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Margin Call: You Were Warned Of The Risk

I have been slammed with emails over the last couple of days asking the following questions:

“What just happened to my bonds?”

“What happened to my gold position, shouldn’t it be going up?”

“Why are all my stocks being flushed at the same time?”

As noted by Zerohedge:

“Stocks down, Bonds down, credit down, gold down, oil down, copper down, crypto down, global systemically important banks down, and liquidity down

Today was the worst day for a combined equity/bond portfolio… ever…”

This Is What A “Margin Call,” Looks Like.

In December 2018, we warned of the risk. At that time, the market was dropping sharply, and Mark Hulbert wrote an article dismissing the risk of margin debt. To wit:

“Plunging margin debt may not doom the bull market after all, reports to the contrary notwithstanding.

According to research conducted in the 1970s by Norman Fosback, then the president of the Institute for Econometric Research, there is an 85% probability that a bull market is in progress when margin debt is above its 12-month moving average, in contrast to just a 41% probability when it’s below.

Why, then, do I suggest not becoming overly pessimistic? For several reasons:

1) The margin debt indicator issues many false signals

2) There is insufficient data

3) Margin debt is a strong coincident indicator.”

I disagreed with Mark on several points at the time. But fortunately the Federal Reserve’s reversal on monetary policy kept the stock market from sinking to levels that would trigger “margin calls.”

As I noted then, margin debt is not a technical indicator that can be used to trade markets. Margin debt is the “gasoline,” which drives markets higher as the leverage provides for the additional purchasing power of assets. However, that “leverage” also works in reverse as it provides the accelerant for larger declines as lenders “force” the sale of assets to cover credit lines without regard to the borrower’s position.

That last sentence is the most important and is what is currently happening in the market.

The issue with margin debt, in terms of the biggest risk, is the unwinding of leverage is NOT at the investor’s discretion.

It is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) 

When lenders fear they may not be able to recoup their credit-lines, they force the borrower to either put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen all at once as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

When an “event” occurs that causes lenders to “panic” and call in margin loans, things progress very quickly as the “math” becomes a problem. Here is a simple example.

“If you buy $100,000 of stock on margin, you only need to pay $50,000. Seems like a great deal, especially if the stock price goes up. But what if your stock drops to $60,000? Suddenly, you’ve lost $40,000, leaving you with only $10,000 in your margin account. The rules state that you need to have at least 25 percent of the $60,000 stock value in your account, which is $15,000. So not only do you lose $40,000, but you have to deposit an additional $5,000 in your margin account to stay in business.

However, when margin calls occur, and equity is sold to meet the call, the equity in the portfolio is reduced further. Any subsequent price decline requires additional coverage leading to a “death spiral” until the margin line is covered.


  • $100,000 portfolio declines to $60,000. Requiring a margin call of $5000.
  • You have to deposit $5000, or sell to cover. 
  • However, if you don’t have the cash, then a problem arises. The sell of equity reduces the collateral requirement requiring a larger transaction: $5000/.25% requirement = $20,000
  • With the margin requirement met, a balance of $40,000 remains in the account with a $10,000 margin requirement. 
  • The next morning, the market declines again, triggering another margin call. 
  • Wash, rinse, repeat until broke.

This is why you should NEVER invest on margin unless you always have the cash to cover.

Just 20% 

As I discussed previously, the level we suspected would trigger a margin event was roughly a 20% decline from the peak.

“If such a decline triggers a 20% fall from the peak, which is around 2340 currently, broker-dealers are likely going to start tightening up margin requirements and requiring coverage of outstanding margin lines.

This is just a guess…it could be at any point at which “credit-risk” becomes a concern. The important point is that ‘when’ it occurs, it will start a ‘liquidation cycle’ as ‘margin calls’ trigger more selling which leads to more margin calls. This cycle will continue until the liquidation process is complete.

The Dow Jones provided the clearest picture of the acceleration in selling as “margin calls” kicked in.

The last time we saw such an event was in 2008.

How Much More Is There To Go?

Unfortunately, FINRA only updates margin debt with about a 2-month lag.

Mark’s second point was a lack of data. This isn’t actually the case as margin debt has been tracked back to 1959. However, for clarity, let’s just start with data back to 1980. The chart below tracks two things:

  1. The actual level of margin debt, and;
  2. The level of “free cash” balances which is the difference between cash and borrowed funds (net cash).

As I stated above, since the data has not been updated since January, the current level of margin, and negative cash balances, has obviously been reduced, and likely sharply so.

However, previous “market bottoms,” have occurred when those negative cash balances are reverted. Given the extreme magnitude of the leverage that was outstanding, I highly suspect the “reversion” is yet complete. 

The relationship between cash balances and the market is better illustrated in the next chart. I have inverted free cash balances, to show the relationship between reversals in margin debt and the market. Given the market has only declined by roughly 30% to date, there is likely more to go. This doesn’t mean a fairly sharp reflexive bounce can’t occur before a further liquidation ensues.

If we invert margin debt to the S&P 500, you can see the magnitude of both previous market declines and margin liquidation cycles. As stated, this data is as of January, and margin balances will be substantially lower following the recent rout. I am just not sure we have “squeezed” the last bit of blood out of investors just yet. 

You Were Warned

I warned previously, the idea that margin debt levels are simply a function of market activity, and have no bearing on the outcome of the market, was heavily flawed.

“By itself, margin debt is inert.

Investors can leverage their existing portfolios and increase buying power to participate in rising markets. While ‘this time could certainly be different,’ the reality is that leverage of this magnitude is ‘gasoline waiting on a match.’

When an event eventually occurs, it creates a rush to liquidate holdings. The subsequent decline in prices eventually reaches a point that triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying ‘collateral,’ the forced sale of assets will reduce the value of the collateral, triggering further margin calls. Those margin calls will trigger more selling, forcing more margin calls, so forth and so on.

That event was the double-whammy of collapsing oil prices and the economic shutdown in response to the coronavirus.

While it is certainly hoped by many that we are closer to the end of the liquidation cycle, than the beginning, the dollar funding crisis, a blowout in debt yields, and forced selling of assets, suggests there is likely more pain to come before we are done.

It’s not too late to take actions to preserve capital now, so you have capital to invest later.

As I wrote in Tuesday’s missive “When Too Little Is Too Much:”

“With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

The good news is that a great ‘buying’ opportunity is coming. Just don’t be in a ‘rush’ to try and buy the bottom. 

I can assure you, when we ultimately see a clear ‘risk/reward’ set up to start taking on equity risk again, we will do so ‘with both hands.’ 

And we are sitting on a lot of cash just for that reason.”

You can’t “buy low,” if you don’t have anything to “buy with.”

Why Gundlach Is Still Wrong About Higher Rates

Last Monday, Jeff Gundlach, famed bond fund manager and CIO of Doubleline, made an interesting comment during an interview with CNBC when he stated that the 10-year Treasury yield would top 6% by 2020 or 2021.

6% would be the highest yield since 2000.

The chart below shows Gundlach’s estimated yield as compared to the long-run range of economic growth. (Note that real GDP growth was running at 5.27% in 2000 as compared to 3.0% today which is also getting weaker.)

As I discussed last week, interest rates are a function of the economy. So, while Jeff suggests that yields are rising to 6% in the next couple of years, such would suggest an extremely strong rebound in economic growth. Unfortunately, there is no evidence currently of a major upturn in economic growth due to surging deficits, debts, demographic, and employment trends. Further productivity trends mean such an upturn in economic growth could only come from a massive surge in debt. Is that likely to happen given our indebted state already?

The biggest problem with rising rates is the negative impact from higher borrowing costs. Given that consumption makes up 70% of economic growth, and that consumers are heavily indebted, a change in rates has an immediate impact to consumption. Take a look at the chart below of the Total Housing Activity Index versus 30-year mortgage rates.

But it isn’t just housing, but everything from automobiles to iPhones. When interest rates rise to a point to where the consumer can no longer afford the payment, the buy decision changes to either a lower priced product or a postponement of the purchase. More importantly, the change to the purchase mentality (either reduction or postponement) specifically slows the rate of economic growth.

Given the structural backdrops to the economy, there is an inability to substantially increase rates of productivity, output, wage growth, savings, or consumption which would lead to stronger rates of economic growth. In fact, we are currently running some of the weakest rates of economic growth, productivity, and wages on record.

The annual rate of economic growth back in the late 70s, early 80s, was between 6 and 8 percent. Today, the long-run outlook for the economy is closer to 2% which is the terminal result of a 40-year long debt-driven expansion. Given that long-run projections of economic growth are between 1.5-2.5%, such means that the 10-year Treasury should run at about the same level. It is simply not feasible for rates to levitate to 4, 5, or 6% when economic growth is unable to support higher rates. Inflation, interest rates, wages, and economic growth are all tied to the consumer.

And the consumer is pretty much tapped out as credit card debt hits all-time highs and most Americans say they didn’t get a pay raise at their current job, or start a better paying job, in the last 12 months, according to a Wednesday survey from

“According to the poll, 62% of Americans report not getting a pay raise or better paying job in the past year – up from 52% last surveyed last year. That said, just 25% of respondents in this year’s survey said they would look for a new job in the next year.”

It’s The Deficit

So, if economic growth is going to remain weak, then what other reason would cause rates to rise?

Jeff made a valid point about the issue of the deficit suggesting such will ultimately be the catalyst for rates to rise.

This is a topic I have discussed much previously:

“While the markets have been the beneficiary of the tax cut legislation, which gave a short-term boost to corporate profitability, the economy has enjoyed a boost from the massive increases to spending from what should have been more aptly termed the ‘Bipartisan Non-Budget Act of 2018.’ Notice in the chart below the pickup in economic activity has coincided with a surge in the deficit. Spending on natural disasters and defense spending increases ‘pull forward’ future economic growth which is an illusion of an economic turn.”

Importantly, surges in budget deficits as a percentage of GDP, are normally associated with ‘recessionary’ activity in the economy. As noted, the increases in Federal spending create a temporary boost to economic growth which supports higher asset prices. Currently, the government is running one of the largest deficits, in both dollar terms, and as a percentage of GDP, in history. This is occurring at a time when the economy is ‘booming’ and deficits should be reduced for the next ‘rainy day.’” 

“Furthermore, with sequester-level budget caps returning next year, the budgetary issues in Washington will become even more complicated. The last time budget-caps came into play Ben Bernanke launched QE-3 to offset the economic drag from expected reductions in government spending. However, given the recent track record of the ‘conservative’ Congress, it is highly likely spending will be increased further in the months ahead. Look for an even larger ‘C.R.’ in December when the current resolution runs out.”

Jeff’s point is one that has been made many times previously by others. The basic premise is that as the deficit expands, it will require more debt to be issued. The problem comes when the demand to purchase that debt does not keep up with the supply. Up to this point, America has been fortunate to maintain its role as the world’s reserve currency which means foreign nations hold Treasuries in their reserve accounts. But, as Jeff states, there are many countries now looking for an alternative. The problem for America comes as the status of “reserve currency” diminishes.

I both agree and disagree with Jeff on this point.

I agree that other countries are looking for alternatives to the dollar as a reserve currency. However, there are two primary reasons why this will likely not be a real threat soon:

  1. If you are any other country where are you going to store your reserve currency: China, Russia, India, Brazil, the Eurozone? Many of these economies are corrupt, weak, too small, or a combination of all three.
  2. When global investors are seeking “safety” from “risk,” where are they going to go?

Both of these reasons have the same foundations:

  1. Liquidity: the U.S. Treasury market is vastly deep and can support billions in transactions without a major dislocation.
  2. Safety: despite all of the flaws in the U.S., it is still the safest country in the world to conduct business with. While there are certainly many issues, the “rule of law” in the U.S. still provides a relative level of safety for storing capital not found in other countries.
  3. Return: the rate on U.S. Treasuries is high enough to attract capital from other areas as a “safe” store of value.
  4. Dollar Value: the rising U.S. dollar is attracting capital flows from weaker currencies and economies.

