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Tuesday/Thursday Market Commentary


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THE ELEPHANTS IN THE ROOM
3/01/18 6:10 AM

We have been discussing for years how the growth of the Fed’s balance sheet from $800bn to $4.5tn from 2009 to thru 2014, and near zero interest rates (ZIRP) have caused all forms of mal-investment that in the final analysis will bring down the “house of cards” that is the stock and bond markets.  But it gets even more interesting, in terms of the central bank “insanity”.  That the ECB, BOJ, and the BOE upped the ante even more by instituting negative interest rate policies (NIRP)  will prove to be even more detrimental, in the long run, than ZIRP.  (We did not include the PBOC (Peoples Bank of China) in this, the reason being that China is not a fully opened economy, given the fact that currency cannot flow freely across its borders.  But they take a second seat to no one when it comes to over-leverage and debt.  The downside of that story will surely come in the future as well.)

While the balance sheet of the Fed has gone basically sideways for the past 3 years, the ECB, BOJ, and BOE were adding just under $5tn collectively, to theirs.  And given the fact that foreign exchange markets are very liquid and well developed, it should be of no surprise that much of that non-US central bank stimulus found its way here to further inflate U.S. stock and bond prices.  Now the Fed is reducing its balance sheet, albeit quite slowly.  If all goes according to plan, however, the combined balance sheets of the big four will still increase by about $235bn this year, according to data from J.P. Morgan and the banks themselves.  It is not until 2019 that the net of the balance sheets result in a reduction.  But there is no doubt about that after ten years of central bank balance sheet expansion, the reversal of the process is a ”giant elephant” in the room for stocks and bonds.

The “second elephant” in the room is the tremendously large and growing Non- Financial Debt to GDP ratios that exist in the developed world.  We, and others of a similar persuasion, have said for years that excessive debt slows growth as increasing resources are consumed by debt service.  According to a report in October 2017 by David A. Rosenberg, at Gluskin Sheff +Associates Inc., these ratios now stand at 250% for the U.S., 372% for Japan, 257% for China, 180% for Germany, and 240% for the G20 as a whole.  All but Germany are up substantially over the past ten years.  Does anyone think these numbers are coming down?   Does anyone think that the Trump tax cut and infrastructure plan, assuming it gets through, will result in lower deficits and less borrowing?  We believe a substantial extended growth in GDP, even once the effect of the tax cut and repatriation are factored in, is a pipe dream.

The "third elephant" in the room is the state of employment, labor force demographics, productivity, entitlements, and how they all relate.  The growth rate in GDP can be viewed as the change in hours worked multiplied by the change in output per hour.  With the economy at or near full employment, it is hard to see how there can be a large increase in hours worked.  In addition, the Trump Administration immigration policies have the potential to cause a reverse migration of the workers, particularly Central American, that have been here.  While there are arguments as to the wisdom of those policies on both sides, we see a reverse migration as being highly wage inflationary as individuals in the social safety net will need financial incentives to enter the work force and take those vacated jobs.  That leaves output per hour, i.e. productivity, to do the heavy lifting.  Productivity growth has been anemic, (under 1%per year).  In the absence of some unforeseen leap in technological innovation there is nothing on the horizon that portends a resurgence of productivity.  In fact, it’s just the opposite.

None other than the “Old Maestro” himself, Alan Greenspan has been sounding the alarm on growth of entitlements as it relates to both debt and productivity.  His thesis, which we subscribe to, is that entitlement dependency discourages savings, which is the lifeblood of investment.  And it is investment in plant, equipment, and human capital that increases productivity.  And of course, given this as a backdrop, what are some of our leading politicians doing?  According to a Wall St Journal editorial of 2/28/18 titled “A New GOP Entitlement”, a new family leave benefit is being proposed and would be financed by a present day raid on the Social Security Trust Fund.  As the editorial points out, “every entitlement since the Revolutionary War Pensions has skidded down the slope of inexorable expansion”.  

So these are just three of the “elephants in the room”, that we believe will provide significant headwinds to economic growth.  They are very detrimental in the long term, and are a large part of the reason we have been so negative on the stock market, and remain so.

 P.T. Barnum’s elephants once thrilled and amused tens of thousands of people around the world every year.  Millions of investors around the world will have quite the opposite reaction when the aforementioned "elephants" bring down the stock and bond markets!


 
THE FREE LUNCH
But Don't Be Fooled Because The Check is Coming Courtesy Of The Central Banks
1/03/18 11:05 AM

So, here we are.  Stock indexes are through the roof and making new highs almost every day.  Realized volatility is collapsing through the floor, and has never been lower for such a protracted period.  The era of (normal) five, ten, or twenty percent corrections seem like a distant memory of another time and place.  Interest rates remain near historical lows, with seemingly benign duration risk in the bond market.  Inflation has all but been pronounced as “dead as a doornail”. 

