Tuesday/Thursday Market Commentary

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Debt Can be Looked Upon in Various Ways
What is the Real Total Debt in the U.S.A.?
4/07/17 10:00 AM


Comstock has been discussing the debt situation in our country for years.  We wrote a “special report” discussing the various forms of debt and explained how the debt is incorporated in “The Cycle of Deflation” (see attachment) as the debt was hindering many speculators and investors just before the dot.com bubble was about ready to collapse.  We warned that the debt was the main reason that the valuations were the highest in history and would eventually break the market.  This was exactly what took place starting in March of 2000 when the stock market crashed and a severe recession began. 

We again warned our viewers about the problems of excessive debt during the housing bubble of 2005 to 2008 when Alan Greenspan, the Chairman of the Federal Reserve at the time, decided to lower interest rates to 1% in June of 2003.  This caused the largest housing mania of all time.  Banks were virtually pushing money to anyone that wanted a loan to buy a house (whether they could afford it or not.)  Back then--they called these loans “no doc loans”.  These were loans that were made without any documentation whatsoever.

The amazing part of this era was that Greenspan warned stock investors about the “irrational exuberance” that was taking place in the late 1990s as the stock market rose almost every day. The “irrational exuberance” speech drove the market down, but that only scared off investors for just a few days and the stock investors regained the losses almost immediately.  After observing the voracity of the market that could not be held down, Greenspan changed his mind and confessed to being wrong about his warnings just before the real break took place in early 2000.  He also witnessed the housing bubble, and not only did he support the banks making the loans, but actually encouraged the banks to continue making these insane loans. 

This leads us to the old time phrase, “fool us one time, shame on you, fool us twice shame on us.”  When the current debt bubble breaks and the stock market collapses we could say, “Fool us 3 times and we should be banned from trading and investing in the financial markets.”  Unless we can understand why the debt caused the collapse in 1929 (after the roaring 1920’s), in 2000, and 2008, we should be forced to compare the debt to GDP in all of these times to the present.

If you were forced to do this you would look at the debt and be shocked at how much the debt grew over the past two decades.  If you are a Democrat you might compare how much the debt grew under President George W. Bush and use examples of how much it grew during the eight years of his administration. You could make comparisons like the debt grew more under George W. than all past presidents (going back to George Washington).  If you are a Republican, you could make the same comparisons of how much the debt grew under Barack Obama and make the same comparisons (going back again to George Washington).  If you did make these comparisons you would come close to going out of your mind, because it would have to scare you. 

The amazing thing is the fact that you would be making the comparisons erroneously since you would look at the debt doubling under George W. and then doubled again under Barack Obama, and think we are in real trouble.  However, the debt you would be using is strictly the government debt, and get scared as hell when you see the debt is now just about equal to the GDP of the greatest country in the world at about $20 trillion apiece. 

If, on the other hand, you were looking deeper into the debt and could see that the debt has grown much more than the GDP of our country.  In fact, the real debt relative to GDP is actually about 370% of GDP if you include the government debt, the state and local debt, student debt, credit market debt, and the loans made to foreign banks overseas.  The 370% of debt relative to GDP also should include all of the entitlements and other off balance sheet debt that we include now.  These are obligations that have been guaranteed to most of the people in this country such as the entitlement promises of Social Security, Medicare, Medicaid, and government employee pensions.  If you take all of them into consideration the debt to GDP would not be just 370% but closer to another $40 trillion of debt which would take the total debt to over 500% of our GDP.  If that doesn’t scare you nothing will!!

Now that President Donald Trump will probably have as much trouble with his other agenda items as he did with his repeal and replace of healthcare, the market could have real problems.  And when this enormous debt comes to light, we would expect the market to decline sharply.  The only way that the Trump Administration can survive without moving his agenda quickly this year would be to grow the economy close to the rate of 3 to 4 % as he predicted.  But it is very hard to grow nearly that fast with these demographics, retiring baby boomers, fewer immigrants--it is impossible to get corporations to make capital expenditures and productivity to increase without being able to increase the labor force. This is why they are in such a bind!

