A False Sense of Security (Hussman)

Sunday, March 25th, 2012

“The world economy has stepped back from the brink and we have causes to be a little bit more optimistic. But optimism should not give us a sense of comfort and certainly should not lull us into a false sense of security.”

IMF Managing Director Christine Lagarde, March 17, 2012

As we examine the present evidence relating to both the financial markets and the global economy, the aspect that strikes us most is the extent to which Wall Street continues to emphasize superficially positive data in preference for deeper analysis, to extrapolate short-term distortions as if they were long-term trends, and to misconstrue freshly printed wallpaper and thin supporting ice as if they were solid walls and floors.

Two propositions we heard last week were characteristic of this false sense of security. One was a remark by an analyst that stocks were in a “secular bull market” here. The other was a Wall Street “factoid” being passed around, suggesting that the “equity risk premium” on stocks has never been higher.

Let’s address these in turn. When people talk about bull and bear markets, they often use the terms “cyclical” and “secular.” One cyclical bull and one cyclical bear market comprise the normal garden-variety market cycle of about 5 years in duration (though with quite a bit of variation around that norm, see “notes on secular and cyclical markets” in Hanging Around, Hoping to Get Lucky ). Taking very broad averages, a cyclical bull market lasts about 3.75 years, averaging a trough-to-peak gain of about 150%, and a cyclical bear market lasts about 1.25 years, averaging a decline of just over 30% from peak-to-trough. If you do the compounding, you’ll observe that the typical bear market wipes out more than half of the preceding bull market gain.

However, those averages mask an additional source of variation, which depends on “secular” conditions. If you examine market history as far back as the late-1800′s, you’ll find that market valuations have moved in broad advancing and declining phases, with each phase lasting about 17-18 years in duration (that still should be treated only as a tendency, and there’s no reason I know for treating it as a magic number). As an example, stocks moved from extremely low valuations in 1947 to quite rich valuations by 1965, producing a long “secular” bull market where each successive cyclical bull market topped out at higher and higher valuation multiples. In contrast, from 1965 to 1982, valuation multiples went through a long contraction, where each successive cyclical bear market bottomed out at lower and lower valuation multiples.

The effect of these longer valuation “waves” is this: during long secular bull phases, the cyclical bull markets tend to be longer and more rewarding, and the cyclical bear markets tend to be shorter and less damaging. In secular bulls, the market is running with the wind at its back. The secular bull market period from 1982 through 2000 was a good example of this tendency.

In contrast, during long secular bear phases, the cyclical bull markets tend to be shorter and less rewarding, while the cyclical bear markets tend to be longer and more violent. In secular bears, the market is swimming against the tide. The secular bear period that began in 2000 has been a good example of this tendency.

As Nautilus Capital observes, the average cyclical bull market in a secular bear market period has produced an average gain of only about 85%, lasting less than 3 years on average. In contrast, the average cyclical bear in a secular bear has been unusually violent, averaging a 39% loss over a span of about a year and a half. Compound the two, and that’s enough damage to drag the cumulative full-cycle return down to just 13%, on average.

Needless to say, the assertion that stocks are in a “secular” bull market is really an assertion that investors can let down their guard, in the sense that downturns are likely to be muted and advances will be extended. But from our standpoint, if you’re going to pick a secular team, it would be best to have reliable data to back up the choice.

So what distinguishes a secular bull from a secular bear? Valuations. Not just any valuation measure however – it’s important to demonstrate that the valuation measure you choose actually has a strong and demonstrable long-term relationship with subsequent market returns (which is where Wall Street’s disingenuous use of toy models like simple price-to-forward earnings multiples and the “Fed Model” makes us nearly apoplectic).

Below, I’ve annotated our usual valuation chart to provide a better sense of what drives the long “secular” movements in the stock market. The chart uses our standard valuation methodology to estimate prospective market returns.

It should be quickly evident that secular bull markets don’t simply come out of the blue. They emerge precisely because stocks become priced to achieve extraordinarily high long-term returns. Both the 1947-1965 secular bull and the 1982-2000 secular bull began at points where stocks were priced to achieve 10-year returns of close to 20% annually. In contrast, the 1965-1982 secular bear began with prospective 10-year returns of just 5.9% (though slightly higher than the 4.4% yield on Treasury bonds at the time), and of course, the secular bear that began in 2000 emerged from bubble valuations, where we projected negative 10-year total returns at the time.

