-101116

“But, hey, he still created almost 11 million jobs. That’s good, right?”

But even this measure of job-creation is inaccurate for several reasons.

First, the President DOES NOT create jobs but hopefully fosters an economic environment that is beneficial for job growth. Given the onset of a massive number of additional regulations, the attack by the EPA on companies progress the Administrations “climate change agenda,” higher levels of taxation and higher health care costs due to the Affordable Care Act, it is actually surprising job growth has been as strong as it has. According to the NFIB, small businesses make up roughly 80% of all businesses that hire employees in the country. It is difficult for them to hire when their top three concerns are Government Regulations, Taxes and Labor Costs. (Note: When labor costs become a rising concern, as they are now, it has generally been a decent leading indicator of a recession.)

nfib-concern-composite-101116

Most likely, had the President not done anything, job growth would have actually been the same or better. This is simply due to the fact that employment increases are affected by increases in the working-age population. Which brings me to my second point. 

What is never discussed in the monthly job reports are the number of jobs created versus the growth in the working-age population of the country. This is an important and overlooked concept. If 1-million jobs are gained, but the working-age population gains 2-million, there is a deficit of sufficient job creation to keep up with those needing work. When comparing job creation to working-age population, a different story emerges.

employment-totpopchg-101116

With the exceptions of Presidents Reagan and Clinton, the working age population has significantly outpaced the level of actual job growth leaving a rising level of individuals unemployed.

Importantly, as opposed to the total labor force calculation, this measure includes ALL individuals available, and of age, to work. 

It is here that we find the problem with the employment reports. The problem shown above is most often explained away by a rather sweeping statement:

“The problem with the labor force is due to the large number of ‘baby boomers’ retiring.” 

As I discussed recently in “Don’t Blame Baby Boomers For Not Retiring,” that argument doesn’t fly.

“This divide is clearly seen in various data and survey statistics such as the recent survey from National Institute On Retirement Security which showed the typical working-age household has only $2500 in retirement account assets. Importantly, ‘baby boomers’ who are nearing retirement had an average of just $14,500 saved for their ‘golden years.’”

retirement-medianaccount-balances-092516

With 24% of “baby boomers” postponing retirement, due to an inability to retire, it is not surprising the employment level of individuals OVER the age of 65, as a percent of the working-age population 16 and over, has risen sharply in recent years.

employment-12mo-avg-65-over-092516

This should really come as no surprise as decreases in economic and personal income growth was offset by surges in household debt to sustain the standard of living. The reality is “baby boomers” are not retiring at a record clip. They simply can’t afford to.

If You’re Not Counted, Do You Not Count?

 

The most recent release from the Bureau of Labor Statistics on employment for the month of September was mostly disappointing with fewer jobs created than originally thought. But that begs the question of who is actually counted:

In order to be considered as unemployed by the BLS one must be:

  • Unemployed, obviously, AND;
  • Have ACTIVELY looked for work in the prior 4-weeks, AND;
  • Are currently available for work.

If you do not fit that criterion you are not counted in the “official” employment report known as the U-3 report. Today there are more than 94-million individuals that do not fit the criteria and are simply not counted.

This is where the employment measures get a lot more obscured. As stated, out of the total population of 254,091,000 working-age individuals (16 and over) more than 94-million are not counted as part of the labor force currently. In other words, 37% of the working-age population is excluded from the employment statistics.

However, even with the exclusion of 1/3 of those of working-age, the labor-force participation rate, the number of individuals employed versus those counted as part of the labor force is still hovering at the lowest levels since the 1970’s. 

employment-lfpr-101116

Importantly, there is also a stark difference between today and the 1980-90’s where the LFPR was rising versus a steady decline. Demographic trends, structural shifts in the employment makeup, and statistical measures all feed into this phenomenon and there is little data on the horizon which suggests this will change anytime soon.

If we really want to know how each President has fared in creating a better economic environment for average American’s, we should measure how they fared in improving the overall participation in the workforce. The chart below shows each President’s performance in the monthly net changes of the LFPR.

employment-netchg-lfpr-100916

This paints a very different picture about the success of job creation in the country post the last recession. This is particularly the case when:

  • 1 out of 5 households has NO ONE employed,
  • 1 out of 3 individuals are dependent on some sort of social support program, and;
  • Over 20% of personal incomes are comprised of government transfers.

But, despite all of the rhetoric, discussions, debates, excuses and finger-pointing in regards to the latest jobs report; there is only one chart of employment that truly matters: the number of full-time employees relative to the working age population. Full-time employment is what ultimately drives economic growth, pays wages that will support household formation, and fuels higher levels of government revenue from taxes.

Since this is a real measure of economic success, we can once again compare each President’s performance of the growth of full-time employment under their tenure.

employment-netchg-fulltime-wap-101116

The “good news” is that for those that are currently employed – job safety is high. Businesses are indeed hiring, but prefer to hire from the “currently employed” labor pool rather than the unemployed masses. More importantly, businesses are hiring only enough to keep up the incremental demand of population growth rather than expanding on the assumption of future growth.

This is the “new normal” of an economy where real economic prosperity remains elusive as the Federal Reserve’s interventions continue to create a wealth effect for market participants which, unfortunately, is only enjoyed by a small minority of the total population. For the other 80%, it remains a daily struggle to make ends meet.

More Deaths Than Births

 

But here is the real problem for President Obama’s victory lap. IF employment was indeed growing at the fastest pace since the 1990’s, then wage growth, and by extension, economic growth should be at much stronger levels as well. That has YET to be the case outside of mandated minimum wage increases.

However, if the economy was actually growing we should see an expansion of businesses created by entrepreneurs stepping out their own. As I have addressed previously, this has NOT been the case. 

Both the formation of firms and establishments, have dropped off precipitously since the financial crisis and remained low.

This is important because new businesses typically hire faster and produce higher levels of productivity than firms that have been around for a while. Thus the decline in business formation can explain some of the labor market’s post-recession problems, and is at least part of the reason for the steep drop in productivity.”

firms-birthdeath-analysis-bi

This decline in business formation is crucial to the issue of the employment reports. Part of the reporting problem, which has yet to corrected by the BLS, is the continued overstatement of jobs through the“Birth/Death Adjustment.” 

Employment-BirthDeath-Analysis-033116

“This chart CLEARLY shows that the number of “Births & Deaths” of businesses since the financial crisis have been on the decline. Yet, each month, when the market gets the jobs report, we see roughly 180,000 plus jobs.

Included in those reports is an ‘ADJUSTMENT’ by the BEA to account for the number of new businesses (jobs) that were “birthed” (created) during the reporting period. This number has generally ‘added’ jobs to the employment report each month.

The chart below shows the differential in employment gains since 2009 when removing the additions to the monthly employment number though the “Birth/Death” adjustment. Real employment gains would be roughly 5.26 million less if you actually accounted for the LOSS in jobs discussed in the first chart above.”

employment-birthdeath-adjusted-091816

Actually, I am being generous. The chart above just assumes NO births or deaths of businesses. However, given that we have been LOSING businesses since 2008, the differential is markedly worse. 

So, before President Obama takes his final victory lap with claims of creating the most robust employment recovery since the 1990’s, the data clearly suggests otherwise.

Of course, if you ask the 37% that are no longer counted as part of the labor force, they will tell you the same thing. 

Just some things I am thinking about.

3 Things: Auto Sales, Oil Peak, Nasdaq Redux

Are Auto Sales Really All That Strong?

 

The media was especially excited yesterday regarding the release of the auto sales data. To wit:

“US auto sales were higher than expected in September after automakers offered a record amount in incentives to buyers.

According to Autodata, sales reached a seasonally adjusted annual rate of 17.76 million. Analysts had forecast a rate of 17.45 million, according to Bloomberg.”

However, despite the bullish headlines, below the surface were some troubling statistics. Let’s look at the data.

Let’s set aside for the moment cars are being financed in progressively worse manners as sub-prime credit, lease terms and length of contracts continue to soar. Dealers have resorted to loans as long as 8-years in order to get payment terms to levels that sub-prime borrowers can afford. This potentially has a very negative side-effect on future auto sales as consumers are locked into eroding cars with negative equity and an inability to trade in. But that is a story for the next economic recovery cycle. 

For now, however, the tools currently being used to move auto inventory may have run their course as incentives supplied by dealers are being stretched as well averaging $3,923 per vehicle. We saw similar gimmicks used to seduce buyers during the last two peaks in sales as well. Do you remember “Get the ’employee discount’ pricing deal?”

The reported rate of 17.6 million automobiles sold is roughly the same as it has been over the last several months. That alone should be a sign of caution and suggestive that sales may be reaching a plateau. More importantly, it is also important to remember this is an annualized number. In reality, only 1.46 million were actually sold, but still a large number.