It was not through brilliance in the management of our major corporations that account for the (irrational) exuberance that the markets seem to be embracing. Though they certainly did their part with stock buybacks that helped inflate prices and knock compensation options “into the money”, thereby coincidentally increasing their own personal incomes.  No, it was something even greater and more damaging that is responsible for the gross inflation of financial assets. It was nothing less than the massive balance sheet growth of the central banks of the United States, Europe, China, and Japan that is responsible for what we have termed “The Free Lunch”.  The “Free Lunch”, in this context, implies there have been little to no negative ramifications to what we and some others have described as “insane” policies on the part of the major central banks.

So let’s get this straight.  The “all knowing” central bankers blew out their balance sheets to unprecedented levels.  They bought not only government and mortgage debt, but in Europe the ECB even bought bushel baskets of corporate debt.  In Japan the BOJ upped the ante by buying enough equity ETFs to become a top 10% shareholder in most companies in the Nikkei Index.  They supplanted the market mechanism of pricing interest rates to the point that short term rates were zero in the U.S., and negative in Europe and Japan (which continues).  They forced savers to become investors and speculators; thereby driving asset prices ever higher.   Given that capital is the life blood of capitalism; its mispricing can result in nothing but mal-investment.   This is true across the entire spectrum; from governments, to corporations, to individuals.  And oddly, during and possibly as a result of this “mad experiment”, the world has seen the emergence of possibly the most strange of all assets, crypto currencies.

So all of this happened; (disparate) wealth created out of thin air, inflation seems decimated, stocks up, bonds up, real estate up, art up, and the amount of government, corporate and personal debt in the stratosphere.   CNBC guest bears have been as rare as sightings of Bigfoot, all because central bankers were so “brilliant”.  If they can just unwind their balance sheets with little or no disruption, they will have truly gifted to the world this rarest of phenomena…”The Free Lunch”.

The problem for us is that we were taught that there’s no such thing as a “Free Lunch”… because someone ALWAYS has to pay.  Sarcasm aside, what the Fed and its central bank European, Chinese, and Japanese counterparts have done is nothing less than caused what we believe will prove to be the greatest asset  bubble of the modern era.  As stated above, by not allowing the free market to price capital, they have allowed years of mal-investment, which will negatively affect growth long into the future.  Furthermore, going forward, the impending new federal tax legislation along with growth of entitlements will likely cause the debt and deficit to further skyrocket.  And excessive debt lowers economic growth in the long run as debt service consumes capital that could be used constructively. We don’t, for one second, believe the projections of the administration, or anyone else, that growth is set to “take off”.  In the past we’ve discussed how, just on demographics alone, the odds are greatly stacked against returning to growth rates of the past.  To our way of thinking, short term blips aside, the economy will revert to the anemic growth of the past eight, or so, years.  The markets will ultimately return to more traditional patterns of volatility as interest rates and risk become more correctly priced.

When that happens, it will be “look out below” for stocks, bonds, and financial assets in general.  The creators of the “Central Bank Bubble” and their cheerleaders in the media may think they’ve given the world a “Free Lunch”.  But we continue to believe the “check” is coming, and when it does, it will be a very, very expensive one.


 
THERE WILL BE SIGNIFICANT ROADBLOCKS IN THE MARKET THE REST OF THIS YEAR, 2018, AND BEYOND
11/11/17 5:50 AM

There have been many of the strongest bulls on Wall Street that have changed their minds on the “Bull” side of the market, just recently.  Many of them have been very concerned about the possibility of continued delays in the “Tax Reform” that is being bandied about in the House and the Senate.  Some others such as Jim Paulson, Chief Investment Strategist at The Leuthold Group, just a week ago, was concerned about how most investors are still just looking over the blue skies and thinking nothing can go wrong.  He also was concerned about the Fed tightening more than most investors anticipated, as well as a flattening out of the bond market.  As the shorter term bonds have been rising faster than the longer term bonds, the flattening could turn out to be inverted soon and we all understand that is a precursor to a recession. The financial stocks that usually rise as rates increase, are now declining, and that also signals that something is wrong.  Paulson is also concerned about the Republican Agenda slowing down, as the House and Senate go back and forth with significant delays. 