It seems to be an article of faith among some analysts that the 2009 low represented the start of a new secular bull market, but two features are noteworthy. The first is that the valuation achieved in 2009 was nowhere near the valuation that typically ushers in a new secular bull market. The second is that the brief undervaluation we observed in 2009 was quickly eliminated. At present, we project total returns for the S&P 500 of just over 4% annually over the coming decade. This is even worse than the valuation where the 1965-1982 secular bear started (though certainly less extreme than the 2000 peak). Though interest rates are lower today than in the 1965-1982 period, satisfactory returns from present levels will require investors to sustain rich valuations indefinitely.

Again, it’s worth emphasizing that our standard valuation methods are (and have remained) well-correlated with subsequent market returns – a very basic criterion that is painfully lacking among many popular valuation measures such as the Fed Model. It strikes me as absolutely bizarre that so many Wall Street “professionals” offer up the Fed Model and the “forward operating earnings times arbitrary multiple” approach so freely, when it takes nothing but some data and a few hours of effort to demonstrate that those approaches are nearly worthless (see for example the August 20, 2007 comment Long Term Evidence on the Fed Model and Forward Operating P/E Ratios – not that many analysts agreed with our valuation concerns at that point either).

A related assertion we’ve heard a lot lately is that “the equity risk premium on stocks has never been higher.” In the finance literature, the “equity risk premium” is essentially the return that stocks are priced to achieve, in excess of the risk-free interest rate. Of course, these estimates vary wildly depending on the method you use (many common ones which, again, have virtually no correlation with actual subsequent returns). A few popular methods include 1) the Fed Model (forward operating earnings yield minus the 10-year Treasury yield); 2) dividend yield plus projected earnings growth, minus the 10-year Treasury yield; 3) historical stock returns minus the 10-year Treasury yield, which is a particularly misleading measure of the returns stocks are priced to achieve in the future, or; 4) any of the above using the prevailing T-bill yield instead of 10-year yields.

Among the problems with these typical approaches is that stocks are not 3-month or 10-year instruments, but have a duration that is essentially the inverse of the dividend yield (so at present, the duration of stocks is roughly 50 years, compared with a 10-year Treasury, which has a duration closer to 7 years). So the appropriate “risk free” return in these estimates should really be either a Treasury yield of equivalent maturity – none which are available, or at least an estimate of the average expected short-term risk free rate expected over the same horizon. Needless to say, estimates of the equity risk premium get a false benefit if you use today’s unusually suppressed, short-duration risk-free rates.

The larger difficulty is the estimate of the prospective return on stocks. If you want to use a 10-year Treasury yield as a benchmark, you would also want to use a 10-year projected return for the S&P 500. On that note, and using reliable valuation methods (see above), the difference between the expected 10-year total return on stocks and the 10-year Treasury yield is presently less than 2% (nominal).

How does this compare historically? It’s notable that the estimated equity risk premium was severely negative during the late-1990′s market bubble. Not surprisingly, stocks have performed terribly versus risk-free Treasuries as a result. Excluding bubble-era data, we estimate that the normal historical equity risk premium (on a 10-year horizon) has been just over 6%, reaching 17% in the late-1940′s as a secular bull market was beginning, and holding in the 5-9% range even during the high-inflation 1970′s. Including the late-1990′s bubble period in the calculation brings the average down to just over 4.5%.

When has the equity risk premium been as low as it is today? Prior to the late-1990′s bubble period, the estimated equity risk premium has been below 2% only during the two-year period leading up to the 1929 peak, between 1968-1972 (when the equity risk premium finally normalized as a result of the 1973-1974 market plunge), and briefly in 1987, before the market crash of that year. We know how each of these periods ended. The only real variation is in how long the preceding overvaluation was sustained.

Profit margins and a false sense of security

One of the aspects of the market that is most likely to confuse investors here is the wide range of opinions about valuation, with some analysts arguing that stocks are cheap or fairly valued, and others – including Jeremy Grantham, Albert Edwards, and of course us – arguing that valuations are very rich.

The following chart may help to bridge that gulf. Essentially, analysts who view stocks as “cheap” here are invariably basing that conclusion on current and year-ahead forecasts for earnings. In contrast, analysts who view stocks as richly valued are typically those who view stocks as a claim not on this years’ or next years’ earnings, but instead are a claim on a long-term stream of deliverable cash flows. Simply put, there is presently a massive difference between short-horizon earnings measures and longer-term, normalized earnings measures.

What’s going on here is that profit margins have never been wider in history. But profit margins are also highly cyclical over time. The wide margins at present are partly the result of deficit spending amounting to more than 8% of GDP – where government transfer payments are still holding up nearly 20% of total consumer spending, and partly the result of foreign labor outsourcing (directly, and also indirectly through imported intermediate goods) which has held down wage and salary payouts. Indeed, the ratio of corporate profits to GDP is now close to 70% above its long-term norm.