To smooth out any “seasonal adjustment” bias, I have taken the non-seasonally adjusted sales and smoothed it with a 12-month average. I then overlaid the reported “seasonal adjusted” sales and calculated the differential between the two numbers.

auto-sales-actural-est-100416

As shown, the reports tend to substantially OVER estimate sales during growth cycles and UNDER estimate during recessions. Importantly, notice that in the most recent reporting period, sales are currently running at levels that have been historically unsustainable.

The problem with general media commentary and analysis is the focus on a “single” data point rather than the “trend” of the series. The chart below shows us two important points.

auto-sales-yoy-12ttm-100416

The first is that while the “annualized” reported sales number was near the highest in 10-years, the historical average of cars sold is still at levels below both previous peaks.

Secondly, and more importantly, is both previous peaks in total auto sales were preceded by a decline in the annual percentage change of cars sold. Since 2013, the rate of change in auto sales has declined markedly even as inventories continue to build. This explains the push for dealer incentives, subprime credit loans, longer loan terms, and special lease provisions to continue to push inventory out.

Lastly, all of this data suggests that the auto sales cycle is very long in the tooth and the economy is likely weaker than the latest “annualized” run of auto sales suggests. As we saw at both previous peaks in auto sales, the push to sell autos at “any cost” has generally ended poorly.

But this chart from Eric Bush via GaveKal really sums it up best – the recovery wasn’t as good as advertised and it appears to be ending. 

20161001_autro_0

What’s Up? Oil Prices

 

Besides interest rates, I also cover oil and energy prices on a regular basis in the weekly e-newsletter. At the beginning of September I wrote:

“In July I suggested, as shown in the longer term oil chart below, there was little to suggest a recovery back to old levels in oil prices anytime soon. With oil prices back to extreme overbought conditions, a retracement to $35 or $40/bbl would not be surprising particularly if, and when, the US Dollar strengthens.”

That call was quite prescient as declined almost back to $40/bbl shortly after that writing. However, not only did we retrace back to almost $40 once, but twice. With oil prices now back at extreme overbought levels (green dots on top), a triggering of a longer term sell signal will likely see a push back towards the $35-40/bbl range. Importantly, with oil prices below the downtrend line, the pressure currently remains to the downside.

wtic-analysis-100416

However, the recent push higher in oil prices, due to the announcement that OPEC might possibly, maybe, hopefully, cap output at August record levels has gotten commodity traders excited, or rather, scared the bejeebers out of the oil shorts.

The reality is the “deal” was nothing more than an agreement to maybe, possibly, hopefully, consider talking about a potential agreement in November. The “deal” will very likely fall apart well before then.

The chart below shows the previous high correlation, as would be expected, between energy stocks and oil prices. The divergence in early 2014 is what prompted my call back then to begin reducing exposure to energy stocks. Importantly, the deviation between oil prices and energy-related investments is expanding once again as individuals chase stocks at a time when prices are well detached from underlying fundamentals. Hindsight bias, which is buying something based on past performance hoping it will repeat, is a very dangerous method of investing.  

wtic-xle-analysis-100416

There is still a significant amount of unwinding left in the energy space as production is still far outstripping demand. If the collapse in China continues, or when the U.S. economy slips into the next recession, it is likely that oil prices will drop back into the low $30’s which will put additional pressure on energy company related earnings.

Furthermore, exuberance is still high. Great buying opportunities come when the markets become convinced that oil prices and energy companies are “eternally dead.” We are not there just yet.

Technicals Suggest A Nasdaq Redux

 

There has been quite a lot of discussion in the past year about the strength of Technology stocks and the return to “Nasdaq 5000.” Of course, such lofty heights also bring out the arguments over various valuation metrics and whether, or not, this is the next “dot.com” bubble.

Yes, for sure, “this time is different” than 2000 as many of the companies leading the technology charge actually do make money. However, while making money is important, it does not nullify the aspects of exuberant price movements and momentum chasing.

First, let’s take a look at the current valuations of the big-5 technology stocks: GOOG, AAPL, NFLX, FB, and AMZN.

valuations-faang

(Note: In order for a company to maintain a Price / Sales ratio of 2.0 it must grow sales at roughly 20% every year indefinitely to maintain that ratio with a respective price increase. In other words, it is very difficult for a company to consistently grow sales at that pace.)

With the exception of AAPL, there is little argument that technology overall is pushing the upper limits of valuations. But, for the sake of argument, let’s set aside the fundamental arguments for a moment and focus on the technical backdrop.

First, as shown below, the current price consolidation, as I discussed with respect to the S&P 500 on Tuesday, is quickly reaching a decision point. A break to the upside should see a rather sharp advance into the end of the year while a break to the downside would produce a relative decline. 

nasdaq-chart3-100416

Secondly, it is the long-term monthly chart that is most interesting. While market participants are once again chasing technology stocks with reckless abandon, because “this time is different”, the reality is it is likely not. 

Given the current extreme overbought conditions of the market on a monthly basis, combined with a potential “sell signal” from similarly high levels, the previous declines have been devastating. 

nasdaq-chart2-100416

While I am NOT suggesting that you should run out and sell all of your technology holdings tomorrow, the belief that somehow, this time, will be different than the last is likely misguided.

As always, when the eventual selling begins, it will be indiscriminate. Given the massive rise in all asset prices over the last eight years, the extensions well above historical norms and valuations that are hard to rationally justify, the unwinding will likely be just as brutal as the last. 

Just some things I am thinking about.

3 Things: Confidence Peak, Dumb Money & Bonds Are Dead?

Confidence Peak

 

It was interesting to see the markets reaction to the Consumer Confidence report on Tuesday, along with some of the media headlines, to wit:

“Consumer confidence just surged to its highest level since the recession. The latest reading on consumer confidence from the Conference Board came in at 104.1 for September, up from the prior month’s 101.8. The index touched 105.6 in August 2007.”

There are a couple of important points to consider in the statement above.

First, it is NOT surprising that after 8-years of an economic recovery that consumer confidence has finally recovered all the way back to where it was prior to the last recession. This is what you would expect of during any economic recovery, much less one driven by massive liquidity injections, Government programs to promote consumption and ongoing Central Bank interventions. The fact we are only NOW back at previous highs shows just how fractured the domestic economy was, and likely still is.

Secondly, and most importantly, records are a record for a reason. Record levels denote the point that previously marked the end of a cycle, not the beginning of a new one. This point is often missed by the mainstream media. Record highs of anything, whether it is economic, fundamental or financial data, are warnings signs of late stage events.

The chart below is the COMPOSITE confidence index which is an average of the Conference Board and University of Michigan consumer confidence indices.

consumer-sentiment-composite-092716

As I said, it is not surprising that consumers are THE MOST optimistic just prior to the onset of a recession.

But is there a possibility of a recession?

On Tuesday, I discussed the MOST IMPORTANT economic indicator – the Chicago Fed National Activity Index.

“While economic numbers like GDP or the monthly non-farm payroll report typically garner the headlines, one of the most useful economic measures is the Chicago Fed National Activity Index (CFNAI). The index is a composite index made up of 85 subcomponents which give a broad overview of overall economic activity in the U.S. Unfortunately, the media gives it little attention.

Currently, the CFNAI is not confirming the mainstream view of stronger “economy” headed into year-end, but rather one that may well be closer to the brink of recession. The chart below shows the diffusion index of the CFNAI index as compared to the S&P 500. Since the markets are reflective of the economy, the diffusion index shows the trend of the 85 subcomponents of the index. As shown, each time the diffusion index has reached current levels previously, the outcome for the economy and the markets was not so good.”

I have compared the CFNAI to the consumer confidence composite below. As you can see, there is a fairly high correlation between the two measures and recessions have been marked by declines.

consumer-confidence-cfnai-092716

We get a different view by using the 6-month average of the CFNAI, and again comparing it to the consumer confidence composite. You will notice the same correlation in the data as shown above. However, the temporary deviations between consumer confidence and the economy tend to occur in the latter stages of an economic expansion as “hope” runs high. Unfortunately, “hope” is eventually grasped by “reality” as consumer confidence plays catch-up with the economy and not the other way around.

consumer-confidence-cfnai-2-092716

While consumer confidence is hitting peaks currently, it should really be viewed as a warning rather than a reason to run out and commit capital to risk assets at potentially the wrong time.

Is The Dumb Money Doing It Again

 

Despite the warnings of the economic and fundamental data, the exuberance of investors is always an interesting phenomenon to watch. One way to view investor behavior is by looking at the commitment of traders (COT) data to see where large traders (supposedly the smart money) and retail investors (the dumb money) are placing their bets. The chart below shows the data smoothed with a 3-month average going back to 1984.

smart-dumb-money-3mo-092716

While the data is “noisy,” a cursory look reveals what is generally accepted in the financial markets – “you suck at investing.” Small traders consistently buy tops and sell bottoms even though they are repeatedly told just to “buy and hold” long-term.