But Politics, Debt, and Stagflation May Change Things
2/28/17 1:05 AM

The Trump rally, which began during the overnight session the night of November 8th has, in our view, built perfection into prices, which we think were already priced to near perfection.  In the bull case, fundamentals were already improving and President Trump’s proposed cutting of regulations, taxes, and instituting pro-growth fiscal spending, just adds fuel to the fire.  It seems to us that every possible benefit of the doubt is being given to the new administration in an economic and political climate that is unprecedented in our lifetime, and possibly our country’s history.

In addition, there is nothing that says that President Trump will get all he wants from Congress.  The most positive outcome is being discounted by the stock market presently and if there is resistance or delay with his programs, the stock market will suffer. The U.S. will need to raise the debt ceiling in mid-March, and we do not believe the market has focused on that.  With debt and interest rate exposure that are enormous, we do not believe that Republican deficit hawks, that have spent their careers as such, will be so eager to approve spending increases that are not offset by spending cuts.    Additionally, we expect Democratic opposition to the President’s agenda to be fierce.  So the Trump programs which have been treated by the market as a forgone conclusion will, in our view, be much more difficult.

The Fed continues to state that three rate increases are on the table for 2017.  Our view of the matter is that the Fed is walking a tightrope as the $20tn. of US debt is relatively short in duration, with a maturity of just over 5 years, and just under a 2% average coupon.  Thus, there is enormous interest rate exposure in terms of the debt and deficit, for that reason alone, it is likely the Fed will be behind the curve.  The exposure created by the $20tn. of debt (and possibly much more debt under President Trump), along with $100tn. in unfunded liabilities and entitlements, puts the US and the Fed in a very serious bind as each 1% increase in funding cost to the government will add $200bn. to the national debt.  Additionally, as labor markets tighten (with corresponding negative effects on profit margins), the Fed moving gingerly risks an acceleration in inflation.

As our readers know, we are believers that high debt is, in and of itself, a dampening factor on economic growth.  We have also written many times about how the 8 years of close to zero interest rates has caused risk assets to be mispriced.  The European Central Bank (ECB) and Bank of Japan (BOJ) mimicked us, and even upped the ante with negative rates.   And the BOJ purchases of equities, has further inflated the bubble in Japan.  The newest economic superpower, China, is in a credit bubble of its own that is even larger than ours as a percentage of its economy.  While President Trump has referred to China as a currency manipulator, they are doing exactly the opposite.  A weak currency will only exacerbate an already serious capital flight problem.  Therefore, they have been trying to strengthen the Yuan.

There is an argument being made currently by Alan Greenspan, that we are headed from “Stagnation to Stagflation”.  In the beginning of this cycle, profit margins and the stock market should move up as inflation gains momentum.  But it will not continue because what is really going on longer term is a problem with the productivity of the economy.  As our country ages and retires, we will not have an influx of baby boomers entering the workforce like we had in the 1980’s and 1990’s. These population demographics cause a problem with growth in entitlements.  The entitlements crowd out savings which results in less investment in productive assets.  We subscribe to this argument and strongly believe this to be a headwind to growth that will exist unless we get many more workers entering the labor force.  More working immigrants entering the country would ease the situation, but would bring its own additional set of problems.

 On the subject of valuation, our favorite measure is the trailing twelve month Generally Accepted Accounting Principles (GAAP) P/E of the S&P 500.  With 92% of S&P companies reporting (as of 2/24/17) it appears the trailing twelve month GAAP earnings are just under $96.  That’s a current P/E of 24.7. We don’t believe that a 2% growth environment justifies that valuation.   Furthermore, analyst’s estimates compiled by S&P, project that earnings growth in the next two years will be just under 17% a year.  This is in an economy which has not been able to get above 2% annual growth and stay there.  Even if earnings did grow at that rate, the GAAP P/E in 2 years (at this level of the market) would still be around 18, which is historically expensive.  If the economy and earnings are growing at that rate, one would have to think that interest rates and inflation will rise.  And if GAAP earnings are capitalized at significantly higher interest rates, it will naturally be a problem for stocks.