Now, if you look at the red line (right scale, inverted), you’ll notice that unusually high profit shares are invariably correlated with unusually low growth in corporate profits over the following 5-year period. Thanks to continuing deficits and extraordinary monetary interventions, this effect has been largely postponed in recent years, allowing profits to expand to present extremes. We are not arguing that profit margins necessarily have to decline over the near-term, and our concerns don’t rest on the assumption that they will. It is sufficient to recognize that the bulk of the value of any stock is not in the early years of earnings, but in the long tail of future cash flows – especially if payouts are low. Stocks are essentially 50-year instruments here in terms of the cash flows that are relevant to their valuation. There are a lot of factors and quiet math that affect the P/E multiple that can be appropriately applied to earnings. Slapping an arbitrary multiple onto elevated earnings reflecting extraordinarily inflated profit margins ignores all of it.

The upshot is that if investors are willing to believe (without the use of off-label hallucinogens) that current profit margins are the new normal, and will be sustained indefinitely, then Wall Street’s valuations based on current and forward earnings estimates can be taken at face value. This assumption of a permanently high plateau in profit margins is quietly embedded into every discussion of “forward earnings” here.

As a side note, analysts continue bemoan the “inexplicable” gap between the economic malaise of “Main Street” and the optimism of Wall Street. Compare the previous graph to the one below, which shows how the “Muppets” are doing (and people wonder why I’m cynical about corporate culture). An economy that is this far out of balance is one that is unlikely to avoid toppling over to some extent. Capitalism and free markets work, and America remains the most creative and innovative nation on the planet, but until policy makers and regulators wake up, it will be impossible to escape the long-term consequences of distorted markets, reckless bubble-seeking Fed Chairmen, repressively low interest rates that penalize saving and lower the bar for productive investment, a self-serving financial system, and bailouts that remove all consequences for misallocating capital that could otherwise create jobs and raise living standards.

The iron law of equilibrium

A final observation. We continue to hear endless variations of this comment – “The Fed is creating huge amounts of money, and all of that money has to go somewhere.”

Actually no, it does not. The iron law of equilibrium is that once a security is issued – whether that piece of paper is a share of stock, a bond certificate, or a dollar bill – that security has to be held by someone in exactly that form, and in no other form, until it is retired. If IBM issues one share of stock, that share of stock can change hands between any number of people, but someone has to hold that share until it is retired. If the Fed creates a dollar of base money, that base money can change hands between any number of people, but someone has to hold that dollar until it is retired. There is no “getting out” of cash and into stocks in aggregate. There is only an exchange of ownership between existing pieces of paper that will each continue to exist until each is retired.

So the proper question isn’t where all of these pieces of paper will go – they still have to be held by someone exactly as they are. They may change hands, but in equilibrium, they don’t go anywhere. They can’t go anywhere in aggregate. The only real question is this: how low do you have to drive the returns on all other competing assets until the “someone” holding that dollar bill has no incentive to try to trade it for some other piece of paper? This, precisely this, and only this, is what the Fed is manipulating with its massive interventions. By creating enormous amounts of paper, and hoarding higher duration securities like Treasury securities, the Fed is trying to force investors into risky assets until the prospective returns on all competing assets are driven so low that investors and banks holding cash are willing to just sit on it. In short, the Fed has focused its efforts on creating a bubble in risky assets, on the misguided, semi-psychotic, and empirically disprovable notion that this will make people feel wealthier and get them to spend and borrow – despite the fact that their incomes can’t support it without massive government transfer payments.

Aside from periodic jolts of enthusiasm that release some amount of pent-up demand for a few months at a time, what this policy has actually produced is near-zero prospective returns on nearly every class of assets. These assets will now go on to actually achieve tepid returns for an extended period of time, provided that things work out well, and a collapse in the prices of risky assets if investors ever get the inclination to demand a normal return as compensation for the risk they are taking.