 Another extremely respected equity analyst for Morgan Stanley, Mike Wilson, has recently changed his opinion, after being a noted bullish economic and equity analyst over the past 8 years.  He now expects either a major decline or at best a bear market pause.  He also sees some of the same problems as Paulson. As stated above, the settlement of the Tax Reform continues to go back and forth as the Republicans are sprinting to the finish line in order to get a compromise between the two chambers.  This is where the Senate Republicans and Senate Democrats have to give something up to get the approval of the Senate Committee first, and then the Full Senate, before this year ends.  So it is crunch time for Republicans as the House Ways and Means Committee enters its final days of hammering out its tax-cut legislation, while a Senate panel has now revealed its own version.  If they don’t get this worked out, the stock market will have a very difficult time throughout the last couple of months in 2017 and all of 2018. Right now they don’t seem to be working out a compromise.

A commentator on CNBC, Mike Santolli, discussed how much the market volatility came to a screeching halt during the wild year of the Trump victory.  Most investors would have to think of this being a strong positive for the markets.  However, according to Santolli, he has gone back for years to show what happens to equity markets after going through long periods of very low volatility-- they are set up to decline significantly.  In fact, the S&P 500 just broke a record today, 11/9/17, by going through the longest streak in history of 370 days without a 3% decline.  Santolli showed that this is not a good streak, and once it breaks, it could turn into a bad bear market. 

There are other Republicans like, Douglas Holtz-Eakin, who in 2003 became the director of the Congressional Budget Office.  He is still very sympathetic to the congressmen that are concerned about the increases in the debt and deficits.  In fact, the budget office undertook a study of tax rates, and found that any tax cuts enacted, that increased the debt and deficits of the U.S., will not generate much growth over the next 10 years.  In fact, the Senate minority leader, Mitch McConnell, appointed Holtz-Eakin to the Financial Crisis Inquiry Commission in 2009, so we are not talking about a novice in this area.  Holtz-Eakin also has a major concern about some of the entitlements that no one seems to bring up during the Tax Reform discussions.  He believes our Social Security entitlements will come back to haunt us, unless we work on them as soon as possible.  Also, he is concerned about the fact that the global debt is three times the global GDP. 

So, as you can see, it looks like we will have plenty of things to worry about for the rest of this year, 2018, and beyond. 


 
THE PURCHASE OF BONDS BY THE FED OVER THE PAST 8 YEARS DROVE STOCKS UP
Now that the Fed is About to Start Selling these Bonds, Stocks Should Soon Turn Down
10/09/17 6:00 PM

Asset prices (especially stocks) clearly have risen because of Quantitative Easing (QE, the Fed lowering ST interest rates and purchasing bonds).   So, if that is the case, why doesn’t it make sense for assets and stocks to decline as the Fed, and soon other central banks, will reverse their stance and sell the bonds previously purchased?  As the Fed, and other central banks, are planning on raising interest rates and tightening, by reversing what they have been doing for the past 8 years, it is obvious to us that assets and stocks will surely decline substantially.  Clearly, the QE that has been taking place for years will be reversed and it will probably be called Quantitative Tightening (QT) (and it will be called QT for a reason—if they don’t tighten, inflation could be next).

Our Fed is slowly tightening, as the other large central banks, such as the Bank of Japan (BOJ), the European Central Bank (ECB), Peoples Bank of China, (PBOC), are all moving much more slowly than our Fed.  It looks like these central banks are listening to our Fed, and plan on following them.  After all, this QE started for most of these central banks about the same time as our Fed (because of most of them following our Fed) and so far it has worked well to help all of the countries using it to boost their stock markets and prevent recessions. It is the reversal of all of these QEs that may wind up having “unintended consequences” since the QEs, and the reversal of QEs have never been tried before. We expect the “unintended consequences” to take place before, or during, the first quarter of 2018.

The other potential problem we have trouble understanding is that most of our country believes that President Trump will be successful in achieving his broad agenda items such as Tax Reform, Repeal and Replace Obama Care, Infrastructure Spending, and much more.  We don’t believe that most of these agenda items will be passed at all (just as the repeal and replace was stopped cold).  Many stock market mavens are putting a number on the “Tax Cut”, or “Tax Reform” and incorporating the increased earnings into their forward valuations to give stocks a lower P/E multiple for next year.   And even if the “Tax Cut or Reform” comes close to being approved many in Congress will realize that the Budget Deficit will skyrocket, and will clearly be a major factor in potentially leading to a downgrade of our debt (just as what took place in the U.S. in 2012, and more recently in China and Hong Kong).  We also expect that much of the tax cut will only benefit the very rich such as with the “estate taxes”. And also, if interest rates increase as the Fed keeps tightening, the dollar will also rise and restrict the US multinationals from selling goods abroad.