In summary, it is our view that the market is in the third credit driven bubble of this century.  We believe that the strong move since the election has more to do with hopes and dreams of what could happen rather than the reality of what is likely to happen.  The additional growth that could come as a result of less regulation and lower taxes pales beside the inflation in asset values, especially stocks, due to the policies of the Fed.  In that sense, it doesn’t actually matter all that much who the president is. Debt and demographics are working against us and it will take, in our view, a bear market of epic proportions to correct the excesses in valuation that exist.

Weak Productivity Will Continue to Hinder the Growth of Our Economy
2/02/17 8:20 AM

This bull market is close to eight years old, and if it continues for another month, it will be the second longest bull market in the history of the stock market.  Being heavily invested in a stock market that is historically just about the longest on record, and is also extremely over-valued, has got to be dangerous. However, for some strange reason the sentiment of investors in this stock market is just about as bullish as it can be.  In fact, the Investors Intelligence, Market Vane, January Michigan Sentiment, and VIX all show extreme bullishness to the point that you would have to call it “euphoria”.  And as you know, bullish markets often end when “euphoria” begins.

Many investors believe that the rationale of being fully invested is due to the low interest rates, and even if the Fed raises rates, it will be a while before they raise rates high enough to get to normalized levels (basically around the inflation rate of 2%).  However, you have to keep in mind that the peg rate of the Fed over the next year ranges from 2% to 2.5% or higher.  Therefore, the one fact that the bulls are leaning on is about to evaporate.  Keep in mind that the Fed did say they would raise rates 4 times in 2016, and they only raised rates once.  We suspect strongly that they will raise rates further, and faster, than in the past, especially since their two mandates have reached the levels they set, and they don’t want to get too far behind the curve. 

Other reasons that the U.S. investor’s sentiment is so high is because of President Trump’s promise to lower taxes on individuals and corporations, roll back regulations, repeal and replace Obama Care, and a push for the repatriation of much of the $2.4 tn held abroad.  He also plans on starting a fiscal plan to invest $1 tn in infrastructure.  This last promise also makes it much easier for the Fed to raise rates much more rapidly since they have been asking for this fiscal type of help for years.  We, however, don’t believe that President Trump will find it as easy to do as the other promises he made-- such as pulling the TPP trade plan, pulling NAFTA, as well as restructuring the key pipelines of Keystone and Dakota.

Another unusual statistic that you might find interesting is the fact that every new president since Dwight Eisenhower had to deal with a recession within 2 years of taking the Presidency.  It does seem that President Trump should be concerned about that statistic and should worry about running into a recession within the next two years.

Another unusual statistic that should be of concern to the bulls, and new president, is that in order to have a sustainable and strong economy there needs to be strong productivity.  In order to increase productivity in an economy as large and as strong as ours, you need growth in the labor force and substantial corporate investments combined to increase GDP and productivity.  There was a study done by Morris Mark (founder of Mark Capital) that showed the screeching halt to productivity and decreases in the labor force starting in the year 2000.  He showed that because of increases in productivity the U.S. economy grew over 3% from the years 1945 to the year 2000.  Since 2000, our economy grew at less than 2%.  This is another statistic that should be of concern to the bulls and President Trump. 

Another study done by Ruchir Sharma, from Morgan Stanley global research, corroborates with Mark about why our economy needs increases in business investments and growth in the labor force.  Sharma stated that the 8 year terms of Presidents Ronald Reagan and Bill Clinton, produced a GDP growth rate of between 3-4%.  This growth rate was produced because the “baby boomers” were entering the work force as business investment was strong.  However, this type of growth is no longer plausible.  We will only grow at 2% or lower due to the demographics in our country.  This is another fact that should worry the bulls and President Trump.  If President Trump can accomplish many of the things that he ran on (such as tax reduction and rollback of regulations) could help, but not solve, the large GDP growth spread from the 80’s and 90’s (3-4%) and the present weak recovery of less than 2% that we are experiencing.