Market Climate

The Market Climate for stocks remains characterized by an unusually hostile set of indicator syndromes, most notably, an “overvalued, overbought, overbullish, rising-yields” syndrome that has historically been unfavorable for stocks regardless of prevailing Fed policy or trend-following indicators. Even in recent years, the effect of Fed policy and other interventions has been evident after significant market weakness (essentially limiting the follow through and helping to re-establish rich valuations), but those interventions have not prevented the weakness itself – not in 2007-2009, not in 2010, and not in 2011. Our primary risk estimates are now in the worst 0.5% of what we observe in historical data. We have increasingly used the word “warning” in our weekly comments for that reason. Strategic Growth and Strategic International remain fully hedged. Strategic Dividend Value is hedged at 50% of the value of stocks held by the Fund, which is its most tightly hedged stance. Strategic Total Return maintains a generally conservative stance as well, with a duration of just under 3 years in Treasuries, and about 5% of assets allocated between precious metals shares, utility shares, and foreign currencies. I strongly expect that we will have significantly better opportunities to accept financial risk in expectation of return than the near-zero prospects the Federal Reserve has forced upon investors at present.

Meanwhile, our economic concerns persist, as detailed last week and in prior comments. Despite a low-level rebound in various coincident measures, we continue to observe general weakness in the most informative leading measures (as we saw again in data from Europe and China last week as well). Based on the typical lead-time of these measures, we are now in a window where we would expect deteriorating coincident data over the coming 2-3 months. As I’ve noted in prior comments, to the extent that we observe economic data coming in better than expected during this window, the inferred state of the economy is likely to improve, and we would then be able to suspend our recession concerns. Regardless, it’s important to recognize that our defensiveness about the stock market here is distinct from those economic concerns, and our risk estimates would remain quite high (based on factors including the prevailing overvalued, overbought, overbullish, rising-yields syndrome), even if we were to zero out our recession concerns.

Tags: Bear Market, Bear Markets, Bull And Bear, Christine Lagarde, Distortions, Equity Risk Premium, False Sense Of Security, Financial Markets, Garden Variety, Global Economy, Hussman, Imf, Market History, Market Valuations, Secular Bull Market, Sense Of Security, Source Of Variation, Term Trends, Trough, World Economy
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John Taylor: “The Nice Risk Rally Since The First Half Of 2009 Is Ending” And Will Be Replaced By A “Scary Descent”

Friday, May 13th, 2011

In the last two years, one of the most accurate predictors of both long and short-term trends has been FX Concepts’ John Taylor, whose April call for a EURUSD peak of 1.4925 was almost to the dot. Which is why he is either about to cheapen his predictive record by being wrong, or the days of the rally are ending. In a statement very comparable to that from Jeremy Grantham released a few days ago, Taylor tells Bloomberg that: “the rally in higher-yielding assets is coming to an end with Europe’s sovereign debt crisis resurfacing, growth sluggish and banking systems unsteady. “This is the end of the nice slow moving risk rally that has lulled us pleasantly to sleep since the first half of 2009,” Taylor, chairman of New York-based FX Concepts LLC, said in an interview. “This warning is worthy of a brass band and bright lights as the other side of this low volatility rally will most likely be a scary descent that will have a very negative impact on markets. Our statistical models say we are about at the end of the road for risk.” Taylor gives a deadline to his prediction: “Higher-risk assets, such as equities, the euro and emerging market currencies, have either peaked or will do so by end of July.” If Taylor’s previous predictive record is any indication, it may get volatile soon. On the other hand, his forte is FX not stocks, and many other forecasters have been burned (or should have been) at the stake of predicting capital markets in a time of central planning.

From Bloomberg:

Higher-risk assets, such as equities, the euro and emerging market currencies, have either peaked or will do so by end of July, according to Taylor, who manages about $8.5 billion and uses statistical models to help predict future movements in assets. Global investors have tempered their optimism about the U.S. and world economies and plan to put more of their money in cash and less in commodities over the next six months, a Bloomberg survey released today found.

FX Concepts, whose returns last year were the company’s best since 2006, reaped gains in the first half of 2010 betting on a slide in the euro against the dollar and then profited by its rise the rest of the year. At present, the fund is short the common currency, which means it will profit if it declines.

Taylor, who predicted several times since 2010 that the euro will eventually fall to parity versus the dollar, boosted returns by wagering on short term swings higher in the shared European currency. FX Concepts, in a Jan. 27 note, said the euro would move higher in a medium-term trend and in April predicted the currency was poised to reach a technical target of $1.4925.

Taylor had some choice words for Europe:

“There is absolutely statistically no way that Greece can survive,” said Taylor, who just returned from France. “There is a one in 10,000 chance; if the Germans give Greece their money to pay back their debt then they’ll be fine. But there is no way Germany will do that.”

Greek government bonds fell today, pushing the two-year note yield to a record high of 26.77 percent. The bonds have lost investors 11 percent this year.

“As the spread of Greek two-year debt goes absolutely crazy over German, it means that at some point we are going to have to have a crisis,” said Taylor, whose Global Currency fund gained 3.33 percent last month. “And I think it’s very soon.”