This should immediately make you question what you hear in the media and from financial pundits. If THEY are all telling you to “buy and hold” because YOU can’t effectively manage your money, then why are THEY not following the same advice?  As the old axiom goes:

If you are playing poker and can’t tell who the pigeon is, it’s you.”

Another way to look at the data is to take the net difference of the two measures and subtracting the “smart money” from the “dumb money.” I have once again smoothed the data with a 3-month moving average to reduce the noise. What we find is once again a high propensity of retail investors to be buying into the market near both short and intermediate-term market peaks.

smart-dumb-money-netdiff-092716

Lastly, if we take the ratio of the dumb-to-smart money and an inversion of the smart-to-dumb ratio we once again find further confirmation of retail investors poor investment decision processes.

smart-dumb-ratio-092716

Here is the point. Once again, we are witnessing smart-money reducing exposure to “risk” while retail investor continues to stay invested. This will likely not end well and, as I addressed Tuesday, there are many indications that we are likely very near a long-term peak in the market.

“The short-term outlook remains bullishly constructive for the moment as long as the market can maintain the bullish trend line from the February lows. However, on a longer-term basis, the economic and fundamental data is having a much more difficult time trying to support current price and valuation levels. As shown in the chart below of quarterly data, the market is currently at levels that have historically ALWAYS been associated with a major peak.”

sp500-marketupdate-092616-4

It might be worth turning off the “nattering nay-bobs” on television and start thinking about what the “smart money” knows that you don’t.

But They Said The “Bond Bull” Was Dead…Again

 

Beginning in 2013, I started writing a series of articles suggesting why interest rates were going lower for longer.

When Bill Gross said the bond bull market was dead – I bought bonds.

When the mainstream media repeatedly touted the “death of the bond bull” each time rates ticked up, I bought more bonds.

Three weeks ago, the media once again started proclaiming the death of the “bond bull market” once again. And…I bought bonds. To wit:

“This past week there was ample commentary suggesting interest rates were set to “soar” higher and the death of the“bond bull market” was finally here. While such commentary is always inevitable whenever rates rise for any given reason, it is hardly the case. 

First of all, as I have stated previously, interest rates do not function in isolation. They are a function of economic growth over time as borrowing costs are driven by the demand for credit given the return on investment generated from borrowing activities. In other words, money isn’t borrowed at 4% interest if the return on the use of those borrowed funds is 3%.

The chart below proves this.”

interestrates-gdp-091016

“Given that interest rates had gotten extremely oversold during the “Brexit,” money poured into bonds for safety, it is not surprising to see rates have a reflexive move higher. What we saw on Friday was likely rate “shorts” being blown out of positions.

However, interest rates are now at extreme overbought levels only seen near peaks in interest movements AND pushing on the downtrend line from 2015. This will likely prove to be a decent opportunity to rebalance bond exposure to target levels in portfolios next week. 

I will be adding more bonds to portfolios next week as well.”

Chart updated through this week:

bonds-rates-092716

Interestingly, as I stated last week:

“With 10-year rates now back to an overbought condition (bonds now oversold), and pushing the accelerated downtrend line that began with the conclusion of QE3, the most likely movement will be down in conjunction with a ‘risk-off’ move in the markets.”

Importantly, while interest rates could possibly tick higher to the long-term downtrend line at 2.1%, (OMG, run for the hills)the reality is the economy is not growing strongly enough to support substantially higher rates which will push the economy more quickly towards the next recession.

Of course, it is during recessions that interest rates fall sharply. Given the rising level of evidence of a potential recession within the next 12-18 months, and with the majority of global economies already sporting negative rates, I continue to expect Treasury yields to ultimately approach zero. 

Of course, there is also this little problem of correlation extremes between bonds and stocks, especially when combined with overbought conditions and sell signals. If history plays out, the next correction in stocks will likely break the uptrend and send money rushing back into bonds for “safety.”

sp500-rate-correlations-092816

I wouldn’t be too quick on making funeral arrangements for the “bond bull market” just yet.

Just some things I am thinking about.

3 Things: The Fed’s Missed Window & Failed Realizations

The Window Is Closed

I have previously written a series of articles has to the Fed’s inability to hike interest rates this year. (see “Fed At Risk Of Missing Window To Hike Rates” , “The Window Continues To Close” and “Liquidity Trapped.”) In each of these articles, I discussed the ongoing problems plaguing the Federal Reserve and the continued flawed economic predictions of stronger economic growth that continues to fall short.

Yesterday’s meeting was no different. Once again, the Fed not only failed to raise interest rates due to ongoing economic instability, but once again lowered forecasts for future growth and interest rates.

fomc-economic-forecasts-092116

This should surprise no one. The Federal Reserve has continued to hope for the last several years that extremely “accommodative” monetary policy, near zero interest rates, would spark stronger levels of economic activity leading to a rise in broad-based inflationary pressures. Unfortunately, this has yet to be the case. This is due to a monetary policy phenomenon known as a “liquidity trap” which is described as follows:

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

The problem for the Federal Reserve is that getting caught in a liquidity trap was not an unforeseen outcome of monetary policy, but rather an inevitable conclusion. As shown in the chart below the more active the Fed has become with monetary policy, the lower the eventual rates of GDP, inflation, and interest rates has become. As stated, the current low levels of inflation, interest rates, and economic growth are the result of more than 30-years of misguided monetary policies that have led to a continued misallocation of capital.

fed-interestrates-gdp-inflation-092116

The lack of productive inflationary pressures (inflation caused by rising wages and increased economic activity that leads to higher prices) has been a construct of the underlying structural dynamics of the economy. Home ownership rates have plunged, technological advances and productivity increases have fostered wage suppression, and high levels of uncounted unemployed (54% of the 16-54 aged labor force) drag on economic strength.

The 5 and 10-year breakeven inflation rates currently give little impression that real inflation is present in the economy. As I stated above, inflation driven by rising healthcare, insurance, and rent IS NOT THE SAME as inflation arising from rising wages, rising prices and increased economic activity. The former acts as a cancer reducing levels of household liquidity and consumptive capacity.

inflation-breakevenrates-5-10-092116-2

The exceptionally low yields on government treasuries are clear evidence that inflation is not a threat. For all the money that has been spent trying to ignite the engine of economic growth; it has all remained a futile effort at this point. Now, after more than seven years of an economic expansion, interest rates remain near zero, and the velocity of money continues to plummet.

You Can’t Go Home Again

From the Washington Post:

“Two years ago, top officials at the Federal Reserve mapped out a strategy for withdrawing the central bank’s unprecedented support for the American economy.

The official paper was titled “Policy Normalization Principles and Plans,” and it was supposed to serve as a rough outline for the tenure of newly installed Fed Chair Janet L. Yellen. Essentially, it consisted of two basic parts: Raise interest rates and shrink the central bank’s massive balance sheet.

But now, both of those steps are being called into question as Fed officials grapple with an economy that appears to be stuck in first gear. Instead of executing its exit strategy, the Fed is confronting the possibility that the dramatic measures it took to safeguard the recovery will remain in place indefinitely.

‘Maybe this is one of those cases where you can’t go home again,’ former Fed chairman Ben S. Bernanke wrote in a recent blog post arguing for a shift in course.”

The problem for the Federal Reserve remains the simple fact there is NO evidence that “Quantitative Easing” actually works as intended. The artificial suppression of interest rates was supposed to spur economic activity by encouraging lending activities through the banks. Such an outcome should have been witnessed by an increase in monetary velocity.

As the velocity of money accelerates, demand rises and inflationary pressures increase. However, as you can clearly see, the demand for money has been on the decline since the turn of the century.

m2v-gdp-092116

The surge in M2V during the 90’s was largely driven by the surge in household leverage as consumers turned to debt to fill the gap between falling wage growth and rising standards of living. (For more on the problem with incomes read “The 80/20 Rule.”)

m2v-debt-gdp-092116

The issue for the Fed is the decline in the “unemployment rate,” caused solely by the shrinking labor force, is obfuscating the difference between a “real” and “statistical” full employment level. While it is expected that millions of individuals will retire in the coming years ahead; the reality is that many of those “potential” retirees will continue to work throughout their retirement years. In turn, this will have an adverse effect by keeping the labor pool inflated and further suppressing future wage growth.

For the Fed, they remain trapped between “policy fantasy” and “economic reality.” 

“Indeed, the Fed has repeatedly pushed back plans to reduce its stimulus in the years since the 2008 financial crisis. The first version of its exit strategy was released in summer 2011 and called for the Fed to start shrinking its balance sheet before raising interest rates. Just over a year later, the central bank was moving in the opposite direction, pumping money into the economy and strengthening its commitment to not raising interest rates.