I have repeatedly stated that when the market rout gets bad enough, money will flow into the “safest of havens” – the U.S. Treasury. Over the past month, this is exactly what happened.

“As a result of this pre-deflationary deluge, investors have flooded into bonds and out of stocks, while within equities there were large moves into defensives via energy and tech into staples and utilities. More importantly, this month’s survey found the biggest ever one-month rotation into bonds class as investors dumped equities around the globe while bond allocations rose 23ppt to net 35% underweight….”

Jeff’s premise is that with all of the new debt needing to be issued by the government to fund their ongoing fiscal largesse, there is a risk that “our neighbors” will not be “gracious lenders” in the future. As such, the “dollar funding” issue causes rates to soar higher until “buyers” can be found.

While I am certainly not denying such is indeed the risk. There isn’t a lot of historical precedents that such is the case with a mature, strong, industrialized country. Japan, as an example, is vastly indebted with a soaring budget deficit, weak economic growth, and does not maintain a “reserve” currency status. Yet, after 30-years, interest rates have failed to rise.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth.

Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes, or that rising budget deficits means higher rates.

The real risk to the domestic economy is that Jeff is right.

If interest rates do rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.

Japan, like the U.S., is caught in an on-going “liquidity trap”  where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.

More importantly, while there are many calling for an end of the “Great Bond Bull Market,” this is unlikely the case for two reasons.

  1. As shown in the chart below, interest rates are relative globally. Rates can’t rise in one country while a majority of global economies are pushing low to negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.
  2. Increases in rates also kill economic growth which drags rates lower. Like Japan, every time rates begin to rise, the economy rolls into a recession. The U.S. will face the same challenges. 

Unfortunately, for the current Administration, the reality is that cutting taxes, tariffs, and sharp increases in debt, is unlikely to change the outcome in the U.S. The reason is simply that monetary interventions, and government spending, don’t create organic, sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

Where Are Rates Headed In 2019

So where are rates headed. Dr. Lacy Hunt of Hoisington Investment Management had a good take:

“The U.S. economy appears to be on a steadily declining path to recession and disinflation/deflation. This may seem improbable in the face of record year-over-year growth in nominal GDP over the past decade.

Significantly, U.S. monetary restraint has caused a similar slowdown in local currency money growth around the world. Additionally, velocity in Japan, the Euro area and China has been declining secularly since the late 1990s, as debt has become increasingly less productive. Since money times velocity (i.e. its turnover) determines GDP in all countries, this cumulative global economic slowdown should impact U.S. economic activity.

 From the standpoint of an investment firm that started in 1980, when 30-year bond yields were close to
15%, the current 30-year treasury rate at 3% seems ridiculously low. In the near future, at 1.5%, the 3% yield will seem generous ”

I agree.

Currently, interest rates are at a level that has historically led to some sort of event. Whether it was economic, financial, or both, there is no real precedent which suggests rates could rise another 3% from here without severe ramifications. Of course, as the market declines, the demand for “safety” would ultimately push rates lower.

At some point, the Federal Reserve is going to step back in and reverse their policy back to “Quantitative Easing” and lowering Fed Funds back to the zero bound.

When that occurs, rates will not only go to 1.5%, but closer to Zero, and maybe even negative.

Weekend Reading: Last Chance For Santa Claus

So far, the month of December has sucked.

From Powell to Gundlach, to Trump, and a falling oil prices, there hasn’t been much “holiday cheer…”

However, with the market very oversold, there is still hope that “Santa Claus” could soon appear.

If we take a look back at history, going back to 1957, we find that only a small percentage of the time does the market decline for more than 4-weeks in a row without a reflexive bounce.

The red vertical bars are every 4- or more consecutive negative return weeks as compared to the S&P 500. As you will note in the statistics, out of the total period of time analyzed 57% of weeks are positive versus 43% negative. Notice that “clusters” of 4- or more negative weeks occur around market peaks and bear markets as opposed to bullish market trending periods. The last cluster of periods was during the 2015-2016 correction.

Of the total number of negative weeks, 33% were negative 4- or more weeks consecutively. However, those 4- or more negative weeks only accounted for a 14% of the total periods analyzed.

However, what about the month of December only. The chart below is the same as the chart above but looks at ONLY the months of December.

What we find is that of all the months of December going back to 1957, there have only been 9-December months that posted 4-consecutive negative weeks.

While we are currently 3-weeks into a very brutal month of December, there is still hope of an oversold bounce to “sell” into heading into the new year. There is a case to be made for this as mutual, pension, and hedge funds “dress” their portfolios for year-end reporting. However, January could well see a resumption of pressure as mangers can sell positions with still large gains and defer taxes into 2020.

Given the collapse in oil prices, the sharp rotation into bonds and rising volatility, it is highly likely that any rally over the course of the post-Christmas week should not be taken for granted.

It could well be a “gift” for investors heading into 2019.

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


Most Read On RIA

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“A good player knows when to pick up his marbles. – Anonymous

Questions, comments, suggestions – please email me.

Weekend Reading: Did The Grinch Steal The Christmas Rally?

On Tuesday, we put on a small S&P 500 trading position for an oversold bounce. At first, it didn’t work and we were almost stopped out, but a late day rally kept us in the position.

Wednesday was a different picture as stocks rocketed out of the gate on more “trade talk” news with China, but that rally faded as well heading into late day as the owner of the “National Enquirer” was granted immunity in exchange for details on another Trump-related “hush money” payment.

Yesterday, the markets struggled out of the gate as economic data pointed to slowing rates of inflationary pressure and economic growth, fell into negative territory, and then ended the day flat.

This morning stocks opened down as concerns of global economic weakness rose from China.

So far, the “Santa Rally” has failed to appear and traders are beginning to wonder if they are on the “Naughty List” this year? With all of the rhetoric over trade, White House shenanigans, and weak economic data, it certainly would seem to be the case.

But, it may actually be more of the “Grinch (aka The Fed) That Stole Christmas” this year.

While the Fed’s rate hikes do indeed raise borrowing costs and slow economic growth, it is the extraction of liquidity from the markets which is most important. As shown in the chart below, the Fed is now reducing their flows by $50 billion each month. This is in direct contrast to the billions they were injecting previously which corresponds with the markets decade-long bull market despite weak revenue growth due to a sluggish economic expansion.

But it is no longer just the Fed. On Thursday, the European Central Bank made two important announcements.

  1. They will stop adding to its stock of government and corporate bonds at the end of December, and;
  2. They are seeing signs of weaker inflation and economic growth.

In other words, as world markets are beginning to struggle as the driver of the decade-long bull market is being removed.

But yet, despite the market turmoil this year, which certainly got investors attention, the debate has turned to whether the decline is over or has it just begun?

Dana Lyons had an interesting point earlier this week on the bout of selling.

“Specifically, regardless of the closing performance, the past 4 days have seen the S&P 500 drop at least 1.89% each day on an intra-day basis. That is just the 11th streak of such selling pressure in the S&P 500 going back to 1960, and the first since 2008. If we relax the parameter a bit to 4 straight intraday drops of at least 1.7%, we observe 17 occurrences going back to 1960. Many of them occurred at interesting market junctures.”

“As the chart displays, several of these instances occurred in the direct vicinity of cyclical market bottoms, including 1974, 1982, 1987, 2002 and 2009. That might give bulls some hope that perhaps things have gotten so bad, i.e., rock bottom, that there’s nowhere to go but up. Although, it is probably a stretch to conclude that we are at a cyclical low right now since we were at all-time highs just about 10 weeks ago. And looking back at the chart, we see that some of the other historical events, e.g., 1974, 2001, 2008, occurred during the meat of a bear market and saw stocks just continue to fall further, going ‘subterranean’ if you will.”

I agree with Dana that it is hard to imagine we are at a cyclical low when we were just pegging all-time highs a few short weeks ago. As noted by Barbara Kollmeyer, Jeff Gundlach may have this right:

“DoubleLine founder Jeff Gundlach, who told clients Tuesday evening that the S&P 500 could take out February’s 2018 low due to a growth slowdown hitting company profits.

‘Many equity markets are down over 20%, which some people call a bear market,’ Gundlach said in his latest webcast, according to Reuters. ‘I don’t really define bear markets as a certain fixed arbitrary percentage. I think of it more as mood. And certainly, the setup for the equity markets looked like a bear market going into the middle of this year…the global equity market which is strongly in a bear market at the present time.’

Bottom line, his mood is still bearish, considering he warned us in November that stocks still hadn’t hit a ‘panic low.'” 

While the Fed could certainly reduce, or even eliminate, their rate hike campaign, the extraction of liquidity is a much more problematic issue. Combined with still elevated valuation, weaker economic growth, and declining profit growth, it is highly likely that Lyons and Gundlach are correct in that the S&P 500 has yet to find a lasting bottom.

For now, “we have our stocking hung with care in hopes that Saint Nick will soon be there,” but don’t be surprised if you wind up with a “big lump of coal.”

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


Most Read On RIA


Danielle Dimartino-Booth – Quill Intelligence, LLC

Peter Atwater – Financial Insyghts

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“The market may be bad, but I slept like a baby last night. I woke up every hour and cried. – Anonymous

Questions, comments, suggestions – please email me.

The Bond Rally Was No Surprise

Nathan Vardi recently penned an article for Forbes entitled “Surprise! The Late-Year Bond Rally.”

“In August, Jamie Dimon, CEO of JPMorgan Chase & Co. and the nation’s most prominent banker, predicted the yield on the benchmark 10-year Treasury note could reach 4% in 2018. He cautioned investors to prepare for 5% or higher.

Dimon’s call was not a contrarian one. It had become conventional wisdom on Wall Street that rates were headed higher and that the Federal Reserve would be tightening monetary policy for the foreseeable future.”

Jamie Dimon wasn’t alone. There were many venerable Wall Street veterans from Bill Gross, Paul Tudor Jones, Ray Dalio, and Jeff Gundlach were also calling for higher rates. But, these calls for higher rates and the “End Of The Great Bond Bull Market” have been flowing through the media since 2013.

And that was just from January.

Of course, those headlines are not the first time we have seen such calls made. One of the biggest problems with predictions of rising 10-year bond yields, since “bond bears” came out in earnest in 2013, is they have been consistently wrong. For a bit of history, you can read some of my previous posts on why rates can’t rise in the current environment.

You get the idea.

But what is it the mainstream analysis continues to miss?

Rates Are Low, So They Must Go Up

The general view as to why rates must rise is simply because they are so low. Looking at the chart below, such would certainly make sense.

However, it is important to note that interest rates can remain low for a very long time. The two previous occasions where rates fell below the long-term median they remained there for more than 35-years. We are currently about 8-years into the current evolution.

But here is the important point.

Higher interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time. There have been two previous periods in history that have had the necessary ingredients to support a rising trend of interest rates over a long period of time. The first was during the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan and others were left devastated. It was here that America found its strongest run of economic growth in its history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed.

It is important to note that interest rates are also a function of inflation. Inflation is a byproduct of money supply. This is the subject of an upcoming article forRIA PRO subscribersbut currently it doesn’t appear the Federal Reserve is quite willing, at least not yet, to generate inflation via the printing presses. 

The U.S. is no longer the manufacturing powerhouse it once was, and globalization has sent jobs to the cheapest sources of labor. Technological advances continue to reduce the need for human labor and suppress wages as productivity increases. Today, the number of workers between the ages of 16 and 54 participating in the labor force is near the lowest level relative to that age group since the late 70’s. This is a structural and demographic problem that continues to drag on economic growth as nearly 1/4th of the American population is now dependent on some form of governmental assistance.

These are issues are only going to become worse due to long-term demographic trends not only in the U.S., but globally.

As shown below, the is a correlation between the three major components of the economy (inflation, GDP and wage growth) and the level of interest rates. Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy. When the economy is expanding organically, the demand for capital rises as businesses expand production to meet rising demand. Increased production leads to higher wages which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs. (Currently, we do not have the type of inflation that leads to stronger economic growth, just inflation in the costs of living that saps consumer spending – Rent, Insurance, Health Care)

The chart above is a bit busy, but I wanted you to see the trends in the individual subcomponents of the composite index. The chart below shows only the composite index and the 10-year Treasury rate.