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Tags: Banking Systems, Brass Band, Bright Lights, Capital Markets, Commod, Debt Crisis, Emerging Market, Forecasters, Global Investors, Jeremy Grantham, John Taylor, Negative Impact, Optimism, Rally, Sovereign Debt, Stake, Statistical Models, Term Trends, Volatility, World Economies
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Where Does Your Gold Come From?

Wednesday, March 2nd, 2011

Gold was the center of attention yesterday after closing at new all-time highs above $1,430 an ounce, breaking the previous record set in December 2010. Gold prices have risen over 7 percent since the unrest in the Middle East began at the end of January.

The turmoil in Libya and the possibility of it spreading to countries including Iran, Iraq and Saudi Arabia have thrown uncertainty and fear back into the market. In addition, inflation has historically been a catalyst for higher gold prices and the expectation of inflation around the world has been growing.

The volatility created by this turmoil and uncertainty is just short-term noise and we caution investors to not get overly wrapped up in the day’s news cycle. Investing from headline news will only have you chasing short-term performance.

That said, gold’s long-term trends are very positive. One of the strongest drivers of higher gold prices is supportive supply/demand fundamentals. Overall gold demand grew 9 percent to a 10-year high in 2010, while mine production only managed a 2 percent increase.

Gold-producing mines can be found all over the world. The list of the top producers includes one of the most underdeveloped countries in the world (Ghana) and economic powerhouses such as the United States and China.

Take a look at our new Global Gold Mining Production Map . The interactive display digs deeper into the top 10 gold-producing countries. By clicking on each named nation, you’ll see the production from 2003 through 2009 (the most recent official statistics) and key factors related to gold around the world. Some countries have had their production decline over the past five years, while others have seen significant increases.

Leading the countries is China, which has increased its gold output over 90 percent since 2000. From 2007 through 2010, the country wrestled away the title of “world’s largest gold producer” from South Africa and hasn’t looked back since.

South Africa’s story is the exact opposite. Plagued by labor issues, rising electricity costs, mine safety considerations and lower ore grades, the country’s gold production has fallen significantly since peaking in 1970.

Last year, Australia retained the world’s second-largest producer of gold, with output rising 17 percent to its highest level in seven years.

How well do you know the countries that mine gold?

View the Interactive Map

Tags: All Time Highs, Catalyst, Center Of Attention, Countries In The World, Economic Powerhouses, Global Gold, Gold Demand, Gold Mining, Gold Output, Gold Prices, Gold Producer, Headline News, Official Statistics, Saudi Arabia, Term Noise, Term Performance, Term Trends, Top Producers, Underdeveloped Countries, Volatility
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Will We Have Inflation, Deflation, or Hyperinflation? Part 3

Tuesday, June 29th, 2010

This is Part 3 of a four part article that deals with what I feel is the primary question investors must now answer: is our future to be inflation or deflation? The answer has vast implications to our investment planning and decisions for the near term, and possibly for our long term. It is a very complex question with a lot of moving parts involving economics and politics.

Like it or not, it is economic theory that is driving macroeconomic policies and political decisions that determine whether we will have inflation or deflation. Since not all of my readers are sophisticated traders I have tried to present the issues in a direct and hopefully understandable way. To those sophisticated readers, please bear with me.

Part 3

What Factors Will Drive the Economy?

This is the point where we need to look at some long-term trends in the economy to see how they will impact a recovery.

If our economy is based on consumer spending (70% of GDP) then GDP will see a decline in the second half of 2010.

In my article, Economic Megatrends That Will Drive Our Future, I point our seven megatrends that will impact our economy for the long term:

1. The culture of consumption is broken and won’t return to former levels. This is the key to everything.
2. Consumers will continue to increase savings to prepare for retirement.
3. Declining U.S. consumer demand will continue to negatively impact the world economy.
4. Deflation (deleveraging) will continue for some time.
5. Home ownership rates will decline to more historical levels of, say, around 66%, down from the high of 69% during the boom, which will keep a lid on home prices.
6. Government stimulus and recovery programs only delay recovery and deepen the pain for workers.
7. Massive federal deficits will double the national debt, result in higher taxes, and will act as a permanent drag on the economy.

I wrote this article in September, 2009, and it still stands. The significant things to note are No. 1 and No.2. Consumers are over-indebted and are doing their best to pay down debt. This article from the Wall Street Journal defines the issue:

After years of bingeing on debt, U.S. households are paring back. Those not doing so by choice are often being forced, because lending standards remain tight.