Such shifts have threatened to undermine the central bank’s credibility, particularly when paired with frustratingly weak economic growth. Both inside and outside the institution, economists and academics are debating whether the Fed needs an entirely new approach.”

It may be too late for that.

Fed & Market Are Now Co-Dependents

From The WSJ:

Recent developments in financial markets underscore how dependent they have become on central banks, the chief economist of the Bank for International Settlements said Sunday.

‘It is becoming increasingly evident that central banks have been overburdened for far too long,’ said Claudio Borio, chief economist at BIS, a Switzerland-based consortium of central banks.

The BIS has for years warned that the global economy is too dependent on its central banks, whose money-printing power allows for a rapid response to crises. The result is that central bank money boosts asset prices even if underlying economic conditions haven’t changed.”

It is an interesting point with respect to the entire discussion. It is quiet evident the financial markets, and by extension, the economy, have become tied to Central Bank interventionsAs shown in the chart below, the correlations between Federal Reserve interventions and the markets is quite high.

fed-qe-sp500-0921116

Of course, this was ALWAYS the intention of these monetary interventions. As Ben Bernanke suggested in 2010 as he launched the second round of Quantitative Easing, the goal of the program was to lift asset prices to spur consumer confidence thereby lifting economic growth. The problem was the lifting of asset prices acted as a massive wealth transfer from the middle class to the top-10% providing little catalyst for a broad-based economic recovery.

Unwittingly, the Fed has now become co-dependent on the markets. If they move to tighten monetary policy, the market sells-off impacting consumer confidence and pushes economic growth rates lower. With economic growth already running below 2%, there is very little leeway for the Fed to make a policy error at this juncture.

Therefore, the Fed remains trapped between keeping the financial markets happy and trying to resolve their monetary dilemma. The problem is that eventually something has to give and it will likely not be the outcome the Fed continues to hope for.

The Window Has Closed

What is clear is the Federal Reserve should have chosen to increase rates long ago where such tightening of monetary policy would have been somewhat offset by the continued floods of interventions. The Fed is now trapped in a difficult position.

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

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

For Janet Yellen, the “window” to lift interest rates appears to have closed which could potentially be a policy nightmare for the Fed, the economy and you.

Just some things I am thinking about.

3 Things: Latest NFIB Survey Trips Economic Alarms

NFIB Survey Suggests Weak Economic Prospects

 

Earlier this week, the National Federation of Independent Businesses released their monthly Small Business Survey. While this data is much overlooked by the mainstream media, it really shouldn’t be. Out of the 26 million businesses registered in the United States, only 6 million have active employment and generate revenue. Of that total, almost 80% have fewer than 5-employees. Simply, it is small businesses that drive the economy, employment, and wages. Therefore, what the NFIB says is extremely relevant to what is happening in the actual economy versus the headline economic data from Government sources.

In August, the survey declined 2-tenths of a point to 94.4. While that may not sound like much, it is where the deterioration occurred that is most important. Furthermore, despite an improvement from the financial crisis lows, the current levels are still well below the levels normally witnessed at the late stage of an economic recovery.

As noted in the chart below, the surge in optimism has now returned the survey to levels normally associated with the onset of recessions.  And it only took 8-years to get there, hardly a recovery to “crow” about.

nfib-survey-091316

However, the internals of the report were much less exuberant as noted by the NFIB:

“Once again, the NFIB survey showed no signs of strength in the small business sector. Uncertainty seems to be the major enemy of economic progress and the political climate is a major contributor to the high levels of uncertainty that we’ve seen. The current economic environment is not a good one for strong or sustained growth.”

This certainly isn’t the message that we are getting from the mainstream media suggesting all is well within the economy. But, here are the interesting highlights:

  • The outlook for business conditions in the next six months had the most dramatic change, dropping seven points.
  • Setting an all-time high for the survey, 39 percent of business owners cited the political climate as a reason NOT to expand. 
  • Uncertainty about the economy and government policy also hit record highs among small business owners.

The issue, despite all evidence the contrary, remains a prevailing “blindness” to the reality of economic cycles. Economic recoveries are finite and by all measures the current economic recovery has been very long when considering this is the 4th longest expansion in history with the lowest overall rate of growth. 

historical-recessions-091316

While longer periods of economic expansion have certainly existed, the underpinnings of those expansions are substantially different than what exists currently. The chart of real, inflation-adjusted, final sales exposes this issue.

gdp-realfinalsales-091416

During previous expansions, real final sales in the economy ran at 4% annualized growth rates or better. The current expansion from the 2009 lows only briefly touched 3% despite massive Government and Federal Reserve interventions. 

However, one of the hopes that continues to drive economic expectations is a return of capital spending to supplant the dearth of consumer spending. The problem is that corporate CapEs, as a percentage of economic growth, is far less than the nearly 70% contribution made up by consumers. The problem, as shown in the chart below, is despite hopes of a surge in capital spending, plans for such expenditures remains very retarded and at levels, not surprisingly, normally associated with recessionary environments.

nfib-capitalexpenditureplans-091316

Importantly, expectations are very fragile. Any stumble in the current environment will see those expectations quickly reverse. The chart above shows expectations of economic improvement (currently at -12%, down from -5% in July) as compared to plans for capital expenditures over the next 3-6 months (currently at 28% which is where it was January of 2015).

If small businesses were convinced that the economy was “actually” improving over the longer term, they would be increasing capital expenditure plans rather than remaining at the same level they were 20-months ago. The disparity between improved economic outlook and CapEx plans is likely a reflection that business owners are hoping for increased economic activity. However, they are not willing to ‘bet’ their capital on it.

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

nfib-economicimprovment-091316

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

The Federal Reserve has started its regular ‘hide the rate hike’ game, sending observers looking under every rock of data to see if there are 25 basis points underneath. Most of the ‘rocks’ look like pebbles, there’s not a lot of growth in the landscape, and there’s that darn international thing, the value of the dollar (which is officially not the province of the Fed) and all that. The inflation and employment goals are defined ‘downward’ in terms of what the Fed might accept, along with prognostications that assure ‘full’ attainment by 2018. Comments by Chicago Fed president Charles Evans, in remarks to the Shanghai Advanced Institute of Finance in Beijing, indicate that the Fed thinks it is the determining force shaping interest rates, not markets, a very troubling view. He said:

‘Long-run expectations for policy rates provide an anchor to long-run interest rates. So lower policy rate expectations act as a restraint on how much long-term rates could rise following a surprise over the near-term policy path.’

These contortions in policy cannot be maintained. We will regret this arrogance even more over the next decade as our private financial institutions become unable to meet the promises they have made.

The Real Employment Report

 

The divergence between the Fed’s “economic fantasy” and “Main Street reality” can also be seen between expectations to increase employment versus those that actually did.

Three months ago, the percentage of respondents that were expecting to increase employment over the next quarter, or two, rang in at 11%. Three months later, the percentage of respondents that increased employment was -3%. This currently is the lowest level of hiring since January of this year and greatly contrasts the stats produced by the BLS showing large month gains every month in employment data. While “expectations” should be “leading” action, this has not been the case.

The first chart below shows the raw data of how firms feel “today” about increasing employment over the next three months versus actual increases in employment over the last quarter.

nfib-employmentplans-vs-actual-091316

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

nfib-retail-sales-091316

This is also one of the great dichotomies of the employment reports that continues to show strong hiring in retail services despite a weakening outlook for, and actual, retail sales.

retail-sales-employment-091416

Furthermore, despite hopes of continued debt-driven consumption, business owners are still faced with actual sales that are still well below long-term trends. Since revenue is what ultimately drives expansion, it is not surprising that when asked whether this is a “good time to expand” their operations, the large majority of responses remain negative. That view has remained unchanged since the depths of the financial crisis.

nfib-expected-sales-goodtimetoexpand-091316

It’s The Government, Man!

 

For small businesses, the overall environment remains very challenging. The top 3 concerns of small businesses remain government regulations, taxes and poor sales as shown by the composite indicator below. While improved somewhat from the financial crisis, levels remain well entrenched at levels where recessions are starting, not eight years into an expansion.

nfib-top3-concerns-2091316

Increased regulations, the onset of the Affordable Care Act (ACA), increased taxes (due to the ACA), and increased costs of compliance keep budgets tight with profitability a primary focus. Taxes and Government Regulations continued to be at the forefront of the decision-making process by business owners.

nfib-top3-concerns-091316

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

As I discussed previously, the gap between incomes and the cost of living is once again being filled by debt. However, using credit to maintain a standard of living is far different that using debt to increase it. This is why consumptions expenditures are weak and “final demand” in the economy remains anemic. In turn, business owners remain on the defensive, reacting to increases in demand caused by population growth rather than building in anticipation of stronger economic activity. 