Let’s go back to Jamie Dimon for a moment. He stated that interest rates should be 4% which would align with economic growth rates earlier this year. However, that growth was not driven by organic factors of rising wages but rather a confluence of natural disasters. Furthermore, the increase in deficit spending also helped boost economic growth.

The issue is that the surge in deficit spending, combined with the pick up in short-term demand for construction and manufacturing processes, gave the appearance of economic growth which got both the Federal Reserve and the “bond bears” on the wrong side of the trade.

As I have stated previously, the impacts of these “one-off” inputs into the economy will continue to fade as we move into 2019.

While it is certainly hoped that the current economic expansion can last for years to come, a simple look at the last 40 years of fiscal and monetary policy suggests it won’t.


Because you can’t create economic growth when it is financed by deficit spending, credit, and a reduction in savings.

You can create the “illusion” of growth in the short-term, but the surge in debt reduces both productive investments into, and the output from, the economy. As the economy slows, wages fall, and the consumer is forced to take on more leverage and decrease their savings rate. As a result, of the increased leverage, more of their income is needed to service the debt, which requires them to take on more debt.

Which is exactly what has happened.

(The chart below shows the shortfall between the inflation-adjusted cost of living and what wages and savings will cover. The deficit is the difference that has to be made up with debt every year.)

Given that nearly 70% of current economy is driven by consumption, it only requires small moves higher in interest rates before the negative impact to economic growth is realized as capital flows are reduced. (Since interest rates affect payments, higher rates quickly impact consumption, housing, and investment which ultimately deters economic growth.) 

The problem with most of the forecasts for the end of the “bond bull” is the assumption we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy.

Interest rates, however, are an entirely different matter.

The Next Crisis

Just recently, Janet Yellen discussed the issue of leverage in the economy stating that companies are taking on too much debt and could be in trouble should some unexpected trouble hit the economy or markets.

“Corporate indebtedness is now quite high and I think it’s a danger that if there’s something else that causes a downturn, that high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector.”

Yellen also warned that the debt is being held in instruments similar to ones used to bundle subprime mortgages that led to the financial crisis a decade ago. Importantly, the investment-grade part of the bond market was $3.8 trillion at the end of October which was 6% higher than a year ago, and BBB-rated bonds accounted for 58% of the total,

In other words, with rates rising, economic growth slowing (debt is serviced from revenues), and the health of balance sheets deteriorating (BBB is one notch above “junk”) the risk of an “event-driven” crisis is real. All it will take is a significant decline in asset prices to spark a cascade of events that even monetary interventions may be unable to stem. As stock prices decline:

  • Consumer confidence falls further eroding economic growth
  • The $4 Trillion pension problem is rapidly exposed which will require significant government bailouts.
  • When prices decline enough, margin calls are triggered which creates a liquidation cascade.
  • As prices fall, investors and consumers both contract further pushing the economy further into recession.
  • Aging baby-boomers, which are vastly under-saved will become primarily dependent on social welfare which erodes long-term economic growth rates.

With the Fed tightening monetary policy, and an errant Administration fighting a battle it can’t win, the timing of the next recession has likely been advanced by several months.

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

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

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

But most importantly, that is how interest rates remain low for a very long-time.

While there is little left for interest rates to fall in the current environment, there is no ability for rates to rise before you push the economy back into recession. Of course, you don’t have to look much further than Japan for a clear example of what I mean.

The “bond rally” was no surprise.

Weekend Reading: Which Yield Curve Really Matters?

So, have you heard the one about the “flattening yield curve?”

It almost sounds like the start of a bad joke because there have been so many discussions during this past year on it. However, it has been largely dismissed under the “this time is different” scenario as trailing economic data has remained strong and the recent stock market struggles are believed to only be temporary.

As I discussed yesterday, however, it is quite likely the message being sent by the bond market should not be dismissed. Bonds are important for their predictive qualities which is why analysts pay an enormous amount of attention to U.S. government bonds, specifically to the difference in their interest rates. This data has a high historical correlation to where the economy, stock, and bond markets are generally headed in the longer-term. This is because volatile oil prices, trade tensions, political uncertainty, the strength of the dollar, credit risk, earnings strength, etc., all of which gets reflected in the bond market and, ultimately, the yield curve.

But which yield curve really matters?

It depends on whom you ask?

“The rate on the 2-year has already jumped above the shorter-term 5-year note, a move that suggests the ‘economy is poised to weaken,’ DoubleLine Capital’s Jeffrey Gundlach told Reuters in an interview on Tuesday. Gundlach, a noted bond investor, has been warning investors to be cautious.” – CNBC

“Michael Darda, the chief economist at MKM Partners, says people may be too focused on the wrong data. ‘Recession forecasting is fraught with difficulty, so it’s important that we don’t make it more difficult than it has to be by focusing on the wrong indicators, or, at a minimum, less reliable one. It is the difference between the 10-year and the 1-year that everyone should worry about.” – CNBC

“While inversions have been reliable recession indicators in the past, the most important relationship — between the 3-month and 10-year government notes — is not inverted and thus hasn’t triggered the likelihood of a contraction ahead.” – CNBC

Wait, so which is it?

My answer is a bit different. When I am looking at technical indicators for the market it is not just “one” signal I am looking at, but several. The reason is that sometimes a single indicator can provide a “false” signal.

For example, the 200-dma has had several violations which did NOT lead to bigger declines. Therefore, there have been numerous articles questioning the efficacy of that moving average as an indicator. However, if you combine the 200-dma with a couple of other indicators to “confirm” the signal being sent, then some of the false readings can be removed.

This same premise applies to the yield curve.

While the 3-5 yield spread is currently in negative territory, it has not been confirmed by other yield spreads across the spectrum. As shown in the chart below, the best signals of a recessionary onset have occurred when a bulk of the yield spreads have gone negative simultaneously. However, even then, it was several months before the economy actually slipped into recession.

However, as I addressed previously, as with all measures, technical or otherwise, it is the trend of the data which is more important to your outlook than the actual number itself.

It is correct that the longer-dated yield curve has not turned negative as of yet.  However, the market is already beginning to adjust to the reality the economy is beginning to weaken, earnings are at risk, valuations are elevated, and the support from Central Banks has now reversed.

So, which one am I watching?

All of them. 

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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“Successful investing is anticipating the anticipation of others. – John Maynard Keynes

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Misdiagnosing The Risk Of Margin Debt

This past week, Mark Hulbert wrote an article discussing the recent drop in margin debt. To wit:

“Plunging margin debt may not doom the bull market after all, reports to the contrary notwithstanding.

Margin debt is the total amount investors borrow to purchase stocks, which historically has risen during bull markets and fallen during bear markets. This total fell more than 6% in October, according to a report last week from FINRA. We won’t know the November total until later in December, though I wouldn’t be surprised if it falls even further.

A number of the bearish advisers I monitor are basing their pessimism at least in part on this plunge in margin. It’s easy to see why: October’s sharp drop brought margin debt below its 12-month moving average. (See accompanying chart.)”

“According to research conducted in the 1970s by Norman Fosback, then the president of the Institute for Econometric Research, there is an 85% probability that a bull market is in progress when margin debt is above its 12-month moving average, in contrast to just a 41% probability when it’s below.

Why, then, do I suggest not becoming overly pessimistic? For several reasons:

1) The margin debt indicator issues many false signals
2) There is insufficient data
3) Margin debt is a strong coincident indicator.”

I disagree with Mark on several points.

First, margin debt is not a technical indicator which can be used to trade markets. Margin debt is the “gasoline,” which as Mark correctly states, drives markets higher as the leverage provides for the additional purchasing power of assets. However, that “leverage” also works in reverse as it provides the accelerant for larger declines as lenders “force” the sale of assets to cover credit lines without regard to the borrower’s position.

That last sentence is the most important. The issue with margin debt, in particular, is that the unwinding of leverage is NOT at the investor’s discretion. It is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) When lenders fear they may not be able to recoup their credit-lines, they force the borrower to either put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen all at once as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

It is when an “event” causes lenders to “panic” that margin becomes problematic. As I discussed just recently:

“If the such a decline triggers a 20% fall from the peak, which is around 2340 currently, broker-dealers are likely going to start tightening up margin requirements and requiring coverage of outstanding margin lines.

This is just a guess…it could be at any point at which “credit-risk” becomes a concern. The important point is that “when” it occurs, it will start a “liquidation cycle” as “margin calls” trigger more selling which leads to more margin calls. This cycle will continue until the liquidation process is complete.

The last time we saw such an event was here:”

Importantly, note in the chart above, the market had two declines early in 2008 which “reduced” margin debt but did NOT trigger “margin calls.” That event occurred when Lehman Brothers was forced into bankruptcy and concerns over counter-party risk caused banks to cut their “risk exposure” dramatically.

Like early 2008, the recent declines have not sparked any real semblance of “fear.” The VIX, Interest Rates, and Gold have yet to demonstrate that a change from “complacency” to “fear” has occurred.

Mark’s second point was a lack of data. This isn’t actually the case as margin debt has been tracked back to 1959. However, for clarity, let’s just start with data back to 1980. The chart below tracks two things:

  1. The actual level of margin debt, and;
  2. The level of “free cash” balances which is the difference between cash and borrowed funds (net cash).

What is immediately recognizable is that reversions of negative “free cash” balances has led to serious implications for the stock market. With negative free cash balances still at historically high levels, a full mean reverting event would coincide with a potentially disastrous decline in asset prices as investors are forced to liquidate holdings to meet “margin calls.”

The relationship between cash balances and the market is better illustrated in the next chart. I have inverted free cash balances so the relationship between increases in margin debt and the market. It is not hard to imagine what a reversion to positive cash balances would do to the stock market.

As stated, the data goes back to 1959. However, prior to 1980 margin debt, along with every other form of debt, was not widely utilized both due to high borrowing costs and a “post-depression era” mentality about debt. Nonetheless, the chart below tracks the percentage growth in debt relative to the S&P 500 (both have been adjusted for inflation).

The next chart is the same as above but is only from 1959-1987 so you can more clearly visualize the impact of margin debt on asset prices.

(Most people have forgotten there were three back-t0-back bear markets in 1960’s-1970’s as interest rates were spiking higher. The 1974 bear market was the one that simply wiped everyone out!)

Again, what we find is a correlation between asset prices and margin debt. When margin growth occurs extremely quickly, which coincides with more extreme investor exuberance, corresponding unwinds of the debt has been brutal.

Let’s go back to Mark’s original discussion with respect to the 12-month average. If we take a longer-term look at the data we find that breaks of the 12-month moving average has provided a decent signal to reduce equity risk in portfolios (blue highlights). Yes, as with any indicator, there are times that it doesn’t work (purple highlights). However, more often than not, reducing equity risk when the 12-month moving average was broken saved you when it counted the most.

It’s All Coincident

Mark is absolutely correct that “margin debt” is a “coincident” indicator. Such should not be surprising since rising levels of margin debt are considered to be a measure of investor confidence. Investors are more willing to take out debt against investments when shares are rising and they have more value in their portfolios to borrow against. However, the opposite is also true as falling asset prices reduce the amount of credit available and assets must be sold to bring the account back into balance.

I both agree, and disagree, with the idea that margin debt levels are simply a function of market activity and have no bearing on the outcome of the market.

By itself, margin debt is inert.

Investors can leverage their existing portfolios and increase buying power to participate in rising markets. While “this time could certainly be different,” the reality is that leverage of this magnitude is “gasoline waiting on a match.”

When an event eventually occurs, it creates a rush to liquidate holdings. The subsequent decline in prices eventually reaches a point which triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying “collateral,” the forced sale of assets will reduce the value of the collateral further triggering further margin calls. Those margin calls will trigger more selling forcing more margin calls, so forth and so on.

Given the lack of “fear” shown by investors during the recent decline, it is unlikely that the recent drop in margin debt is a function of “forced liquidations.” As I noted above, it will likely take a correction of more than 20%, or a “credit related” event, which sparks broker-dealer concerns about repayment of their credit lines.