But Normalized Interest Rates Will End The Party
1/03/17 11:00 AM

The past eight years provided a phenomenal environment for stocks, bonds, and real estate due to the tremendous expansion of the Fed’s balance sheet and the resulting eight year zero interest rate policy.  During that eight year period the world became familiar with terms like Quantitative Easing (QE) and Operation Twist as the Fed moved into uncharted waters in both the magnitude and length of its easing programs.  What began as an emergency program to rescue the U.S. and the world from the Global Financial Crisis turned into a longer term attempt to stimulate growth through the inflation of financial assets; the theory being that wealthy people would spend more and that wealth would “trickle down”,  and result in economic growth.  As it turned out, it should also be mentioned, that the Fed alone pretty much carried the economic football as the budget sequester limited the impact of fiscal policy as the U.S. government continues to struggle with debt and deficits.

Several times during the past eight years, sell offs in the stock market were alleviated or reversed as the Fed “rode to the rescue” with more QE and the aforementioned Operation Twist.  So powerful were the effects of the Fed’s activity that other major central banks in Europe and Asia started QE programs of their own.  The ECB and BOJ have “upped the ante” by taking interest rates to negative levels several years out on the yield curve, and in the case of the BOJ, have even resorted to buying equities through the ETF market.  As a result approximately $12tn of sovereign debt in Europe and Japan have negative yields and in addition, the Government Investment Fund of Japan is a top ten shareholder in the majority of the market capitalization of the Japanese stock market.  We don’t know where the Japanese buying of equities stops or possibly reverses, but it is not healthy to have the national government interfere in free markets and substitute public for private capital in the ownership of what should be the nation’s growth engine.

We have discussed many times how ill advised, to put it mildly, the major central bank policies are.  In essence these policies distort the relationship between risk and return that is essential for the efficient pricing of capital.  This causes bad investments to be made and good investments not to be made.   Zero and negative interest rates also push investors into riskier investments than would otherwise be made as they chase yield.   The companies themselves, in the U.S. and increasingly elsewhere, have been on a “feeding frenzy”, buying stock back at extremely inflated levels to the detriment of investing in their businesses.  In many cases, compensation of senior managements is determined by EPS metrics not adjusted for stock buybacks.  Since it is the managements and boards of companies that authorize and execute these programs, an inherent conflict of interest exists as managements ”knock” options “into the money”, thus influencing their own compensation.  With the stock market at or near all-time highs the public is not focused on this, as the “music is still playing”.  But we maintain that the day may come when the focus of politicians and regulators will be how much money was stripped from shareholder’s equity of U.S. companies as stock was bought back at valuations that in more normal times would cause them to want to SELL equity, not buy!

The rally that has taken place since the election of Donald Trump comes at a time that the Fed is (slowly, so far) reversing the zero interest rate policy of the past eight years. In addition, they are not selling the bonds they bought and are holding on their balance sheet, but rather are letting the balance sheet “run off”.  Said another way, this is money printing, i.e., currency debasement, plain and simple.  In our view, the market is betting the Trump promises of tax cuts, deregulation, repatriation, and fiscal stimulus across defense and infrastructure related industries will outweigh the potential negatives of possible trade wars and tariffs, a stronger dollar, inflation, and further rising debt and deficits.  To our way of thinking, and to no surprise to our readers, we believe the market’s positive reaction thus far will be dead wrong.

The damage has been done over the last eight years by the Fed’s ill-conceived and irresponsible zero interest rate policy and unprecedented money printing.  Financial assets have been inflated to at or near the most expensive levels in history.  As the Fed raises rates and tries to normalize, debt will continue to climb, and in our view, Trump or no Trump, we will not grow our way out of the problems that exist.  Whether we have low growth and low inflation, or whether we have stagflation remains to be seen.  But either way, when rates normalize, as they must, the markets will become rational again.  In our view, when that happens, both stock and bond prices will be substantially lower.

But The National Debt Could Grow Even More
12/02/16 4:30 AM

We have to admit to being as surprised as everyone else at the stock market’s reaction to the Donald Trump victory.  And it is not because we think the policies of the incoming administration will be less growth oriented than the Obama or the not to be Clinton administration.  Quite the contrary.  President-Elect Trump’s policies will be friendlier to business and to the taxpaying public than the alternative.  The problem is that those policies could also explode the debt, which we believe is the most significant financial threat to the country’s growth and economic well being.