Lastly, as Bill notes, some of the increases we have seen in spending and wages have come at the expense of economic growth rather than a benefit from it.

“Health insurance costs keep rising, diverting compensation gains into benefits rather than take home pay. Other regulatory pressures such as a rising minimum wage and mandatory paid leave also put an upward pressure on reports of compensation increases. Capital spending will remain M.I.A., plans are at the highest level for the recovery, matching the previous peak in 2014, but not typical of an expansion and reports of actual spending have been weakening.”

What this suggests is that the current “struggle through” economy will likely continue until some unexpected exogenous shock tips the proverbial “apple cart.”

The problem for the Fed is that once again the window for a “rate hike” has likely closed. Economic uncertainty, deflationary threats, and market volatility will keep them boxed in for now. Unfortunately, the recent spike in LIBOR has likely already done a bigger job of tightening monetary policy than the Fed actually intended to do. This could cause problems in the not too distant future.

Just some things I am thinking about.

3 Things: The Fed Is Likely Trapped

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Wishful Thinking

The confusion at the Fed continues as Federal Reserve Bank of San Francisco President John Williams painted an upbeat picture of the U.S. economy in a speech on Tuesday. This, of course, comes despite recent disappointing data on both the employment and economic fronts.

“The economy is in good shape and headed in the right direction. As a result, it makes sense to get back to a pace of gradual rate increases, preferably sooner rather than later.” 

Of course, the Fed’s Williams is once again “jawboning” the media and Wall Street, as despite their best efforts over the last several years, economic growth has continued to slow to ever lower growth rates. This is clearly shown in the chart below which shows the Fed’s “predictions” versus actual outcomes.

fomc-economic-forecasts-090116

However, despite Mr. Williams hopes of stronger economic growth in the months ahead, the data currently doesn’t suggest this will be the case. Let’s start with the manufacturing and service data.

In June, I discussed my Economic Output Composite Index (EOCI) which is a very broad measure of economic activity consisting of not just manufacturing data, but services as well as leading indicators. (The chart below compares the EOCI to both GDP and the Leading Economic Indicator Index. The EOCI is comprised of the CFNAI, Chicago PMI, LEI, NFIB, ISM, and Fed regional surveys.)

EOCI-Index-090116

As I have explained previously, since 2009 the U.S. economy has remain mired in an ongoing rotation between inventory draw downs which lead to restocking cycles. These restocking cycles provided a temporary boost to economic activity but very quickly that activity fades and the economy softens once again.

This time has been little different. The recent restocking cycle once again came lined with hopes of continuing economic strength, however, much of the data now coming in suggests those hopes may once again be disappointed.

The recent releases of the ISM Manufacturing and Services index suggest this to be the case. With both of the indices slowing sharply in the past month, the subsequent data releases of manufacturing and service data are likely to slow also. The chart below is a composite index (and one of the components of the EOCI) which is an average of both ISM indexes.

ISM-Composite-090116

As illustrated, it is not uncommon during an economic cycle for the composite ISM to have a growth stage followed by a slow down, a secondary growth bounce which leads to the next recession. We see much of the same pattern developing currently which suggests that we are late in the current economic expansion. With the composite index sitting currently at 50.4, the risk of slower economic growth through the end of the year has risen markedly as the trend of the data over the last several months is negative.  

But dont’ take my word for it. Here is Chris Williamson, Chief Economist at Markit:

“The weak PMI readings send a downbeat note on economic growth in the third quarter. Taken together, the manufacturing and services PMIs are pointing to an annualized GDP growth rate of a mere 1%, similar to the subdued pace signaled by the surveys throughout the year to date, suggesting that those looking for a strengthening in the rate of economic growth will be disappointed once again.”

Fed’s Got An Employment Problem

Speaking of disappointing. Despite mainstream trumpeting of the recent employment data headlines, Danielle Dimartino-Booth recently put it into perspective.  (Admit it, you gotta love a woman who quotes “Dirty Harry.”)

“I know what you’re thinking: ‘Did he fire six shots or only five?’ Well, to tell you the truth, in all this excitement, I’ve lost track myself. But being this is a .44 Magnum, the most powerful handgun in the world, and would blow your head clean off, you’ve got to ask yourself one question: ‘Do I feel lucky?’ Well, do you punk?

Investors no doubt went into the recent August jobs report asking themselves the same question, whether they too felt lucky. It’s a good question, all things considered.

The Bank Credit Analyst reckons that valuations on the stock market are near record levels as gauged by the median price-to-earnings ratio. And evidence is mounting that retail investors are flocking into stocks after a prolonged buyers strike. Vanguard, the crowned king of passive investing, raked in a record $25 billion in August alone, taking the total thus far this year to nearly $200 billion. The groundwork is laid to surpass 2015’s record $236 billion in inflows.

In the minds of the slaves to momentum, the only thing standing in the way of fresh record highs in the stock market is a measly quarter-of-a-percent rate hike care of the Federal Reserve. And the only thing that assures that rate hike comes to pass is a jobs market that’s also gaining momentum.

That message was certainly not in the August data released this morning. Forget the abysmal pace of job creation in May – that paltry 24,000 figure was an aberration. By the same token, discount the strength in June and July, where average gains of 273,000 also look deceptively high. Focus instead on the 12-month average of 204,000. That’s the best yardstick against which to compare August’s 151,000-gain, which fell short of consensus estimates of a 180,000 gain.

So nothing disastrous, and nothing remarkable. The outcome, just what the market most wished for, was simply too wishy-washy to pull the Fed off the sidelines. We now reset the clocks and ask ourselves if we’re feeling any luckier about September job growth.”

So, with investors chasing stocks on the assumption the economy is improving, and the Federal Reserve expecting to normalize rates into a stronger economic environment, the simple question is whether they will be right? The problem is the Fed’s own data suggests they won’t.

In May of 2014, the Federal Reserve began discussing a newly designed labor market index to help support their claim that employment conditions in the U.S were improving. This was an important facility for the Fed which needed support to raise interest rates. My good friend Doug Short has a complete discussion on the LMCI, which is worth reading for context. As he defines:

“The Labor Market Conditions Index (LMCI) is a relatively recent indicator developed by Federal Reserve economists to assess changes in the labor market conditions. It is a dynamic factor model of labor market indicators, essentially a diffusion index subject to extensive revisions based on nineteen underlying indicators in nine broad categories

The indicator, designed to illustrate expansion and contraction of labor market conditions, was initially announced in May 2014, but the data series was constructed back to August 1976.”

As stated, the Fed’s own index is not supporting the Fed’s claims that employment is growing at a rate strong enough to withstand a tightening of monetary policy. In fact, as shown in the chart below, the LMCI index (smoothed with a 12-month average) has been a leading indicator of future weakness in employment. The recent downturn in the LMCI suggests that employment gains may more muted in the months ahead.

lmci-employment-090116

Therein lies the problem for the Fed. If the LMCI is indeed forecasting weaker employment, then the Fed’s ability to raise interest rates is negated. However, as shown in the chart below, the Fed has ALWAYS been late to the game when hiking interest rates. Each time the Fed began hiking interest rates was at the point the LMCI had effectively peaked.

lmci-fedfunds-090716

Once again, the Fed is behind the curve in tightening monetary policy. With employment likely to weaken further in the months ahead, along with the economic, the ability to lift rates in the current environment is extremely risky. In other words, in an economy growing at roughly 1% currently, there is very little room to avoid a policy mistake.

As Larry Summer just recently stated:

“My second reason for disappointment in Jackson Hole was that Federal Reserve Board Chair Janet L. Yellen, while very thoughtful and analytic, was too complacent to conclude that ‘even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.’ This statement may rank with former Fed chairman Ben Bernanke’s unfortunate observation that subprime problems would be easily contained.”

Retail-Less

While the weakness in the LMCI is suggesting more disappointing employment growth ahead, retail sales are suggesting that the economy is likely much weaker than headlines suggest.

The chart below shows the annual percent change in retail sales on a monthly basis with a 3-month moving average to smooth the volatility. This gives a much more realistic look at what is actually happening with retail sales in the economy that makes up roughly 40% of total personal consumption expenditures. 

retail-sales-080116

As shown, when retail sales have fallen below 2% growth it has historically been a leading indication of the onset of economic weakness or a recession. While there has been no official recession call as of yet by the NBER, it is important to remember that much of the economic data is subject to rather large annual revisions. It will not be surprising to see economic growth revised lower next year. 

The chart below shows the annual rate of change in “control purchases” which is more closely related to the actual activity of average consumers. I have overlaid the analysis with a simplistic economic cycle. Again, as shown above, control purchases are also suggesting that the economic environment is, in fact, very weak. 

retail-sales-economiccycle-090116

The weakness in retail sales will feed into the personal consumption component of GDP which comprises almost 70% of the economic equation. Combined with the economic and employment data, this will likely continue to be a problem for the Fed.