The risk to the market is “when” those “margin calls” are made.

It is not the rising level of debt that is the problem, it is the decline which marks peaks in both market and economic expansions.

Currently, the “bullish bias” remains intact and the recent volatility in the market has not shaken investors loose as of yet. Therefore, it is certainly understandable why so many are suggesting you should ignore the recent drop in margin debt.

But history suggests you probably shouldn’t.

Weekend Reading: The Powell Put

All it took was two 10% stock market corrections in a single year and some heavy “browbeating” from President Trump to reverse Jerome Powell’s hawkish stance on hiking interest rates.

On Wednesday, Powell took to the microphone to give the markets what they have been longing for – the “Powell Put.” During his speech, Powell took to a different tone than seen previously and specifically when he stated that current rates are “just below” the range of estimates for a “neutral rate.” This is a sharply different tone than seen previously when he suggested that a “neutral rate” was still a long way off.

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

Such will also correspond with a drop in inflationary pressures, as we noted previously, which is already occurring with the drop in energy prices.

More importantly, falling oil prices are going to put the Fed in a very tough position in the next couple of months as the expected surge in inflationary pressures, in order to justify higher rates, once again fails to appear. The chart below shows breakeven 5-year and 10-year inflation rates versus oil prices.”

But here was the key comment that suggests the recent blasting by President Trump hit home:

Powell says moving too fast would risk shortening U.S. expansion, moving too slow could risk higher inflation and destabilizing financial imbalances.”

President Trump has been adamant that Powell’s aggressiveness was jeopardizing the economic recovery.

More interesting was when Powell reiterated they see no major asset class, however, where valuations appear far in excess of standard benchmarks” 

I am not sure which benchmarks the Fed looks at exactly.

The real risk to the market is not valuations at historically high levels by virtually every measure, but rather the risk of a credit related event due to the impact of higher rates on an abundance of lower-rated corporate debt.

Nonetheless, in the short-term, the “bulls” got their Christmas wish as noted by Bloomberg economists

“Tim Mahedy and Yelena Shulyatyeva:

‘Powell’s comment that rates are just below neutral is a step back from his comments earlier in the fall implying the FOMC still has a ways to go. This could be the first sign that the pace of rate hikes is set to slow next year.’

However, not all economists got the same dovish message as noted by Greg Robb via Marketwatch.

“I really don’t think he was dovish, not really. He didn’t say inflation was weaker or the economy was weaker than we thought. It is a bit of a market overreaction.” -Paul Ashworth, chief U.S. economist at Capital Economics.

“The Fed has said they wanted to go above neutral. If they wanted to be neutral, they could have walked that back. He gave no hint of a pause in December.” – Avery Shenfeld, chief economist at CIBC

All the “bulls” need now is for President Trump to “cave in” on his demands on China, a problem he created in the first place, at this weekends G-20 summit. I would expect a deal that is well short of any original objective as China agrees to issues which are economically unimportant to them. However, such will “look like a win” for the Trump administration and should clear the way for “Santa to visit Broad and Wall.” 

After that, it’s anyone’s guess, but the real issues plaguing the economy and the markets have not been resolved.

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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There is nothing like price to change sentiment. – Helene Meisler

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Weekend Reading: Why This Isn’t “THE” Bear Market…Yet

After two significant corrections during 2018, this has to be the beginning of a “bear market,” right?

It certainly is possible given the headwinds that are starting to weigh on corporate outlooks such as ongoing trade wars, weaker revenue growth, a strong dollar, and higher interest rates. However, despite these concerns, there are three things which suggest the necessary psychological change for a more meaningful “mean reverting” event has yet to occur.

Interest Rates

During previous market declines, where “fear” was a prevalent factor among investors, money rotated from “risk” to “safety” which pushed Treasury bond prices higher and rates lower. Despite two fairly strong corrections in 2018, bonds have not attracted the “flight to safety” as investors remain complacent about the future prospects of the market.


A look at the Volatility Index (VIX) confirms the same as the bond market. Despite the two corrections, the VIX never spiked to levels consistent with “fear” that a correction was in process. Currently, the VIX remains below the average level of the index going back to 1995 and during the “October massacre” failed to even rise above the level seen in February of this year.


Another “fear trade” which has failed to show any fear is that precious yellow metal. Again, despite two major corrections, gold has failed to find buyers in a “safe haven” trade. In fact, despite consistent calls that gold was needed to offset inflation, it has failed to find any support from investors who continue to chase market returns.

Here is the point – the pickup in volatility this year should have dislodged investors out of their “passive investment slumber.” Yet, there is no anecdotal evidence that such has been the case. There are two possible outcomes from this current situation:

  1. The majority of investors are correct in assuming the two recent corrections are just that and the bull market will resume its bullish trajectory, or;
  2. Investors have misread the corrections this year and have simply not yet lost enough capital to spark the flight to safety rotations.

Historically speaking, the “herd” tends to be right in the middle of the advance at very wrong at the major turning points.

There is mounting evidence that we may indeed be at the beginning of one of those turning points in the market. If that is the case, investors are likely going to find themselves once again on the wrong side of history.

The “real” bear market hasn’t started yet. When it does we will likely see traditional “safe haven” investments telling us so. It will be worth watching gold and rates for clues as to when the masses begin to realize that “this time is indeed different.” 

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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 Interview with Mike “Mish” Shedlock

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Treat their incessant optimism, in the future, with skepticism. Watch what they do not what they say.” – Doug Kass

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Weekend Reading: American Gridlock & Why Mid-Terms Don’t Matter

With some bit of relief, I am glad to see the mid-term elections now behind us as another cloud of uncertainty is removed. However, in reality, I suspect the outcome of the elections will have much less impact on the markets than most currently think.

Barbara Kollmeyer penned a note earlier this week for MarketWatch:

“For financial markets, one takeaway mattered above all others in the midterm election—no curveballs.

And that’s basically what was delivered as pundits who got it so wrong in 2016, correctly forecast the end of one-party rule this time. With Dems calling the shots in the House, we could see no end to investigations, subpoenas and possibly impeachment talk and a hard push for POTUS to cough up those tax returns.

All that may slow down President Donald Trump’s MAGA plans.”

While that is entirely true, I think the markets are going to quickly look past the now “gridlocked” Congress to the more important drivers of the market – earnings and share buybacks.

As I noted in yesterday’s missive on rising headwinds to the market, earnings expectations have already started to get markedly ratcheted down for the end of 2019.

More importantly, beginning in 2019, the quarterly rate of change in earnings will drop markedly and head back towards the expected rate of real economic growth. (Note: these estimates are as of 11/1/18 from S&P and are still too high relative to expected future growth. Expect estimates to continue to decline which allow for continued high levels of estimate “beat” rates.)

So, really, despite all of the excitement over the outcome of the mid-terms, such is really unlikely to mean much going forward. The bigger issue to focus on will be the ongoing impact of rising interest rates on major drivers of debt-driven consumption such as housing and auto sales. Combine that with a late stage economic cycle colliding with a Central Bank bent on removing accommodation and you have a potentially toxic brew for a much weaker outcome than currently expected.

Of course, the one thing that a “gridlocked” Congress can likely agree on is “more spending.” While there will likely not be any funding approved for “boarder walls,” immigration reform, or further defense spending, they can probably reach an agreement for an “infrastructure spending” bill. The problem, as President Obama found out when he tried it, is that:

“Shovel ready jobs weren’t all the shovel ready.” 

Furthermore, most of the things that will likely be funded are “pet projects” from Congressional members which have very low returns on investment. As Woody Brock wrote in his book “American Gridlock:” 

“Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures, but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the ‘deficit’ over time.”

There is no disagreement about the need for government spending. The disagreement is with the abuse, and waste, of it.

Keynes’ was correct in his theory. In order for government “deficit” spending to be effective, the “payback” from investments being made through debt must yield a higher rate of return than the debt used to fund it.

The problem, as noted by Dr. Brock, is that government spending has shifted away from productive investments, like the Hoover Dam, that create jobs (infrastructure and development) to primarily social welfare, defense and debt service which has a negative rate of return.  According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending. 

In other words, the U.S. is “Country A.” 

As Dr. Brock aptly stated in his speech:

“Today we are borrowing our children’s future with debt. We are witnessing the ‘hosing’ of the young.’”

So, yes, the markets may love a “gridlocked Congress” as the restriction of “Trumponomics” will remove some of the daily angsts. However, longer-term, the trend of spending, deficits, and demographics will continue to weigh heavily on American prosperity.

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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Exclusive Interview: Peter Boockvar

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“Stupidity has a knack of getting its way.” – Albert Camus

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Weekend Reading: October Exposed The Passive Problem

I have written about the “problem with passive” previously which mostly fell on “deaf ears.” Such should not be surprising after one of the longest advances in market history with virtually no volatility in 2017.

However, as they say, “payback is a bitch.”

This year started off with a January rush higher followed immediately by a 2-week sell-off that wiped out the entire advance. But then it was over, and the market began to stair step higher ultimately reaching all-time highs.

Once again, the “buy and hold” and “passive indexing” mantras were seemingly proved right.

And then the month of October arrived and stocks plunged more in one month (-7.4%) as compared to the decline from the closing highs in January to the lows of March (-6.5%).  (As noted, it is important that November musters a fairly strong rally to keep the monthly MACD sell signal from triggering. Such would denote a much more negative backdrop for stocks in the months ahead.)

Over the last couple of months, we have repeatedly warned our readers that a pickup in volatility in October was highly likely due to the strong advances made by the markets during the preceding summer months. At the beginning of September I penned:

“However, there are plenty of warning signs that the “good times” are nearing their end, which will likely surprise most everyone.”

Then I reiterated that point two weeks later. To wit:

“While we are long-biased in our portfolios currently, such doesn’t remain there is no risk to portfolios currently. With ongoing “trade war” rhetoric, political intrigue at the White House, and interest rates pushing back up to 3%, there is much which could spook the markets over the next 45-days.”

The chart below only shows months where the market lost more than 5%. You will notice clusters of losses during the centers of major bear markets such as 1974, 2000, and 2008.

So, with October behind us, the market should march back to all-time highs. Right? Maybe not, as this time is not like last time.

  • The Fed is hiking rates versus either lowering or keeping them at zero.
  • The Fed is reducing rather than increasing their balance sheet.
  • The current Administration is insisting on a “trade war” which slows global growth.
  • The economic cycle is mature rather than recovering.
  • Record levels of debt at risk of rising rates versus a re-leveraging cycle with ultra-low rates.
  • A mature housing, auto, and consumption cycle versus a recovery.
  • Global central bank interventions have begun to taper versus expansion
  • Peak earnings growth versus expansion
  • Peak valuations versus expanding valuations

While the sell-off this past month was not particularly unusual, it was the break of material levels of support which was different. Furthermore, the uniformity of the price moves revealed the fallacy “passive investing” as investors headed for the door all at the same time. Such a uniform sell-off is indicative of what we have been warning about for the last several months and should serve as a warning.

“With everyone crowded into the ‘ETF Theater,’ the ‘exit’ problem should be of serious concern. Unfortunately, for most investors, they are likely stuck at the very back of the theater.

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your ‘risk exposure’ will likely not have the desired end result you have been promised.

As I stated often, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered ‘bearish’ to point out the potential ‘risks’ that could lead to rapid capital destruction; then I guess you can call me a ‘bear.’ 

Just make sure you understand I am still in ‘theater,’ I am just moving much closer to the ‘exit.’”

Despite the best of intentions, individual investors are NOT passive even though they are investing in “passive” vehicles. When these market swoons begin, the rush to liquidate entire baskets of stocks accelerate the decline making sell offs much more violent than what we have seen in the past.

This concentration of risk, lack of liquidity, and a market increasingly driven by “robot trading algorithms,”  reversals are no longer a slow and methodical process but rather a stampede with little regard to price, valuation, or fundamental measures as the exit becomes very narrow.

October was just a “sampling” of what will happen to the markets when the next bear market begins.

Oh, I almost forgot, the other problem with the whole “passive investing” mantra is that “getting back to even” is not a successful investment strategy to begin with.


Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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“You get recessions, you get stock market declines. If you don’t understand that’s going to happen, then you are not ready and you will not do well in the markets” – Peter Lynch

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Weekend Reading: Recession Risk Rising

In yesterday’s post, we discussed the importance of the S&P 500 as a leading indicator of recessions in the U.S.

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are “best guesses” about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

My friend David Stockman from Stockman’s ContraCorner (a must-read site) sent me an email on Thursday morning stating:

“On your topic of today regarding recession recognition, here’s another point about after-the-fact revisions. NF payrolls were revised down by about 500,000 per month during the September-February 2008 plunge:”

The point here is that while CURRENT economic data points are positive, there are numerous ancillary data points which suggest the economy is already weakening. My colleague, Richard Rosso, sent me this note on the Fed’s alternative GDP calculation called GDP Plus:

“GDPplus is the Federal Reserve Bank of Philadelphia’s measure of the quarter-over-quarter rate of growth of real output in continuously compounded annualized percentage points. It improves on the Bureau of Economic Analysis’s expenditure-side and income-side measures.  Currently, it is showing GDP at 4.0% annual growth with both GDI and GDP-Plus running at 2.0% or less.”

Historically, when GDP has deviated above both GDP-Plus and GDI, GDP has eventually “caught-down” with the rest of the data. 

Currently, it is currently believed that the U.S. can remain an island of economic growth in a world struggling with weakness. As shown in the Ned Davis Research chart below, recession risk on a global scale has now surged above 70.

What does that mean?

“Readings above 70 have found us in recession 92.11% of the time (1970 to present).  Several months ago, the model score stood at 61.3.  It has just moved to 80.04.  Expect a global recession.  It either has begun or will begin shortly.  Though no guarantee, as 7.89% of the time since 1970 when the global economic indicators that make up this model were above 70, a recession did not occur.”Stephen Blumenthal

As we discussed yesterday, the dynamics of the market have now changed in a manner which suggests that “something has broken” in both the outlook for the economy and earnings.

While we have had corrections in the past, those corrections have not violated important long-term trends which have remained solidly intact since the 2009 lows. However, this past week, those violations began to occur. Over the long-term, trends are important to consider. The chart below shows the market versus a 75-week moving average. During bullish trends, the market trades above that average. During bearish trends, it’s the opposite.

With the market starting to violate that long-term support, it is worth paying attention to the risk of the market currently.

However, this does not mean you should “panic sell” the market currently. So far, this has been an expected, while painful, pickup in volatility as we discussed in our weekly missives. Most importantly, while the risks of a more meaningful mean reversion are rising, the market does not historically go straight up or down. Therefore, the change of the market’s tone from bullish to bearish does change the trading backdrop from buying dips to selling rallies.

Use rallies to reduce risk, rebalance portfolios, and raise cash for whatever happens next. If the market stabilizes, there are lots of great companies on “sale” currently. If the market declines further, you will appreciate the reduced volatility. 

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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  • Is The Market Predicting A Recession? by Lance Roberts
  • Higher Rates Are Crushing Investors by Michael Lebowitz
  • The #MAGA Market Trendline Is Broken by Jesse Colombo
  • An Open Letter To Larry Kudlow by Doug Kass
  • Average Stock Is Overvalued: Between Tremendously & Enormously by Vitaliy Katsenelson
  • Fed’s Survey Of Economic Un-Well Being by Richard Rosso
  • An Investor’s Desktop Guide To Trading by Lance Roberts

Research / Interesting Reads

“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected..” – George Soros

Questions, comments, suggestions – please email me.

Weekend Reading: Tax Cuts Saved The Economy?

IBD recently penned an article touting the success of the recent tax cuts from the Trump administration.

“The Treasury Department reported this week that individual income tax collections for FY 2018 totaled $1.7 trillion. That’s up $14 billion from fiscal 2017, and an all-time high. And that’s despite the fact that individual income tax rates got a significant cut this year as part of President Donald Trump’s tax reform plan.”

Hold on a second.

A $14 billion increase on $1.68 Trillion in receipts is a very paltry 0.8% increase. This is the 8th LOWEST rate of increase in the history of data and is more representative of population growth rather than the success of tax cuts bringing in more revenue.

In fact, when looking at Federal Receipts on an annualized basis, growth in receipts as of the end of Q2 has fallen by more than 4% annually. Importantly, throughout history, negative growth rates in Federal receipts have been associated with recessionary periods in the economy rather than expansions.

But IBD in their effort to support the Trump tax cuts continues:

“Critics of the Trump tax cuts said they would blow a hole in the deficit. Yet individual income taxes climbed 6% in the just-ended fiscal year 2018, as the economy grew faster and created more jobs than expected.”

Well first, as we have shown previously, the tax cuts DID INDEED blow a hole in the deficit. Currently, the deficit is rapidly approaching $1 Trillion and will exceed that level in 2019.

To IBD’s point, the economy has grown faster than expected and jobs have increased (but not more than expected.)

“Yes, the economy was booming in fiscal 2018. But it probably wouldn’t have been booming without the tax cuts.

Actually, no.

It wasn’t Trump’s tax cuts that led to this growth but, as we discussed recently with Danielle Dimartino-Booth, it came from a “sugar-high” created by 3-massive Hurricanes in 2017 which have required billions in monetary stimulus, created jobs in manufacturing and construction, and led to an economic lift. We saw the same following the Hurricanes in 2012 as well.

However, these “sugar highs” are temporary in nature. Fortunately, for the economic bulls, a bit of reprieve has come from Hurricanes Florence and Michael which will provide some continued boost to economic growth into Q2 of 2019.

The problem is the massive surge in unbridled deficit spending which provides a temporary illusion of economic growth but leads to long-term economic suppression.

Eventually, the debt will come due.

So, while IBD is taking a victory lap touting the success of the Trump agenda, the reality is that the pro-growth policies were launched to late within an economic cycle. This will ultimately ensure the next recessionary drag will likely be larger and last longer than most expect as both fiscal and monetary policy tools were spent during the boom, rather than saved for an eventual “rainy day.”

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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Research / Interesting Reads

Every once in a while, the market does something so stupid it takes your breath away.” – Jim Cramer

Questions, comments, suggestions – please email me.

Weekend Reading: We Are All In….Again!

Despite the recent angst in the market over increasing interest rates, there has been little evidence of concern by investors overall. A recent report showed that investors have the LEAST amount of cash in their investment accounts…EVER.

“Individual investors drew down cash balances at brokerage accounts to record lows as the S&P 500 surged 7.2 percent in the three months ended Friday.

Cash as a percentage of assets among Charles Schwab Corp. clients in August fell to 10.4 percent, matching the level in January that marked the lowest since at least 2004.”

Of course, eight months ago the markets suffered a 10.4% decline just as investors scrambled to “get in.”

The monthly survey from the American Association of Individual Investors shows the same. Individuals are carrying some of the highest levels in history of equities, are reducing their exposure to bonds, and carrying very low levels of cash.

As Dana Lyons recently noted:

” From the Federal Reserve’s Z.1 release, we find that U.S. Households had a reported 34.3% of their financial assets invested in the equity market as of the 2nd quarter. Outside of a slightly higher reading in the 4th quarter of 2017, that is the highest level of stock investment in the 70-plus year history of the series, other than the 1999-2000 bubble top.”

Investors are once again….“all in.”

And the market once again tumbled. 

The one thing we know for sure is that individual investors do exactly the opposite of what they should when it comes to investing – “buy high” and “sell low.” 

Households have repeatedly learned, and then subsequently forgotten, this lesson repeatedly over the entirety of the financial market history.

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

The reality is that the majority of investors are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high, risk is dismissed for chasing returns, and value is displaced by momentum.

The recent sell-off was NOT the impact event. That event is still coming, and the discussion of why “this time is not like the last time” remains largely irrelevant. Whatever gains that investors garner in the between now and that next event by chasing the “bullish thesis” will largely be wiped away in the swift and brutal downdraft. The routs in February and October are only early warnings of how swift and brutal the actual event will be.

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

You can do better.

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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Research / Interesting Reads

“Investors always decide to do the same thing, at the same time, and it is usually the wrong thing.” – T.R. Roberts.

Questions, comments, suggestions – please email me.

Weekend Reading: Are Dividends Telling Us Something?

Earlier this week, Eddy Elfenbein has an interesting post discussing the “Bull Market In Dividends.” 

“For the third quarter, dividends from the S&P 500 grew by 10.96%. That’s the strongest growth rate in more than three years. It’s the 34th quarter in a row of dividend growth.

Over the last eight years, dividends are up 234%, which is pretty close to what the S&P 500 price index has done.

Considering how simple it is, the S&P 500 has tracked a 2% dividend yield fairly closely for the last several years.”

It is an interesting point particularly when you consider that there are a lot of dividends which have been “financed” through “cheap debt.” There is also the issue of record debt issuance by companies with marginal balance sheets at best or are walking “zombies” at worst.

As John Coumarionos noted earlier this week.

“Low interest rates have allowed companies that would have otherwise gone out of business to stay alive, and this has caused a tepid recovery. Chancellor notes the cumulative default rate on junk bonds during the entire recession was 17%, or “around half the level of the two previous downturns.” And while central bankers might view this as a victory, he views it as the cause of economic weakness.

The lessons for investors are to remain vigilant about stock valuations and higher yielding bonds. At some point, the zombies will not be able to sustain themselves any longer.”

This is an interesting point when you begin to think about the long-term history of dividends and what they represent with respect to long-term market cycles.

Let’s start with the notion that “dividends always increase.”

First, the statement is incorrect because during market reversion “cash dividends” DO NOT increase – but the YIELD does because of the collapse in prices. 

But, more to the point, that notion is only true, until it isn’t.

During the 2008 financial crisis, more than 140 companies decreased or eliminated their dividends to shareholders. Yes, many of those companies were major banks, however, leading up to the financial crisis there were many individuals holding large allocations to banks for the income stream their dividends generated. In hindsight, that was not such a good idea.

But it wasn’t just 2008. It also occurred bust in 2000. In both periods, while investors lost roughly 50% of their capital, dividends were also cut on average of 12%.

Of course, it wasn’t EVERY company cutting dividends by 12%. Some didn’t. Many did, and some even eliminated their dividends entirely to protect creditors. The last point is the most important. For any company shareholders are a secondary concern. However, access to the debt market is a far more important consideration when it comes to financial decision making, who gets paid, and who doesn’t.

Since 2009, due to the Federal Reserve’s suppression of interest rates, investors have piled into dividend yielding equities, regardless of fundamentals, due to the belief “there is no alternative.” The resulting “dividend chase” has pushed the valuations of dividend yielding companies to excessive levels disregarding underlying fundamental weakness. 

As with the “Nifty Fifty” heading into the 1970’s, the resulting outcome for investors was less than favorable. These periods are not isolated events. There is a high correlation between declines in asset prices and the actual dividends being paid out throughout history. The chart below shows the history of inflation-adjusted dividends and the S&P 500 going back to 1900. (Data courtesy of Dr. Robert Shiller.)

The first thing to note is the extreme deviation of real annual dividends above their long-term linear growth trend. As you will notice is that such extensions have ALWAYS mean reverted throughout history. (In other words, the best time to BUY dividend yielding companies is when the dividend has deviated well below the long-term growth trend.)

Here is another way to look at the same data. The chart below shows the percentage deviation above and below the 5-year average annual cash dividend. There are two things you should take note of.

  1. When deviations have exceeded a 20% deviation it has denoted very overvalued markets.
  2. Reversions below the 5-year average have been coincident with secular bear markets. 

Notice that the current deviation from the 5-year average has already started to decline which is coincident with the Federal Reserve rate hike campaign. Given that much of the dividend issuance was done through cheap debt over the last decade, it is not surprising that with rising rates, the rate of dividend issuances has begun to slow.

Dividends may well already be telling us of a more troubling trend for investors is coming. 

While I completely agree that investors should own companies that pay dividends (as it is a significant portion of long-term total returns)it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress. During the next major market reversion, we will see much of the same happen again.