[T]he household sector’s debt level, which includes both consumer credit and mortgage loans, remained at about 20% of total assets in the first quarter.

In the mid-1990s that ratio was around 15%, compared with a peak in the first quarter of 2009 of about 22.5%.

Just getting debt down to 18% would require households to shed an additional $1.4 trillion of debt.

The way to pay down debt is to decrease spending and increase savings, especially when unemployment is at 9.7% and when real wages  (inflation adjusted) have been essentially flat:

J. M. Keynes referred to the phenomenon of increased savings and reduced spending as “hoarding” by consumers and believed it harmed the economy, which is why, he said, the government needs to spend in their stead. In fact, what consumers are doing is very rational economic behavior in light of uncertainty. Savings will actually lead the economy out of the recession by creating new capital to fund an economic expansion.

The main point here is that the consumption cycle for the majority of big spenders, the Baby Boomers, has changed, in my opinion, permanently. Boomers now realize that they need to save for retirement because Social Security won’t be enough, they don’t have enough financial assets, their home values will not regain their former highs, and they won’t inherit enough from their parents to help them in their old age.

This has significant impacts on the recovery and the inflation/deflation issue. That is because the politicians making policy decisions believe that Keynes is right. I’ll discuss this later.

Is Credit Unfreezing?

Recently lending has increased and excess reserves have decreased. Some have suggested that this is the beginning of the end of the credit freeze but I disagree.

This chart (TOTLL, YoY) reveals an increase in lending by commercial banks in Q1 2010:

This corresponds to a like decrease in excess reserves (EXCRESNS) during the same period:

This lending is evidenced by an increase in consumer loans in Q1 2010 (CONSUMER):

What happened was that consumers went on a mild spending spree. I believe that almost all of the increase in consumer spending had to do with government fiscal stimulus: Cash for Clunkers, Cash for Appliances, and the home buyer credit which has spurred sales in home improvement goods.

New car sales have been doing better as a result of dealer incentives. The data show that nonrevolving loans (NREVNCB), the measure for (mainly) auto loans (up 7.1% in April), went up dramatically in Q1 2010:

Retail sales increased during that period, but now it is declining, much to the concern of the Fed.

The latest Fed Flow of Funds report showed renewed declines in total credit as well as consumer credit. For Q1 overall household debt decreased for the seventh consecutive month (-2.4%). Consumer credit contracted 1.5%. Nonfinancial business debt was flat after four months of declines.

The Report said revolving credit, or credit-card use, fell a 19th straight time in April, down 12.0%. Further, personal savings are increasing again after the drawdown.

It appears that the temporary increase in consumer spending was not related entirely to money supply increases. Nonrevolving loans for autos increased, but a significant portion of general spending was fueled by personal savings of consumers. The following chart reveals that the rate of consumer savings (PSAVERT) declined in response to government incentives which favored certain industries (mid-2009 to Q1 2010). It appears that personal savings is starting to rise again, but we will need to watch the data to confirm such a trend.

The Fed’s Problem

The Fed has a dilemma.

On the one hand, if they believe we are in a strong recovery, then they are worried about inflation.

There was a lot of talk about recovery and the problem of what will happen when banks start lending again: banks will use their huge excess reserves which would cause money supply to explode, thus fueling “inflation” which they define as rising prices. This is what has been popularly referred to as the “draining the pond” or the “exit strategy” problem: how can the Fed sop up excess reserves before they hit the economy and cause rising prices? It is a very serious issue.

The Fed closely monitors CPI and, as shown before, prices are growing at the rate of 2% YoY. (I’ll discuss signs of a decreasing CPI rate below.) If they decide to decrease the money supply by raising the Fed Funds rate from nearly zero percent, they believe they run the risk of jeopardizing the nascent recovery.

For many months now most of the discussion by the Fed and most economists concerned exit strategy. Now the discussion has changed almost 180°: the buzz is now all about the possibility of deflation and economic decline. (See discussion below.)

For these reasons, I don’t think they are that concerned with inflation for the near term.

The Implications of a Double-Dip Decline

Temporary Effects of Stimulus

I think the economy is headed for a decline commencing at some point in the second half of 2010. I believe the Fed is concerned about this as well. Evidence of this is starting to show up in the numbers. The reasons for this are complex, but:

1. Most of the economic gains have been the result of fiscal stimulus which is running out of steam.
2. There has not been sufficient deleveraging in the economy by which banks have repaired their balance sheets.
3. The remaining huge real estate debt hanging over banks, especially commercial real estate, has not been dealt with because of various government policies that postpone the inevitable write-downs (mark-to-make believe, extend and pretend, housing credits, and delay and pray) and will restrict lending.
4. Monetary stimulus has failed to create viable economic growth.
5. These facts inhibit the creation of credit and will act like an anchor on the economy.
6. The long-term megatrends mentioned before will reduce economic activity and cause major shifts in the economy.