Just some things I am thinking about.

Q2 Earnings Review – Hockey Stick Hopes Remain

Q2-2016-Earnings-Review

With roughly 97% of the S&P 500 having reported earnings, as of the end of August, we can take a closer look at the results through the 2nd quarter of the year. Despite the exuberance from the media over the “number of companies that beat estimates” during the most recent reported period, 12-month operating earnings per share FELL from $98.61 per share in Q1 to $98.33 which translates into a quarterly decrease of 0.2%. While operating earnings are widely discussed by analysts and the general media; there are many problems with the way in which these earnings are derived due to one-time charges, inclusion/exclusion of material events, and outright manipulation to “beat earnings.”

Therefore, from a historical valuation perspective, reported earnings are much more relevant in determining market over/undervaluation levels. It is from this perspective the news improved modestly as 12-month reported earnings per share rose from $86.44 in Q1 to $86.99, or 0.6% in Q2. However, despite the improvement in reported earnings for the quarter, the trend remains clearly negative.

Earnings-Operating-Reported-090116

Always Optimistic

There is one commodity that Wall Street always has in abundance, “optimism.” When it comes to earnings expectations, estimates are always higher regardless of the trends of economic data. The problem is that the difference between expectations and reality have been quite dramatic.

Earnings-ForwardEstimates-History-090116

The game is simple:

“Lower the earnings bar until companies can beat earnings to justify the ‘buy’ the bullish meme.” 

Notice in the chart above that in just the last month forward earnings expectations have been lowered further for the year. The downward slide of earnings expectations over the last several months can be more clearly seen in the chart below.

Earnings-Estimates-Trends-090116

Earnings Manipulation Reaching Limits

There is no arguing corporate profitability improved in the last quarter as oil prices recovered. The recovery in oil prices specifically helped sectors tied to the commodity such as Energy, Basic Materials, and Industrials. However, such a recovery may be fleeting as the dollar remains persistently strong which continues to weigh on exports and the recovery in commodity prices continues to remain muted as the global economy remains weak.

However, looking back it is interesting to see that much of the rise in “profitability” since the recessionary lows has 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 211%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 28% during the same period.

Earnings-Buybacks-SharesOutstanding-090116

In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons:  wage reduction, productivity increases, labor suppression and stock buybacks.  The problem is that each of these tools creates a mirage of corporate profitability which masks the real underlying weakness of the overall economic environment.  The problem, however, is that each of the tools used to boost EPS suffer from diminishing rates of return over time.

One of the primary tools used by businesses to increase profitability has been the accelerated use of stock buybacks. The chart below shows the total number of outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks.

Earnings-vs-Buybacks-090116

The reality is that stock buybacks create an illusion of profitability.  If a company earns $0.90 per share and has one million shares outstanding – reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created, no more product was sold, it is simply accounting magic. Such activities do not spur economic growth or generate real wealth for shareholders. However, it does provide the basis for with which to keep Wall Street satisfied and stock option compensated executives happy.

It is also worth noting the level of stock buybacks financed by debt has also reached previous peak levels. According to JP Morgan:

“S&P 500 companies announced 141 new buyback programs YTD with an aggregate dollar value of $327 billion. 39% of repurchases YTD were funded by issuing new debt versus 22% in 2015.”

Debt-Funded-Stock-Buybacks-090116

Furthermore, while the majority of buybacks have been done with cash it just goes to show how much cash has been used to boost earnings versus 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. The last point is most prevalent as I discussed previously:

“While there are many hopes of an end to the current ‘profits’ recession, there is mounting evidence those hopes may once again be disappointed. One of the latest such indications is rising employee compensation.

While rising employee compensation is good from the view it should lead to rising consumption, it also reduces corporate profitability (wages reduce profits.) Furthermore, this is especially problematic currently as rising compensation is being offset by soaring healthcare costs due to the Affordable Care Act.”

Employee-Compensation-Profits-082516

“Like jobless claims, which hit historically low levels prior to recessions (see here), rising employee compensation has also denoted turns in economic growth and has preceded the onset of recessionary economic drags.”

Employee-Compensation-GDP-082516

“It is worth noting that in both charts above, despite hopes of continued economic expansion, both employee compensation, and economic growth have continued to trend to lower since the 1980’s. This declining growth trend has been compensated for by soaring levels of debt to sustain the current standard of living.”

Economics Matter

The chart below compares economic growth to earnings growth. Wall Street has always extrapolated earnings growth indefinitely into the future without taking into account the effects of the normal economic and business cycles. This was the same in 2000 and in 2007. Unfortunately, the economy neither forgets, nor forgives.

Earnings-GDP-090116

With analysts once again hoping for a “hockey stick” recovery in earnings in the months ahead, it is worth noting this has always been the case. Currently, there are few, if any, Wall Street analysts expecting a recession at any point the future. Unfortunately, it is just a function of time until the recession occurs and earnings fall in tandem.

There is virtually no “bullish” argument that will currently withstand real scrutiny. Yield analysis is flawed because of the artificial interest rate suppression. It is the same for equity risk premium analysis. Valuations are not cheap, and increase in interest rates by the Fed 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.

The deterioration in earnings is something worth watching closely. While earnings have improved in the recent quarter, modestly mind you, it is likely transient given the late stage of the current economic cycle, continued strength in the dollar and potentially weaker commodity prices in the future.

Lastly, with stock buybacks slowing and corporate cost cutting now running in reverse, overly optimistic expectations may continue to be in jeopardy.


Lance Roberts

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

3 Things: $4 Trillion QE, VIX Update, Wage Warning

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Would Another $4 Trillion In QE Work?

 

Just recently, David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap keeping them unable to raise interest rates sufficiently to reload that particular policy tool. As I have discussed in recent weeks, and below, there are an ever growing number of indications the U.S. economy is currently headed towards the next recession. 

He compares three policy approaches to offset the next recession.

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

Here is the problem with the entire analysis. It assumes a normalized economic environment in which the Federal Reserve has several years before the next recession AND that large-scale asset purchases actually create economic growth. Both are likely faulty conclusions.

First, the current economic expansion is, by many measures, extremely long and is currently pushing the fourth longest expansion in history. Interestingly, this expansion is also the weakest of any expansion previously.

Economic-Recoveries-082516

Secondly, is the issue of the success rate of QE on creating economic growth.

In the latter part of summer in 2010, then Fed Chairman Ben Bernanke launched a second QE program. The purpose of these programs were made very clear by Bernanke when he stated:

“Conventional monetary policy easing works by lowering market expectations for the future path of short-term interest rates, which, in turn, reduces the current level of longer-term interest rates and contributes to an easing in broader financial conditions. These changes, by reducing borrowing costs and raising asset prices, bolster household and business spending and thus increase economic activity.”

Well, we know for certain that ongoing Federal Reserve interventions have indeed boosted asset prices as shown below.

Fed-BalanceSheet-SP500-053116

However, the question is did the elevation of asset prices actually translate into stronger economic growth. The answer is “yes” – each QE program was successful at pulling forward future consumption to provide a short-term boost to growth but the efficacy of each round of QE has declined. In other words, as shown in the chart below, each QE program must be larger to obtain weaker results.

QE-GDP-SP500-Effectiveness-082516

The charts below, show the effectiveness of QE on various parts of the economy. For comparison purposes, I have compared the total increase of the Fed’s balance sheet from 2009 to present to the percentage increase in each sector of the economy. I then derived from this analysis the total dollars of QE required to generate $1 of growth.

For example, it required $1.82 of QE for each $1 of increase in the S&P 500.

Fed-QE-Sp500-053116

So, with this formula, we can take a look at the “effective cost” of QE on various parts of the economy.

It required $6.83 to boost consumer sentiment.

Fed-QE-ConsumerSentiment-053116

$22.42 for a very small increase in nominal hourly wages.

Fed-QE-Wages-053116

Consumer spending, the backbone of economic growth has increased by a total of 27.93% since 2009 at a cost of $13.31 of QE for every $1 increase in spending.

Fed-QE-ConsumerSpending-053116

While companies are converting liquidity, high asset prices, and low interest rates to increase debt for M&A, stock buybacks, and dividends, little has translated into actual fixed investment. At $11.34 of QE to generate $1 of fixed investment, the transmission system is clearly weak.

Fed-QE-FixedInvestments-053116

The same goes for corporate profitability. $11.26 of QE for each $1 of corporate profits. It is actually substantially worse than that when compared to top line revenues which strips out share buybacks, accounting gimmicks, and other balance sheet chicanery.

Fed-QE-CorporateProfits-053116

While President Obama touts “the longest streak of employment growth since the 90’s,” it has come at the highest cost of growth of all at $47.16.