It is during these times when prices collapse, and dividends are slashed, the “I bought it for the dividend plan” doesn’t work out.

EVERY investor has a point, when prices fall far enough, that regardless of the dividend being paid, they WILL capitulate and sell the position. This point generally comes when dividends have been cut and capital destruction has been maximized.

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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Research / Interesting Reads

“Any fool can buy a stock. It takes a smart investor to know when to sell.” – Anonymous

Questions, comments, suggestions – please email me.

Weekend Reading: Fiscal Irresponsibility

Without much fanfare or public discussion, Congress has decided to push the U.S. into deeper fiscal responsibility. Earlier this week, the House passed another Continuing Resolution (CR) to keep the government from “shutting down” prior to the mid-term elections.

“The House on Wednesday passed an $854 billion spending bill to avert an October shutdown, funding large swaths of the government while pushing the funding deadline for others until Dec. 7.

The bill passed by 361-61, a week after the Senate passed an identical measure by a vote of 93-7.”

For almost a decade, Congress has failed to pass, and operate, underneath a budget. Of course, without any repercussions from voters in demanding that Congress “does their job,” the path to fiscal insolvency continues to grow.

The Committee For A Responsible Federal Budget made the following statement:

“We’re pleased policymakers have likely avoided a shutdown and actually appropriated most of this year’s discretionary budget on time. But let’s not forgot that Congress did so without a budget and had to grease the wheels with $153 billion to pass these bills. That isn’t function; it’s a fiscal free-for-all.”

Of course, with trillion-dollar deficits just around the corner, the negative impact from unbridled spending and debt increases will begin to reverse the positive effects from deregulation and tax reform.

The bigger problem with the $854 billion CR just passed by the House, and awaiting the President’s signature, is that it only covers spending from now until December. Such means that by the time we get the full 2019 budget funded, with the annual automatic increases still in place, we will be looking at more than $2 Trillion in annual spending. Such will require further increases in debt issuance at a time when there are potentially fewer buys of Treasuries readily available.

As shown in the chart below, with the major Central Banks reducing their balance sheets simultaneously, some of the more major buyers are being removed from the market.

“Central bank balance sheets have shrunk by over half-a-trillion dollars since March. This decrease in global liquidity – in the face of a global slowdown – raises the risk of policy mistakes much higher than is commonly assumed.” – ECRI

More importantly, next year, sequester-level budget caps will return. The last time budget-caps came into play Ben Bernanke launched QE-3 to offset the economic drag from reduced government spending. Given Central Banks are effectively “out of the game” for now, it is most likely Congress will just bust the budget and then spin it as a “Conservative victory” as they did this year.

As the Committee for a Responsible Federal Budget previously stated:

  • Debt Is Rising Unsustainably
  • Spending Is Growing Faster Than Revenue
  • Recent Legislation Will Substantially Worsen the Long-Term Outlook if Extended. 
  • High And Rising Debt Will Have Adverse and Potentially Dangerous Consequences (Will lead to another financial crisis.)
  • Major Trust Funds Are Headed Toward Insolvency. 
  • Fixing the Debt Will Get Harder the Longer Policymakers Wait. 

While the CRFB suggests that lawmakers need to work together to address this bleak fiscal picture now so problems do not compound any further, there is little hope that such will actually be the case given the deep partisanship currently running the country.

As I have stated before, choices will have to be made either by choice or force.

The CRFB agrees with my assessment.

“CBO continues to remind us what we’ve known for a while and seem to be ignoring: the federal budget is on an unsustainable course, particularly over the long term. If policymakers make the tough decisions now – rather than wait until there’s a crisis point for action – the solutions will be fairer and less painful.”

Just something to think about as you catch up on your weekend reading list.

Economy, 2008 & Fed


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Research / Interesting Reads

“There is only one side to the stock market, and it is not the bull side or the bear side, but the right side.” – Jesse Livermore

Questions, comments, suggestions – please email me.

Weekend Reading: What’s The Magic “Yield” Number?

An interesting thing has begun to occur in the market which is more a symptom of exuberance than prudence as there seems to be nothing that can derail the market advance to new highs. However, as Doug Kass noted recently in his diary, the ingredients to shock market participants are already in place.

  •  Speculative activity is on the rise (materially so in the case of Tilray (TLRY) and others in the space).
  •  Investor complacency (not a soul, save permabears, are looking for anything like a large markdown in market).
  • Rising interest rates — with the pace of the yield climb now accelerating to the upside.
  • Trade and tariff risk is rising.
  • An extreme change in the market structure — much like portfolio insurance in 1987, (ETF and Quant strategies and products dominate the market) — in which participants are all on the same side (long) of the boat.
  • Social unrest as the benefits of monetary and fiscal policies failed to trickle down.
  • Weak market seasonals.
  • Technical divergences.

The market is currently ignoring, in my opinion, two of the biggest risks to the fundamental underpinnings of the market which are earnings growth and valuation.

While the market has been rising on stronger rates of earnings growth, due primarily to tax cuts and share buybacks, that effect will begin to roll off in the months ahead. Tariffs and higher interest costs are a direct threat to bottom line profitability, particularly when combined with higher labor costs.

Today, however, I want to focus on the interest rate issue as it is the biggest threat the markets currently face if rates do indeed continue to rise further.

The following video takes a deep dive into rates and historical outcomes.

(Subscribe to our YouTube channel for daily videos on market-moving topics.)

But this is THE chart you should be paying attention to:

There are several important points to note in the chart above:

  1. In the past 40-years, there have only been seven (7) other occasions where rates were this overbought. In each case, it was a great time to buy bonds and sell stocks. (When rates got oversold, it was time sell bonds and buy stocks.)
  2. There were only two (2) other periods where rates were this extended above their long-term moving averages. The one that occurred between 1980-1982 began the long-term decline in bond prices. 
  3. Economic growth has peaked every time rates got this extended. (Which shouldn’t be a surprise.)
  4. Whenever rates have previously pushed 2-standard deviations of their 2-year moving average – bad things have tended to occur such as the Crash of 1974, Crash of 1987, Long-Term Capital Management, Russian Debt Default, Asian Contagion, crash, and the Financial Crisis.

While the markets are currently ignoring the risk of higher rates, even a cursory glance at the chart above suggests that we are near the point where “rates will matter.”

I suspect the “Magic Number” is likely no higher than 3.25%.

But we will only know for sure when the “rabbit pops out of the hat.”

Just something to think about as you catch up on your weekend reading list.

Economy, 2008 & Fed


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“It’s all fun and games until someone gets their eye put out.” – Every Mom In History

Questions, comments, suggestions – please email me.

Weekend Reading: A Permanent Shift To Valuations?

One of the ongoing thesis behind a continuation of a bull market from current valuation levels is that there has been a permanent shift higher in valuations due to changes in accounting rules, propensity for share buybacks, and a greater adoption by the public of investing (aka ETF’s).

This apparent shift to valuations is shown in the chart below.

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

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

The chart below tracks the cumulative increase in “excess” Government spending above revenue collections. Notice the point at which nominal GDP growth stopped rising. It is also the point that valuations shifted higher.

Given that economic leverage (corporate, consumer, financial, and Government debt) is at all-time records, and rising, the ability to create stronger, sustainable, economic growth (which would lead to higher rates of inflation) remains little more than a hopeful goal.

The issue with the idea that valuations have had a permanent shift upward is that the assumption is based on a market anomaly form 1990-2000 which temporarily skewed valuations above the long-term medians. However, economic growth set to remain near 2% over the long-term, the average valuation ranges will most likely trend lower in the future.

Ed Easterling at Crestmont Research made a great point recently in this regard:

“However, as real economic growth significantly declined over the past two decades, it triggered a series of adjustments that represent the forces behind The Big Shift. Most importantly, the downshift in real economic growth disrupted the financial relationship of profits, future growth, and market value.

Slower growth drives P/E downward for similar reasons that it drives EPS upward.”

Of course, much of the shift upward to EPS has been a function of wage suppression, buybacks and tax cuts more than actual top-line revenue growth as I discussed just recently. Ed continues.

“Therefore, since future economic growth is expected to be slower, it is only consistent that the future average for the market P/E will be lower. The new normal growth rate (i.e., slower) for the economy will drive slower overall earnings growth. Such slower growth will drive market P/E lower, just as previously higher growth supported the market’s P/E at a higher level.

The inflation rate also drives the level of market P/E, but it occurs within the range driven by the growth-rate environment. Higher inflation drives P/E lower; deflation drives P/E lower. The level of P/E peaks when the inflation rate is low and stable. Thus, while the growth rate drives the level of the P/E range, the inflation rate drives the relative position of P/E within the range. 

Figure 6 illustrates these effects. The bar on the left illustrates the range for P/E under a historically average level of growth. The bar to its right illustrates the range for P/E under slower growth. Not only does the range downshift, the expected long-term average P/E also downshifts. This has major implications for analyzing the stock market.”

“Going forward, we should expect a new paradigm. Slower growth drives the ranges for P/E lower, which will affect future assessments of fair value. Keep in mind that, had real economic growth averaged 2% instead of 3.3% over the past century, the historical average for P/E would have been near 11—not 15 or 16. In the future, the fair value for P/E when the inflation rate is low will be 13 to 15. With average inflation, expect P/E to be near 11. During periods of high inflation and significant deflation, expect the low range for P/E to be 5 to 8.”

With the markets still currently trading near 30x earnings, a revaluation of markets will likely be just as painful to investors in the future as they have in the past.

While this time may indeed appear to be different, it will most likely end the same as every other period in history.

Just something to think about as you catch up on your weekend reading list.

Economy, 2008 & Fed


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Research / Interesting Reads

“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” – Warren Buffett

Questions, comments, suggestions – please email me.

Weekend Reading: Fall Back

Doug Kass made an interesting observation about the market yesterday:

“The month of September started with optimism.

That optimism has faded in the last two trading days.

The most notable winners (year to date), FANG, have been particularly weak as investors begin to understand (thanks to the Congressional testimony and hearings) that the component companies’ costs will balloon in order to deliver a product that is palatable to the U.S. government and other authorities – something I have been suggesting for a while. As noted yesterday, many other former market leaders are also falling back in price.

While there has been some rotation (there always is), there have been no notable winning sectors (save the speculative marijuana space).

Meanwhile, over there, the European banks are making new lows as the European bourses dramatically underperform and diverge from the S&P Index. And China’s stock market is moving swiftly into bear market territory.

I continue to believe that we are in an ‘Acne Market’ in which Mr. Market’s complexion is changing for the worse.

Economically, global high-frequency data is growing ambiguous.

In terms of sentiment, investors seem unduly complacent in their optimism and I know no strategists who are even contemplating the possibility of a large market drawdown.

The bottom line is that the economic, policy (trade, etc.), political (midterm elections are only two months away), currency and geopolitical outcomes are numerous and growing: Many of those outcomes are market adverse.

Over the last few years, it has paid to buy the dip.

It might be different this time as a maturing economy and stock market are showing their rough edges – just when global monetary authorities are pivoting and many non-US fiat currencies are imploding.”

I addressed last week, that emerging markets are likely sending a signal which is being largely dismissed by mainstream analysis. At the end of September, unless things markedly improve over the next 3-weeks, emerging markets will trigger the 4th major “sell” signal in the last 20-years.

“In 2000, 2007 and 2012, emerging markets warned of an impending recessionary drag in the U.S. (While 2012 wasn’t recognized as a recession, there were many economic similarities to one.)”

Currently, there is a high degree of complacency among investors, and Wall Street, the current bull market advance will continue uninterrupted into 2019. Targets are already being set for the S&P 500 to hit 3200, 3300, and higher.

While anything is certainly a possibility, it doesn’t mean that such will occur in a straight line either. The lack of leadership from the technology sector is certainly concerning given its extremely heavy weighting to the overall index. But likewise, the lack of performance from international markets also suggest “something isn’t quite right.” 

This also shows up in the Baltic Dry Index which is just a representation of the demand to ship dry goods. While the index bounced from the lows in 2016, as global central banks infused massive amounts of liquidity into the system, early indications suggest that the cycle of global growth has started to wane.