There is no question that consumer spending has been stimulated by government programs. Those programs are now coming to an end. Recent data showing a decline in retail sales surprised most economists.

The Wealth Effect

Another factor is that the stock markets have had a positive impact on families’ perceived wealth which has helped consumer spending. But, it appears that most of such spending has been from the wealthier segment of the economy. A recent Gallup poll showed that consumers earning more than $90,000 accounted for the bulk of that spending increase. A market stock decline will reduce this wealth effect.

Manufacturing Recovery

I believe our manufacturing recovery has been a result of cyclical factors unrelated to stimulus programs. As nervous retailers and wholesalers cleared out inventories in the early stages of the recession, at some point they had to restock. While unemployment is high, the fact is that at least 80% of the work force have jobs and, even though they may feel insecure, they still spend on what is necessary. That boosted manufacturing. But manufacturing without renewed consumer demand and a revival of credit will not lead us out of the recession.

Also, manufacturing has been benefited by the cheap dollar which has boosted exports. Other countries, especially developing countries, have been buyers of US products. But I think this is changing because of:

1. The dollar’s rise caused by Europe’s deep economic problems will reduce our cheap dollar advantage; and
2. China’s economy is based on exports and declining US and EU economies will impact its growth. Further they are facing a serious housing bubble that will burst the hard way. China needs an American economic recovery to save them, not vice versa.

It is clear that the American economy headed for a double dip decline, which I believe will occur in the second half of 2010.

Deflation Fears

I have noticed in the mainstream media that with increasingly weak numbers coming out recently there is a lot of talk about deflation. This is important because it is a reflection of mainstream economic thinking, which includes the Fed. Ben Bernanke reads the same headlines as you and I do.

Here are some recent headlines and the issues they raise:

CPI Declines

The consumer price index dropped 0.2% last month, the Labor Department said. The “core” rate of inflation–underlying consumer prices, which strip out volatile energy and food items and are closely watched by the Fed–rose 0.1% in May. …

This concerns shows up in Core CPI YoY (CPI less energy and food):

Deflation Fears Stir in Developed Economies

Deflation makes it harder for consumers, businesses and governments to pay off debts. Principal repayments on debt are fixed but deflation is marked by falling incomes, so as deflation sets in the burden of paying off old debts gets greater. …

That’s an acute worry today. In addition to government debt, U.S. households are still trying to work off large debt burdens built up in the last two decades. A Federal Reserve report Thursday [Flow of Funds report] showed households cut their borrowings in the first quarter to $13.5 trillion, down from a peak of $13.9 trillion in 2008.

Bernanke Warns on Deficits

Deflation isn’t a concern at moment

Bernanke Calls for Deficit Plan

Advancing a theme he has emphasized in the last few months, Mr. Bernanke said that if Congress pursued more fiscal stimulus to sustain the recovery, it should be accompanied by a concrete plan to bring the deficit back into line in the long run. Without a fiscal “exit strategy,” he said, the U.S. could, “in the worst case,” see financial instability like in Greece.

The Congressional Budget Office projects the U.S. deficit will hit $1.4 trillion this year, or 9.4% of gross domestic product. Even as the economy recovers, it projects deficits in excess of $400 billion a year later this decade.

Bernanke Urges Deficit Cuts

At a moment when many economists warn that the American economic recovery is likely to be imperiled by prolonged high unemployment and slow growth, President Obama is discovering that the tools available to him last year — a big economic stimulus and action by the Federal Reserve — are both now politically untenable.

Fed Weighs Growth Risks

But fiscal woes in Europe, stock-market declines at home and stubbornly high U.S. unemployment have alerted some officials to risks that the economy could lose momentum and that inflation, already running below the Fed’s informal target of 1.5% to 2%, could fall further, raising a risk of price deflation.

Martin Wolf on the Danger of Deflation

There is no world economy big enough to offset renewed contraction in Europe and the US. Concerted fiscal tightening could, in current circumstances, fail: larger cyclical deficits, as economies weaken, could offset attempts at structural fiscal tightening. …

Policymakers must recognise that deflation is a risk, too, and that tighter fiscal policy requires effective monetary policy offsets, which may be hard to deliver today, above all in the eurozone.