Fed-QE-Employment-053116

In fact, QE was actually much more cost effective at rolling individuals off of the employment rolls and shrinking the labor force by increasing those counted as “Not In Labor Force.” NILF has grown twice as fast and at half the cost of employment at just $22.83.

Fed-QE-NILF-053116

Of course, since each of these individual components are part of the broader economic landscape, how much QE did it require to boost overall economic growth? Just $14.10 of QE for each $1 of economic growth. What a deal?

Fed-QE-GDP-053116

The Fed’s hope has always been that at some point they would be able to wean the economy off of life support and it would operate under its own strength. This would allow the Fed to raise interest rates back to more normalized levels and provide a policy tool to offset the next recession.

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last seven years and there is little evidence suggesting growth is accelerating. In fact, there may be more evidence suggesting quite the opposite. 

The problem for the Fed is the diminishing effects of QE as the forward pull of consumption is finite. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. While another $2-4 Trillion in QE might indeed be successful in further inflating the third bubble in asset prices since the turn of the century, there is a finite ability to continue to pull forward future consumption to stimulate economic activity.

Furthermore, were we to have a recession within the next two-years, a very likely outcome, it is very unlikely the Fed will have the effect the paper describes. The more likely outcome is the effectiveness of rate reductions and QE will be substantially diminished and the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

The potential for a Fed policy mistake at this juncture is extremely high and climbing and the current “faith in the Fed” is likely misplaced.

The VIX Addendum

 

Over the last couple of weeks both Michael Lebowitz, CFA and I have been discussing the extremely low levels of the volatility index and the positions we have added to client portfolios as a hedge against a sudden reversion. (See here and here)

Michael did some additional work this past week into the VIX’s current situation.

The complacency in the equity markets, as measured by implied volatility (VIX), is at levels rarely seen. On its own this is not breaking news, but it is very strange when contrasted with the palpable concerns over the coming election and more general market risks such as weak economic growth, extreme valuations, corporate earnings recession and various geopolitical worries. We ended the previous article asking investors to consider employing equity insurance which looks cheap in the context of the risky environment.

The VIX is an equity volatility index that uses put and call option pricing to calculate an implied level of future volatility. Upon researching specific VIX insurance strategies, we noticed something that caught our attention and further strengthens the case for adding VIX exposure.

VIX-NetSpeculative-Short-082516

All futures and commodities exchanges release data on the contract volumes and positioning. As one can see in the graph above, net speculative positions in the VIX futures contracts are at record levels of short exposure. In other words, speculators betting on a VIX decline outnumber those betting on an increase in volatility by the largest margin in at least twelve years. A normalization of this positioning could quickly occur and in a disorderly fashion due to the extreme positioning of speculative traders. If this were to occur it would likely add to downside pressure on equity prices. 

The current low level of implied volatility may be justified, and the political and economic environment that concern us may turn out to be benign. However, given the potential for market damaging events, the historically low price of insurance, the limited downside of the VIX and the massive net short VIX positions we simply ask one question: What is the harm in acquiring some cheap insurance to protect against downside risk? 

“Got Vix?”

Another Warning Sign

 

As stated above, I have been pointing out signs as of late that only tend to appear during late stage economic expansions and generally precede the onset of a recession.

While there are many hopes of an end to the current “profits” recession, there is mounting evidence those hopes may once again be disappointed. One of the latest such indications is rising employee compensation.

While rising employee compensation is good from the view it should lead to rising consumption, it also reduces corporate profitability (wages reduce profits.) Furthermore, this is especially problematic currently as rising compensation is being offset by soaring healthcare costs due to the Affordable Care Act.

Employee-Compensation-Profits-082516

Like jobless claims, which hit historically low levels prior to recessions (see here), rising employee compensation has also denoted turns in economic growth and has preceded the onset of recessionary economic drags.

Employee-Compensation-GDP-082516

It is worth noting that in both charts above, despite hopes of continued economic expansion, both employee compensation, and economic growth have continued to trend to lower since the 1980’s. This declining growth trend has been compensated for by soaring levels of debt to sustain the current standard of living.

Of course, the question to ask is what happens when the “debt well” runs dry.

Liquidity Trapped! The Fed’s Policy Nightmare

Liquity-Trapped-Nightmare

Yesterday, we got the release of the minutes from the FOMC meeting in July. Not surprisingly, we see a Fed just as confused as ever as to what monetary policy actions should be taken. To wit:

  • FED OFFICIALS SPLIT IN JULY ON WHETHER RATE HIKE NEEDED SOON
  • A COUPLE FED OFFICIALS BACKED JULY RATE HIKE
  • FOMC VOTERS AGREED TO WAIT FOR MORE DATA TO GAUGE ECONOMY
  • SEVERAL FED OFFICIALS CONCERNED OF FIN. RISKS FROM LOW RATES
  • SEVERAL FED OFFICIALS SAW AMPLE TIME TO ACT IF INFLATION RISE
  • FOMC VOTERS DIVIDED ON WHETHER JOB-GAIN PACE WORRISOME

As I wrote previously, I think the Fed is making a major policy mistake.

First, with the markets making new all-time highs, there is a ‘price’ cushion available for the markets to absorb a rate hike without breaking important downside support.

Secondly, with Central Banks globally flooding the markets with liquidity, a further ‘shock absorber’ is currently engaged in softening the impact of a rate hike.

Lastly, the economy is likely going to show a bit of ‘strength’ in upcoming reports, with slightly stronger inflationary pressures. This pickup in economic strength will be another inventory restocking cycle following several months of weakness. As has been in the past, it will be transient and that strength will evaporate as quickly as it came.

If I was Janet Yellen, I would hike interest rates by .50 bps immediately in a surprise announcement and use the price and Central Bank liquidity cushions to soften the blow. This would move the Fed towards its goal of reloading its primary policy tool while there is some ability to temporarily control the outcome of the rate hike.

But that is just me. She won’t do it.”

Technically, a correction due to a surprise rate hike might sting a bit but would likely remain well within the confines of a “bull market correction” as shown below. The previous two corrections, leading up to and following the last Fed hike, were between 10-11%. I have noted a minimum/maximum correction potential from a rate hike of between 7-15%.

SP500-FedRateHike-Correction-081816

My point, as stated above, is the Fed is likely missing a significant opportunity to use the market’s current “exuberance” to achieve two goals.

  1. Hike rates to catch up with LIBOR which is already tightening monetary policy, and;
  2. Reduce some of the exuberance in the markets which the Fed is now concerned with.

“… during the discussion, several participants commented on a few developments, including potential overvaluation in the market for CRE, the elevated level of equity values relative to expected earnings, and the incentives for investors to reach for yield in an environment of continued low interest rates.”

The Liquidity Trap

What the dichotomy of the data, markets, and Fed actions suggests, now more than ever, is the realization the Fed has gotten caught in a “liquidity trap.” 

Here is the definition:

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

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

First, there is little argument that Central Banks globally are injecting liquidity into the financial system.

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

Fed-BalanceSheet-InterestRates-081816

While, in the Fed’s defense, it may be clear that since the beginning of the Fed’s monetary interventions that interest rates have declined this has not really been the case. I would venture to argue that, in fact, the Fed’s liquidity driven inducements have done little to affect the direction of interest rates. I say this because interest rates have not been falling just since the monetary interventions began – it is a phenomenon that began three decades ago as the economy began a shift to consumer credit leveraged service society.  The chart below shows the correlation between the decline of GDP, Interest Rates and Inflation.

GDP-Inflaiton-Rates-081816

The ongoing decline in economic activity has continued to be the driving force behind falling inflationary pressures and lower interest rates and massive surges in consumer debt to sustain an increased level of living standards. 

Consumer-Credit-Incomes-081116

For these reasons, it is difficult to attribute much of the recent decline in interest rates to monetary/accommodative policies when the long term trend was clearly intact before these programs began. The real culprits behind the declines in economic growth rates, interest rates, and inflation are more directly attributable to increases in productivity, globalization, outsourcing and leverage (debt service erodes economic activity).

However, the real question is whether, or not, all of this excess liquidity and artificially low interest rates is spurring economic activity? To answer that question let’s take a look at a 4-panel chart of the most common measures of economic activity – Real GDP, Industrial Production, Employment, and Consumption.

GDP-4-Panel-Chart-QE-081816

While an argument could be made that the early initial rounds of QE contributed to the bounce in economic activity it is important to also remember several things about that particular period. First, if you refer to the long term chart of GDP above you will see that economic growth has ALWAYS surged post recessionary weakness. This is due to the pent up demand that was built up during the recession that is unleashed back into the economy. Secondly, during 2009 there were multiple bailouts going on from “cash for houses”, “cash for clunkers”, direct bailouts of the banking system and the economy, etc. However, the real test for the success of the Fed’s interventions actually began in 2010 as the Fed became “the only game in town”. As shown above, at best, we can assume that the increases in liquidity have been responsible in keeping the economy from slipping into a secondary recession. With most economic indicators showing signs of weakness it is clear that the Federal Reserve is currently experiencing a diminishing rate of return from their monetary policies.