The biggest concern domestically remains the strength of earnings growth going forward as well. Currently, estimates remain extremely high and the drag from a stronger dollar, tariffs, and rising rates will likely bring estimates lower. As I noted last week:

“But looking forward, year over year comparisons are going to become markedly more troublesome even as expectations for the S&P 500 index continues to rise.”

While I am certainly hopeful the analysts are correct, as bull markets are much easier to navigate, the risk of disappointment is rising. As Doug notes, the contraction of monetary policy is beginning to take effect on the markets and the economy.

Risks are always under-appreciated when bullish enthusiasm prevails. But knowing when to “fall back” and regroup has always been a better strategy than fighting to the last man.

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


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“I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up.” – Jesse Livermore

Questions, comments, suggestions – please email me.

Weekend Reading: Are Emerging Markets Sending A Signal

I have been, and remain, bearish on emerging markets for three reasons:

  1. As discussed yesterday, the U.S. is closer to the next economic downturn than not. When the U.S. enters a recession, emerging markets are hurt considerably more given their dependence on the U.S. 
  2. International risks in countries like Turkey, Greece, Spain, France, Italy, etc. 
  3. A strong dollar from flows into U.S. Treasury bonds for a “safe haven.” 

I recommended in January of this year to remove all international and emerging market exposure from portfolios and have been updating that position since each week in the newsletter:

“Emerging and International Markets were removed in January from portfolios on the basis that “trade wars” and “rising rates” were not good for these groups. With the addition of the “Turkey Crisis,” ongoing tariffs, and trade wars, there is simply no reason to add “drag” to a portfolio currently. These two markets are likely to get much worse before they get better. Put stops on all positions.”

This has been the right call, despite the plethora of articles suggesting the opposite.

For example, in January, Rob Arnott stated:

“Look at value in emerging markets. In the U.S., value is trading about 25% cheap relative to the market. In emerging markets, it’s close to 40% cheap. 

That’s pretty cool. If you can buy half the world’s GDP for nine times earnings or buy the U.S. for 32 times earnings, I know where I’m going to put my money.”

Now, I am not arguing Rob’s point. But, my position is simply that the economic dependency of emerging markets on the U.S. is extremely high. Therefore, when the U.S. gets a “cold,” emerging markets get the “flu.” 

Over the last 25-years, this has remained a constant.

In 2000, 2007 and 2012, emerging markets warned of an impending recessionary drag in the U.S. (While 2012 wasn’t recognized as a recession, there were many economic similarities to one.)

Currently, emerging markets have once again diverged from the S&P 500 suggesting economic growth may not be as robust as many believe. While a 2-quarter divergence certainly isn’t suggesting a “financial crisis” is upon us, it does suggest that something isn’t quite right with the global economic backdrop.

Lisa Abramowicz recently noted the problem with EM default risk in some of the emerging markets.

While the markets are currently dismissing Turkey, Brazil, China and Russia as non-events, the problem is the issue of funding needs for these countries.

“The second, more salient point is that a key reason for the solid growth across emerging markets in recent years, has been the constant inflow of foreign capital, resulting in a significant external funding requirement for continued growth, especially for Turkey as discussed previously.

But what happens if this outside capital inflow stops, or worse, reverses? This is where things get dicey. To answer that question, Morgan Stanley has created its own calculation of Emerging Market external funding needs, and defined it as an ‘external coverage ratio.’ It is calculated be dividing a country’s reserves by its 12-month external funding needs, which in turn are the sum of the i) current account, ii) short-term external debt and iii) the next 12 months amortizations from long-term external debt.”

Given the ongoing pressures of “tariffs,” trade wars and rising geopolitical tensions, the risk of something going “wrong” has become increasingly elevated.

Yet, market participants are ignoring the risk simply because prices are rising. As Doug Kass noted yesterday:

There is nothing like stock price advances to change sentiment. 

Just like fear dominates politics these days, the opposite is occurring in the markets as greed has emerged as a byproduct of sharply rising prices (which have desensitized investors to risks, doubt, and fear).

Besides growing economic ambiguities, the most notable lack of criticism is the unusual nature of the last decade, in which interest rates sustained themselves around the world at generational low levels. To presume that foundation to be sound in the future (particularly when a pivot of global monetary restraint has already started), is to congratulate Lance Armstrong for his Tour de France wins without noting his use of illegal drugs.

T.I.N.A. (‘there is no alternative’) is no longer a present condition as 1-month, 3-month, 6-month and 1-year Treasury yields are now at their highest levels in 10 years:

There is now an alternative.”

“The magnitude of the market’s rise in the month of August is almost certainly borrowing from future returns. In the extreme, a more durable and significant top may be forming.”

Higher borrowing costs on the short-end reduces consumption and the demand for imported goods. Emerging markets are likely already signaling there is an issue from the Federal Reserve’s actions, and the consequence historically has not been good. But, as I quoted yesterday:

Unfortunately, Powell left the unsettling feeling that monetary policy can be summarized as ‘We plan to keep hiking until something breaks.’”Tim Duy

Just something to think about as you catch up on your weekend reading list.

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“Stay humble…or the market will do it for you.” – Anonymous

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Weekend Reading: Impeachment Risk

Yesterday, the President stated:

“If I ever got impeached, I think the market would crash. I think everybody would be very poor. Because without this thinking, you would see, you would see numbers that you wouldn’t believe in reverse.”  

It is an interesting statement because there has been little to seemingly deter the bullish momentum of the market. Trade wars, tariffs, geopolitical stresses, a stronger dollar, and tighter monetary policy have all been quickly dismissed in exchange for hopes that corporate earnings and profitability will continue to accelerate into the future.

Even as I write this note this morning, the market is opening higher in the attempt to push the S&P 500 to “all-time” highs despite the fact the recent rally over the past week was attributed to “trade resolutions” with China which completely fell apart overnight.

“When reports emerged last week of a low-level Chinese delegation coming to meet with members of the Treasury department ahead of what the WSJ described would be a November trade summit in the US, stocks spiked and yields ran up (they have since tumbled with the 2s10s yield curve collapsing to just 20 basis points) on hopes that the long-running trade feud between the US and China may finally be coming to an end.

The skeptics were right because, after the conclusion on Thursday of the second day of the closely watched trade talks between the U.S. and China, there was ‘no major progress’ according to Bloomberg, with the stage once again set for further escalation of the trade war between the US and China.”

As you know, I was one of those skeptics.

Despite the headline rhetoric, the drive of the market is simply the momentum chase or more commonly known as the “Fear Of Missing Out (FOMO).” The momentum push is historically the last stage of a bull market cycle and is very difficult to stop. It is at this point in the cycle where “everything is as good as it can get,” literally. Confidence is at a peak, earnings and profitability are expanding and economic data is optimistic. Such provides the support to discount overvaluation and investment related risk.

But as I penned last week:

“’Record levels’” of anything are ‘records for a reason.’

When a ‘record level’ is reached it is NOT THE BEGINNING, but rather an indication of the PEAK of a cycle. Records, while they are often broken, are often only breached by a small amount, rather than a great stretch. While the media has focused on record low unemployment, record stock market levels, and record confidence as signs of an ongoing economic recovery, history suggests caution. For investors, everything is always at its best at the end of a cycle rather than the beginning.”

But the cracks are already starting to appear as underlying economic data is beginning to show weakness. While the economy grinds higher over the last few quarters, it was more of the residual effects from the series of natural disasters in 2017 than “Trumponomics” at work. The “pull forward” of demand is already beginning to fade as the frenzy of activity culminated in Q2 of 2018.

For the stock market, an impeachment process, which is a very low probability event, is likely the least of concerns over the next 9-12 months. What will matter to investors, in my opinion, are three things:

  • The Fed
  • China 
  • The 2nd Derivative

The Fed is important as they continue to hike rates which is already impacting, as we discussed yesterday, some of the more economically sensitive areas of the market.

China matters because they are a major trading partner with the U.S. and the potentially negative impact on corporate earnings from trade, tariffs, and a stronger dollar should not be quickly dismissed. While those things may not be immediately noticeable, even though they have been mentioned in recent corporate earnings reports, the longer they persist, the more they will matter. 

Lastly, the annual rate of change in earnings and economic data will begin to weaken as the year-over-year comparisons become much more difficult. Importantly, the explosive earnings growth in earnings this year, due to a lowered tax rate, has been key to supporting higher stock prices. That growth rate is set to slow markedly beginning in Q3 as the “tax rate effect” is absorbed and discounted. 

As far as the political backdrop goes, the biggest risk is the upcoming mid-term elections. If the House and/or Senate falls to the Democrats, the inability to push forward, or even the potential reversal of, any of the “Trumponomic” agenda will likely be much more unsettling for the markets in the short-term.

Nonetheless, the trend and momentum remains bullish, and bullish sentiment is an extremely hard thing to turn.

But it will eventually turn. The only question is what causes it?

There are certainly plenty of reasons for investors to be concerned, however, none of those “reasons” have seemed to matter so far. Most likely, the one that does is likely the one we aren’t even talking about yet.

Just something to think about as you catch up on your weekend reading list.

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“The trick of successful investors is to sell when they want to, not when they have to.” – Seth Klarman

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Weekend Reading: Why We Don’t Talk Anymore

I have been doing a daily radio talk show for 18-years. I started out, totally by accident, doing a financial talk show on a business radio station in early 2000 as the “” crash was underway. It was the genesis of what would eventually become Real Investment Then, in 2007, I got picked up by a larger radio station in Houston, Texas to do my own radio program and was eventually asked to expand the show to cover conservative politics.

As a “fiscal conservative,” discussing the intersection of political and fiscal policies as it relates to the economy, financial markets, and our families was an easy transition. As the “financial crisis” ensued our commentary regarding capital preservation and risk management brought on a larger audience. During the next 8-years under the Obama Administration, I openly disagreed with policies like the Affordable Care Act, IRS suppression of conservative groups, and unbridled spending and debt expansion in Government.

I didn’t disagree with these policies because they were from an opposing party, but because they weren’t good for the country, the economy, or our families.

Importantly, my show allowed for open and honest discussions by those on both sides of the argument. While we certainly had our share of “heated” debates, they were always civil, respectful and honest. We discussed facts, exposed fallacies, and shared beliefs in an educational format.

However, over the last two years, having those open and honest discussions are no longer viable. The “heated” exchanges are now simply vitriolic. There is no ability to “simply disagree” with those on the “right” or the “left” as debates are have devolved into yelling matches.

The hypocrisy of both sides has become acidic. During the Obama Administration, the “right” consistently droned on about the flaws in the U-3 unemployment rate. Now, they use it as proof that Trump’s policies are working. The “left” is just as bad in switching arguments to support their narrative as well.

Who would have ever believed that #FakeNews would actually be “a thing.”

Just as in any marriage, when two people are no longer “talking,” the end is near.

The same is true in this country.

A recent PEW study shows the political divide that engulfed our country.

Don’t dismiss this divide lightly. As Ben Hunt recently noted:

“Has all this happened before? Sure. Time to dust off your copy of Gibbon’s Decline and Fall. Time to reread Will and Ariel Durant. Just be forewarned, the widening gyre can go on for a loooong time, particularly in the case of a major empire like Rome or America. It took the Romans about four centuries to officially exhaust themselves, at least in the West, with a few headfakes of resurgence along the way. Four centuries of mostly ridiculousness. Four centuries of profitable revenge and costly gratitude. Four centuries of a competitive equilibrium in a competitive game.

Has this happened before in American history? Hard to say for sure (how dare the Pew Research Center not be active in the 1850s!), but I think yes, first in the decade-plus lead-up to the Civil War over the bimodally distributed issue of slavery, and again in the decade-plus lead-up to World War II over the bimodally distributed issue of the Great Depression. I really don’t think it was an accident that both of these widening gyres in American politics ended in a big war.”

Even the Bible notes the importance of unity:

“And if a house be divided against itself, that house cannot stand.” – Mark 3:25

We are currently on a path that can not end well.

