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.)
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.
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
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.
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
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”.
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
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
THERE WILL BE SIGNIFICANT ROADBLOCKS IN THE MARKET THE REST OF THIS YEAR, 2018, AND BEYOND
11/11/17 5:50 AM
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
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.
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
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
(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.
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
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.
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.
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.
© 2018, Comstock Partners, Inc.. All rights reserved.