Lack Of Velocity

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

Velocity-FedFunds-081816

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

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

The chart below shows that, in fact, the Fed has actually been trapped for a very long time.

FedFunds-GDP-Inflation-081816

The problem for the Fed has been that for the last three decades every time they have tightened monetary policy it has led to an economic slowdown or worse. The onset of economic weakness then forced the Federal Reserve to once again resort to lowering interest rates to stabilize the economy.

The issue is with each economic cycle rates continued to decrease to ever lower levels. In the short term, it appeared that such accommodative policies did in fact aid in economic stabilization as lower interest rates increased the use of leverage. However, the dark side of those monetary policies was the continued increase in leverage which led to the erosion of economic growth, and increased deflationary pressures, as dollars were diverted from productive investment into debt service. Today, with interest rates at zero, the Fed has had to resort to more dramatic forms of stimulus hoping to encourage a return of economic growth and controllable inflation.

No Escape From The Trap

For the Federal Reserve, they are now caught in the same “liquidity trap” that has been the history of Japan for the last three decades. With an aging demographic, which will continue to strain the financial system, increasing levels of indebtedness and poor fiscal policy to combat the issues restraining economic growth it is unlikely that continued monetary interventions will do anything other than simply foster the next boom/bust cycle in financial assets.  The chart below shows the 10-1-year Japanese Government Bond yield spread as compared to their quarterly economic growth rates. Low interest rates have failed to spur sustainable economic activity over the last 20 years.

Japan-YieldSpread-GDP-081516

The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a ‘soft patch’ currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the ‘liquidity trap’ they have gotten themselves into without cratering the economy, and the financial markets, in the process. 

Should we have an expectation that the same monetary policies employed by Japan will have a different outcome in the U.S? More importantly, this is no longer a domestic question – but rather a global one since every major central bank is now engaged in a coordinated infusion of liquidity. The problem is that despite the inflation of asset prices, and suppression of interest rates, on a global scale there is scant evidence that the massive infusions are doing anything other that fueling the next asset bubbles in real estate and financial markets. The Federal Reserve is currently betting on a “one trick pony” which is that by increasing the “wealth effect” it will ultimately lead to a return of consumer confidence and a fostering of economic growth? Currently, there is little real evidence of success.

Are we in a “liquidity trap?”  Maybe.  Of course, no one recognized Japan’s problems either until it was far too late.

3 Things: The Economic Fabric & Rising Recession Risks

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


LIBOR Pointing To Weaker Economy

Last week, I laid out the 12-reasons for why stock market “bulls” should pray that interest rates don’t rise. Just one word describes the outcome of that event given the current excessively leveraged consumption based economy of today – disaster.

The point here is that with the Federal Reserve talking about “tightening” monetary policy by hiking the “Fed Funds” rate – the reality is the Fed Funds rate has little to do with the actual credit market. The Fed rate is not actively traded and variable rate financial products are not linked to it. However, the London Interbank Offered Rate (LIBOR) is the rate used as the benchmark for many adjustable rate mortgages, business loans and financial instruments traded on global financial markets. In other words, increases in LIBOR tightens the flow of liquidity in many of the debt markets that directly affect the average consumer and small business by increasing costs. This is particularly burdensome when annual rates disposable income growth is on the decline.

Danielle DiMartino-Booth pointed out this problem in her latest post:

“Disposable personal income growth, adjusted for inflation, grew by 2.2 percent over last year, a full percentage point below March’s 3.2-percent pace. That downshift helps explain two things. For starters, the saving rate fell in June to 5.3 percent, the lowest since last October. Meanwhile, revolving credit growth, aka credit card spending, galloped ahead at a 9.7-percent annual rate.”

Consumer-Credit-Incomes-081116

In other words, consumers are turning to credit consumption to support their current standard of living rather than the expansion of consumption. This is why economic growth continues to wane. 

This brings me to my point. If it is LIBOR that affects the consumer, and ultimately economic growth given the 70%ish contribution of consumption to it, then we should be looking at the rates that directly impact the consumer. Whether it is auto loans, mortgages, variable rate debt, credit cards, etc., those interest rate costs are directly impacted by changes in LIBOR.

The chart below shows the spread between the 10-year Treasury and the 12-month LIBOR. With interest rates rising sharply on the short end of the yield curve the impact to consumption will likely occur sooner than currently anticipated.

Interest-Rates-10-Libor-081116

We can see this more clearly by looking at the very short-end of the yield curve and the spread between the 2-year Treasury rate and the 1-month LIBOR.

Interest-Rates-2-Libor-081116

As shown, there is a very high correlation between negative spreads and future economic growth. In every instance where there has been a negative spread on rates, the economy has either slowed markedly or was in a recession.

As my Dad used to warn me just before I broke something that was previously working:

“Do you really think it is a good idea to mess with that?”

With the Fed hopeful strong economic data is on the way, the recent bounce in the data is likely not much more than that. The data suggests, on any fronts, the Fed will once again be disappointed as LIBOR “front ran” them to sharply tightening liquidity leading to further consumer constraint.

The potential for a Fed policy mistake at this juncture is extremely high and climbing.

All Tapped Out

Let me expand on this idea that consumers are ramping up debt to maintain their standard of living, primarily to offset surging healthcare costs courtesy of the Not-So-Affordable Care Act. 

Recently, there have been many articles pointing to the rising saving rate, as reported by the BEA, as the reason why consumers are spending less. That rise was short-lived as wage growth turned sharply lower since the beginning of this year. 

GDP-Wages-Savings-PCE-081116

As shown, the savings rate, while higher than it was in prior to the financial crisis, is still well below levels that would signify a more healthy household balance sheet. However, I suspect that even the current increase in the personal savings rate, as reported by the BEA, is wrong.

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

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

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

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

PCE-Struggle-To-Maintain-LivingStandard-081116

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

PCE-ConsumerDebt-081116

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

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

Ultimately these diminished investment opportunities repeatedly lead to widespread malinvestments. Not surprisingly, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments which were only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk. We see it playing out again in the “chase for yield” in everything from junk bonds to equities. Not surprisingly, the end result will not be any different.

So, don’t blame those poor consumer’s for not spending – they are spending everything they have and then some. 

The Job Recovery Is Likely Over

Wolf Richter penned a very interesting piece lately entitled: “This Is When The Jobs “Recovery” Goes KABOOM.”

It will eventually impact the labor market. Here’s why: despite the hiring that companies have been doing, sales – the ultimate measure of “output” – have been heading south since mid-2014.

Total business sales, according to Census Bureau data, which include sales within the US by all companies, not just the largest in the S&P 500, peaked in July 2014 at $1.35 trillion. By May this year, the most recent data available, they’d dropped 4.4% to $1.29 trillion.

Despite sales cascading lower for a year-and-a-half, nonfarm employment from June 2014 through July 2016 has risen by 5.6 million jobs! And that’s what the productivity decline is also showing: the additional labor hours have been accompanied by a decline in sales!

The chart shows how jobs and total business sales are normally on the same wave length: When sales get hit, businesses cut their payrolls; when sales pick up, businesses hire. But since June 2014, a peculiar phenomenon has set in, with employment (blue line, left scale) rising and sales (red line, right scale) falling.”

US-jobs-v-business-sales-2006-2016-07

This also confirms my comment recently on business investment.

“The +85k unadjusted number also confirms the trends of fixed and non-private residential investment. Businesses hire against the demand for their products and services. This is why, as shown in the chart below, the historical relationship between employment and fixed investment is extremely high….until now.”

Employment-BusinessInvestment-080616

Business investment does not fall in isolation. Companies invest in buildings, property, plant, and equipment when consumer demand is strong and economic growth is strengthening. As investment is made to expand production, more employment is needed to meet that demand. The opposite occurs prior to recessionary onsets.

Currently, while the BEA continues to spew out record job numbers, due primarily to seasonal adjustments and other factors, a substantial number of business activity indicators are suggesting the data is being substantially overstated. Future negative revisions to the data should not be surprising. 

If you step back and weave all of these points together from consumer credit, to employment to wages, savings and interest rates, the picture of rising recession risks clearly emerge.

With markets ignoring the data, the outcome for investors is likely not pretty.

As David Rosenberg stated just recently:

“Okay, this really is one weird market.

I am looking at the hedge fund proxy market positioning from the latest Commitments of Traders report from the Commodity Futures Trading Commission, and the results are startling. I’m quite sure I have not seen such levels of confidence on one hand, and cognitive dissonance on the other.”

Just some things I am thinking about.


Lance Roberts

lance_sig

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