We are no longer talking.

Yesterday, was the end of my “political” talk show.

I am returning to my roots beginning September 4th to help prepare you for the coming crash. 

It is not a bearish view.

It’s not a “doom and gloom” forecast.

It is just the simple the reality we are on a collision course in this country which won’t be stopped. I hope you will tune in and listen.

Just something to think about as you catch up on your weekend reading list.

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“The contrary investor is every human when he resigns momentarily from the herd and thinks for himself” – Archibald MacLeish

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Weekend Reading: Mathematical Adjustments Don’t Change Reality

Yesterday, I discussed the mathematical adjustment to the GDP calculation that added $1 trillion to economic growth. To wit:

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

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

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

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

The change to a lower inflation rate also boosted disposable incomes and personal consumption expenditures which also boosted the savings rate. However, what doesn’t change is economic reality. The chart below shows what we call “real DPI” or rather it is disposable incomes (which is gross income minus taxes) less spending. What we have left over after paying our bills, healthcare costs, food, tuition, etc. is what is really disposable for spending on other “stuff” or “saving.”

Despite the adjusted bump in savings, consumer activity continues to remain weak. Given that roughly 70% of the economic calculation comes from personal consumption, watching consumer activity is a good leading indicator of where the economy is headed next. PCE figures also suggest the recent bump in economic growth is likely transitory. Looking back historically, GDP tends to follow PCE and not vice-versa.

More importantly, weaker economic growth rates will also be met with much tougher year-over-year comparisons on corporate earnings which likely further hamper equity returns in the near term.

As we summed up yesterday:

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

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

Changing the math doesn’t change reality.

Just something to think about as you catch up on your weekend reading list.

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“Everything eventually reverts to the mean.”Frank Holmes

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Weekend Reading: Price Is What You Pay

Yesterday, I discussed the failure of tax cuts to “trickle down” as they have primarily been used for corporate share repurchases. As I was digging into the data, Doug Kass emailed me a quick note:

“Berkshire Hathaway, likely under the weight of an enormous cash horde and more scarce alternative investment opportunities, has announced that it is loosening the terms of its buyback policy. It is also a signpost that the company has matured and will only duplicate GDP-like growth.”

While the announcement set the shares of Berkshire (BRK/A) (BRK/B) surging higher yesterday, there is a much more important message that investors should be heeding.

We recently delved into the performance of Berkshire as it has become the 10th-largest company in the world in terms of revenues. To wit:

“The graph below highlights this concern. It shows that 90-day rolling correlation of price changes in BRK/A and the S&P 500 are statistically similar. In the market crash of 2008/09 BRK/A’s price was cut in half, similar to the S&P 500. Based on correlations we suspect a similar relationship will hold true for the next big market drawdown.”

Both the sheer size of Berkshire, and the chart above, confirm Doug’s comment that Berkshire is likely to only generate rates of growth equivalent to GDP going forward.

So what’s the message that Mr. Buffett is sending? Simple:

“Price is what you pay, value is what you get.”

Investing is about maximizing the return on invested dollars by buying something that is undervalued and selling it when it is overvalued. This is the point missed by those who promote “buy and hold” investing which is the same as “buy at any price.” 

Corporations are, in many ways, held hostage by Wall Street and short term investors. An earnings miss can be disastrous to a companies stock price which can have severe consequences to stock option compensated executives and employees, shareholders and even bondholders. So, with pressure on companies to deploy excess cash, what are the options considering the “beat the estimate” game that must be played.

  • Hire Workers? Employees are a high cost and have a direct impact on profitability. Companies hire as needed to meet excess demand. Demand has remained stable and increased at the rate of population growth which is also the rate of employment increases: (Read this)
  • Invest To Produce More Products? Investments in future growth are accompanied by a negative short-term impact to profitability. Further, with rates rising the cost of borrowing for CapEx adds to the negative impact on current earnings.
  • Mergers & Acquisitions? Using cash to acquire revenue can be accretive to bottom line profitability. However, with stock price valuations elevated the costs to acquire revenue in many cases is becoming less attractive and often not immediately accretive.
  • Share Repurchases? While share repurchases do not increase top-line revenue growth or bottom line profitability, it does make it APPEAR the company is more profitable when they report earnings on a per share basis. The illusion of an immediate increase in profitability supports asset prices in the short-term despite potentially decreasing fundamental value.

From an investment standpoint, share repurchases by companies are a message that companies simply have no better options available with which to grow earnings and protect shareholder value.

So, back to Mr. Buffett who has been sitting on over $100 Billion in cash and T-bills over the last few quarters. With a dearth of value in the market, there have been few opportunities for a legendary value investor to deploy capital in a manner that will generate an attractive future rate of return. However, sitting on cash, in a low interest rate environment, is also not conducive as the purchasing parity power of cash is eroded by inflation.

So, what does the “World’s Greatest Value Investor” do when there is no better use for cash – buy back shares of your own company, of course.

The message from Buffett is quite clear – there is little value left in the market today otherwise he would be allocating his cash hoard very differently.

While many suggest that individuals should just “buy and hold” investments regardless of what the market does, Mr. Buffett’s actions reinforce the view that buying assets at current valuations is likely to have a disappointing outcome. 

Does this mean you should never invest? Of course, not.

But as Mr. Buffett himself has stated:

“Be fearful when others are greedy. Be greedy when others are fearful.” 

Just something to think about as you catch up on your weekend reading list.

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“Predicting rain doesn’t count. Building arks does.”Warren Buffett

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Weekend Reading: Renter Nation

“The psychological factors are harder to assess. People aren’t flipping condos for sport the way they were during the bubble when mortgages were available to anyone regardless of whether they had income or assets. Yet it seems there’s a widespread desire to own assets – stocks, bonds, and real estate – regardless of price. It’s not an obviously happy mania, where people are motivated by promises of great wealth. It’s more like a need to be an asset owner in an economy that continues to hurt workers without college degrees and becomes more automated. Nevertheless, the price insensitivity of many buyers is enough to cause concern.” – John Coumarianos

It is an interesting comment and John is correct. Low rates, weak economic growth, cheap and available credit, and a need for income has inflated the third bubble of this century.

But when it comes to housing, as I was digging through the employment data yesterday, I stumbled across the “rental income” component which is included in national compensation. When I broke the data out into its own chart, I was a bit surprised.

Let’s step back for a moment to build a bit of a framework first. While there has been much speculation about a resurgent “housing boom” in the economy, the data suggests something very different which is that housing has simply become an asset class for wealthy investors to turn into rentals.

As the “Buy-to-Rent” game drives prices of homes higher, it reduces inventory and increases rental rates. This in turn prices out “first-time home buyers” who would become longer-term homeowners, hence levels of homeownership rates first seen in the 1970’s. (Also, note surging debt levels are supporting higher homeownership.)

The chart below shows the number of homes that are renter-occupied versus the seasonally adjusted homeownership rate. As noted above, with owner-occupied housing at the lowest levels since the 1970’s, “renters” have become the norm. 

The surge in “renters” since the financial crisis, due to a variety of financial reasons, has pushed rental income to record levels of nearly $800 billion a year. Given the sharp surge in incomes, it is not surprising that multifamily home construction and “buy to rent” continues apace in the economy for now. For investors, it has become an alternative asset class with increasing asset values and income yielding well above the current 10-year Treasury rate.

With roughly a quarter of the home buying cohort either unemployed or underemployed and living at home with their parents, the ability to create households has become more problematic. The remaining members of the home buying, household formation, contingent are employed but at lower ends of the pay scale and are choosing to rent due to budgetary considerations. This explains why the 12-month moving average of household formation, used to smooth very volatile data, is near its lowest levels going back to 1955.

The risk to the “renter nation” bubble is a “rush for the exits” by the herd of speculative buyers turning into mass sellers. With a large contingent of homes being held for investment purposes, if there is a reversion in home prices a cycle of liquidation could quickly occur. Combine that with the onset of a recession, and/or a bear market, and the problem could well be magnified. Of course, it isn’t just the liquidation of homes that is an issue but the inability to find a large enough pool of qualified buyers to absorb the inventory.

Just something to think about as you catch up on your weekend reading list.

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“Risk comes from not knowing what you are doing.” – Warren Buffett

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Weekend Reading: The Japanification Of America Continues

Last week, I discussed the ongoing debt issue in the U.S. with respect to the recent CBO report and the trajectory of debt growth over the next 30-years.

The fiscal issues facing the U.S. are nothing new and have been a frequent discussion on this site. More importantly, I have discussed these issues directly with members of Congress, and especially with Congressman Kevin Brady, Chairman of the House Ways and Means Committee, who agree with my concerns yet have been unable, and unwilling, to tackle the “tough” issues. While conservatives in Congress talk a great game of fiscal responsibility, the reality is there is little “will” to actually be “fiscally responsible.”

While the country today is more politically divided than at just about any other point in history, “spending money” is the one thing that all members of Congress willingly agree to.

As I discussed previously, this is the same path Japan took previously.

“Debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service. 

The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and increasingly drawing on social benefits.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.”

“Japan, like the U.S., is caught in an on-going “liquidity trap”  where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.”

I was reminded of this previous discussion this past week when Tyler Durden discussed a new bill in Japan limiting overtime work to 99-hours a month to cure “Death by Overwork.”

“Recently released government data revealed that Japan’s jobless rate touched 2.2% in May, the lowest level in 26 years. And as Japan’s working-age population dwindles, job openings have outpaced the number of workers available to fill them: As a reference, two months ago, there were 160 job offers available for every 100 workers seeking a job.”

What got my attention was the similarity to an issue that has stumped economists over the last couple of years – surging job openings that go unfilled. We can restate quote above to apply to the U.S.:

“Recently released government data revealed the U.S. jobless rate touched 3.8% in June, the lowest level in 48 years. And as Japan’s working-age population dwindles, job openings have outpaced the number of workers available to fill them: As a reference, two months ago, the ratio of offers to unemployed hit the highest level of this century.”

Employment growth has essentially done little more than to absorb population growth over the last several years but has begun to deteriorate over the last few years. With net hires (hires less layoffs and quits) declining the ratio of job openings to hires is likely to rise further.

While the surge in “job openings” has remained a conundrum for economists, the answer may not be so difficult as employers continue to report the problems with filling jobs as:

  1. unfit to do the job (too fat/unhealthy/old),
  2. lack of requisite skills (education/training), and; 
  3. unwilling to accept the job for the rate of pay.

This was noted in the recent FOMC minutes:

Contacts in several Districts reported difficulties finding qualified workers, and, in some cases, firms were coping with labor shortages by increasing salaries and benefits in order to attract or retain workers. Other business contacts facing labor shortages were responding by increasing training for less-qualified workers or by investing in automation.”

A recent job posting revealed what we already suspected about the “new economy.”

While these are anecdotal examples, it potentially explains why labor force participation remains stuck at multi-decade lows as government benefits provide more income than working. Currently, social welfare makes up a record high of 22% of disposable incomes. The reality is that if the jobless rate was actually near 4%, job openings would be filled, wages would be surging for the bottom 80% of workers along with interest rates and economic growth. Instead, we see more evidence of economic stagflation than anything else.

Despite many exuberant hopes of an “economic resurgence,” the vast majority of the data continues to point to a very late stage economic cycle. While I am not suggesting the U.S. actually IS Japan, I am suggesting we can look to Japan as “road map” as to the consequences of high debt levels, aging demographics, deflationary pressures and opting for “short-term fixes” rather than fiscal responsibility.

Unfortunately, the Administration has chosen to follow the path of Japan which is unlikely to have a different outcome. There is no evidence that monetary interventions and government spending create organic, and sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

There is certainly time to change our destination, but it will require a massive shift in perspective and desire to do so. With a rising number of Millennials starting to embrace socialism over capitalism, the future of the U.S. may be more like Japan than we readily wish to admit. 

Just something to think about as you catch up on your weekend reading list.

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“If you have large cap, mid cap, and small cap, and the market declines, you are going to have less cap” – Martin Truax

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Weekend Reading: #MAMI – Make America More Indebted