On the positive side, there are a number of pro growth initiatives in the Trump plan.  A partial list would include, infrastructure related spending and jobs resulting from the fiscal response, rebuilding a depleted military including new investment in weapons systems, scaling back or eliminating Obamacare, tax cuts for individuals and corporations, reducing the maze of Federal regulations that are choking certain business activity including energy production, building the Keystone and other pipelines, possible corporate investment in neglected real plant and equipment due to a shift to optimism from pessimism, and importantly, repatriation of corporate profits that are being held offshore, mainly in Europe.

On the opposing side, there are at least several negatives.  Among those are building a wall financed by Mexico that causes friction and reverse immigration of low skilled workers (ultimately very inflationary), minimum wage laws, which are not only inflationary but actually can destroy jobs, renegotiation of trade agreements that slows business activity, trade tariffs that are ultimately borne by the U.S. consumer, and possible political interference in the activity of the Fed (our readers know that we have vehemently criticized this Fed in particular, but we have never espoused political interference).

Below are a few statistics, sourced from www. usdebtclock.org.  We compare to the same series eight years ago, at the end of 2008, and encourage our readers to view for themselves.

  1. The National Debt went from $10.9tn to $19.9tn, an increase of 82.5%.

  2. GDP went from $14.1tn to $18.7tn, an increase of 32.6%. (This increase in debt relative to increase in GDP is clearly unsustainable.)

  3. Though the National Debt stands at $19.9tn, which given GDP is an increasing and ominous number, the Unfunded Liabilities, which include Social Security and Medicare, stand at an almost unfathomable $104tn.

  4. Total Public and Private Debt is now $66.8tn, up from $50.8tn.  Given the above, Total Credit Market Debt now stands at 357% of GDP.

We could go on and on with many more statistics but we think that you, the reader, get the point.  Our thesis is, and has been, that the excessive debt that exists has slowed growth.  This is evident in the anemic GDP growth statistics since the end of “The Great Recession”.  We believe the better than expected 3.2% increase in GDP increase reported by the government last week will prove to be another false start, especially in light of the rapidly increasing dollar relative to the currencies of our trading partners. 

At the same time that debt was going through the roof, the Fed was increasing its balance sheet from $800bn to $4.5tn.  Said another way, the increase in debt, at least on the public side, was financed in large part through the printing of money.   That has, in our view, led to the inflating of financial assets to levels not seen before on the fixed income side, and to near the most expensive valuations in history on the equity side.  In its most recent reporting summary S&P 500 Trailing Twelve Month  GAAP earnings are $89.29 (24.2X P/E on 9/30/16 Close).  We have written about what we view as dangerously high equity valuations many times, most recently in the piece entitled “Malaise” on this website.

That brings us back to President-Elect Trump and what he will face as he attempts to implement the policies he espoused during the campaign.  In March 2017, the federal debt limit, which has been suspended since the fall of 2015, will be reinstated.   It is at the time, or more likely, in the weeks immediately preceding, that the markets will focus on the issue.  We could again get a glimpse of just how topsy-turvy the world has become, for it may be the republicans that become the debt lovers and the democrats that, in the spirit of obstruction by both parties that has existed for some time, try to put the brakes on.   While it may not be possible to predict the outcome, we feel it is safe to say that this is one of several catalysts that have the potential to ignite the bear market we have been anticipating for some time.

We think President-Elect Trump would be wise to heed the advice espoused by Randall Forsythe in the last two issues of Barron’s magazine.  Essentially, it boiled down to taking advantage of artificially low interest rates and issuing  50 or 100 year bonds while cutting corporate tax rates to a theoretically revenue neutral 22%.  At $20tn in debt, each 25 bps is $200bn of interest.  In the longer term, this will have the effect of crowding out other spending.   In our view massive infrastructure spending may boost the economy temporarily.  But more spending means more debt and potentially more inflation and interest rate exposure.  Whether President-Elect Trump and his advisors heed the advice remains to be seen.  But from our perspective, we see more money printing, more currency debasement, and more risk to the financial assets that have been so grossly inflated by the Fed’s irresponsible experiment.



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