As far as the U.S. stock market, we are still concerned about the extreme valuations, and the fact that we don’t seem to be able to grow fast enough to break through and achieve our “old norm” of GDP 3 % or higher, and get to the goal of "escape velocity".  

 


 
WE ARE AS BEARISH AS WE HAVE EVER BEEN
And The Central Banks Have Not Even Begun To Shrink Their Balance Sheets
9/06/17 7:25 AM

A reader of this commentary recently asked us if we were “throwing in the towel?  The reader was, of course, referring to our long running bearish outlook for the U.S. stock market.  To quote the great Bob Dylan, “The times they are a changin”…for the bulls, but not for us!  We remain in the bearish camp as firmly as we have in the past. So below is a summary of our latest thoughts as to where things stand.

Let’s start with the root cause of what we believe will be among the most vicious bear markets in history, when it does occur.   The major central banks of the free world have, since the Great Recession hit with full force as the Housing Bubble burst in the fall of 2008, expanded their balance sheets and printed money like no central bank has ever done before.  The term for this is Quantitative Easing.  The Fed, European Central Bank (ECB), Bank of Japan (BOJ), and Bank of England (BOE) have all purchased trillions of dollars of government debt and related securities.  The ECB has also purchased large amounts of corporate debt, and the BOJ has upped the ante by even purchasing Japanese equity ETFs.  They have yet to reduce their balance sheets by the equivalent of a single penny, and we believe they will find it very difficult, it not nearly impossible, to extricate themselves from the situation without highly negative effects on the markets.  If Quantitative Easing was largely responsible for creating the bubble in financial assets we believe exists, it stands to reason that when they start doing the reverse the results could be very negative for the markets.

One of the major effects of Quantitative Easing is to drive interest rates lower than the free market would otherwise price them.  In the case of Europe and Japan this has even resulted in negative interest rates.  This is a first in the history of financial markets.  Low and negative rates mainly punish savers.   This has resulted in overpricing of stocks and bonds as investors from the developed countries, in particular, have chased returns. 

Just how mispriced are the markets?  Let’s start with U.S. equities.  As of 8/31/17, the S&P 500 Reported Earnings were 23.8X Trailing Twelve Months (TTM).  This is with the index less than 1% from its all-time high.  By way of contrast, the Housing Bubble burst in 2008, but the market actually peaked in October of 2007.  At the end of September 2007, the TTM P/E was 19.4X.  Admittedly, the TTM P/E was higher before the DOT Com Bubble burst.  The number was 29.4X and was skewed by the Tech sector.  Though quarterly earnings peaked coincident with the highs, both earnings and prices continued to decline dramatically for the next two years.  Other metrics, like price to sales, are by far the highest ever for the S&P 500 median company.

How about government bonds?  Here is a recent cross section of ten year Government rates:  United States 2.07%, Italy 2.02%, Spain 1.55%, United Kingdom 1.04%, France .67%, Germany .36%, and Japan .006%.  Ask yourself.  Does this make any sense?  Could it exist in any world but a world where the central banks have run amok, and distorted financial asset relationships like never before.  Clearly, at these prices, the bond markets are pricing in little, if any, growth.  And apparently pricing in little, if any, default risk.  Is Italy a better credit than the U.S.?

We are not the first to point out the dichotomy between the pricing of stocks versus bonds.  In the US, 23.8X TTM earnings and a 2.07% ten year just doesn’t jive.  Stocks are saying growth and bonds are saying no growth.  We believe the bond market will be right for reasons we have stated in the past.  The recent 3% print in Q2 GDP will, we believe, prove to be a blip.  The long term population demographics, trends in numbers of both employed and those out of the workforce, low long term growth in productivity, and skilled immigration (or lack thereof) will all prove to be a long term inhibitor to growth.

As far as President Trump’s ability to get his agenda through congress it is not at all clear that he will be successful.  And even if he is, in our view, it is already priced in.  There used to be a saying that “politics stops at the waterline”.  This referred to the fact that even though we Americans have our differences, we are still Americans and when a foreign threat arises, we are united as one and all politics cease.  Today that old saying seems to have morphed into “politics stops at the center of the aisle”.  Anyone that thought that acrimony had peaked at the end of the Obama administration, (naively) thought wrong!  Never before have we witnessed such political division that seems to be mainly for the sake of division.  So we’ll see where that all goes, but it doesn’t appear to be a good development given we are hovering near all-time highs in the major indexes.

We thank our readers for their loyalty and attention and assure them that the towel still rests in the corner.  We’ve wiped some sweat from our brow, but are standing and waiting for the bell and the next round, when the central banks reverse what they have been doing for the past few years (8 years for the Fed).  And when they reverse, it could be very detrimental for stocks.


 
 



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