Premature fiscal tightening is, warns experience, as big a danger as delayed tightening would be. There are no certainties here.

S&P Warns of Rising Corporate Defaults

Small banks are big problem in government bailout program

Business Hold Record Amounts of Cash

The Federal Reserve reported Thursday that non-financial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest increase on records going back to 1952. Cash made up about 7% of all company assets including factories and financial investments, the highest level since 1963.

You get the drift: the economy is not going as the Fed and most economists have predicted so naturally they talk about deflation. They are worried about the possibility of experiencing deflation similar to what occurred in the Great Depression.

Why Most Economists Have it Wrong

Most economists believe that more fiscal stimulus is needed now and that Bernanke’s cries for fiscal sanity must not be heeded or we will sink into a depression. This is a normal Keynesian reaction to the world. In fact the arch knee-jerk Keynesian of our time, Paul Krugman’s last three editorials have spoken to this issue. Across the pond Martin Wolf of the Financial Times has been beating the same drum.

I wish they would explain why all the fiscal and monetary stimulus the government has done since October, 2008 hasn’t worked yet. Krugman would just say government hasn’t spent enough. But then he always says that. Perhaps he should read some of Romer and Reinhart’s research on what government debt does to a country’s ability to recover. The fact is fiscal stimulus never works and never has. But it will leave us saddled with huge debt.

It would be a mistake to credit government spending on fiscal stimulus projects for any lasting economic gains. Since the government can ultimately only obtain money from taxpayers, it is only a shift of capital from individuals (i.e., the folks that make the economy function) to the government to fund projects it deems politically beneficial.

Government fiscal stimulus projects do not create any lasting economic benefit. While it is true that new roads and safe bridges benefit the economy, that is not the purpose of fiscal stimulus. The purpose of fiscal stimulus is to create “jobs” and stimulate consumer spending. Such stimulus is wasteful and never creates a viable economic enterprise which would continue after the money dries up.

One must ask what the private economy would do with the $62 billion already spent through the American Recovery and Reinvestment Act ($202 billion contracts, grants and loans awarded to date). I urge anyone who believes the spending through ARRA would stimulate the economy to check out the various contracts and grants that are being awarded. The main web site is Recovery.gov. You will see that most are repairs to federal facilities or grants for federal programs. I recommend you hold your nose while doing this. They are outrageous wastes of your tax money and they will damage the ability of the economy to recover and will place a great burden on future generations to pay them.

If government spending were the key to economic wealth then we should all be rich.

Tomorrow, Part 4. The Fed’s response to a decline, money supply, and the likely outcome.

After Part 4, I will publish the entire article as one downloadable PDF.

Source: Daily Capitalist

Tags: Bill Gross, Capitalist, China, Consumer Spending, Drag On, Economic Theory, Federal Deficits, Home Ownership Rates, Hyperinflation, Inflation Deflation, Investment Planning, Jeff Harding, Macroeconomic Policies, Megatrends, Moving Parts, National Debt, Political Decisions, Sophisticated Readers, Sophisticated Traders, Stimulus, Term Trends, World Economy
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US stock market confirms primary downtrend

Wednesday, January 9th, 2008

Jan. 9, 2008 – Prieur du Plessis provides his clarity on the current downtrend that is unfolding in the US Market.

The original post is here:

“Winter, spring, summer or fall, all you have to do is call, and I’ll be there, you’ve got a friend …” These are the lyrics of Carol King’s song. Yes, as life swings from boom to gloom it is the support of friends that often provide the necessary solace.

It is unlikely that Mr Market will come patting you on the back when your investments go pear-shaped, but he does provide his own unique variety of comradeship. In an environment cluttered with noise, Mr Market offers us the very simple but true adage of “the trend is your friend”. This sounds comforting enough, but Mr Market still expects us to fulfill a task: to identify the direction of the trend.

An important point to realize is that there are trends within trends, varying from ultra short (intra-daily) to short (daily) to intermediate (weekly) to long term (monthly). Although day traders play short-term trends from minute to minute, I believe that it is really the identification of the primary (multi-year) trends that holds the key to successful investing.

One way of approaching this is to gauge the fundamental landscape – factors such as unfavorable valuations, stretched profit margins, mounting evidence of an imminent recession and increasing default risk. These paint a fairly bleak picture, but keep in mind the discounting nature of the stock market, having already factored in the gloomy news we are faced with 24/7. In order for the market to fall further the nature of the problems should turn out to be broader and deeper than currently discounted. As mentioned previously, I believe that the fallout of the housing and subprime situation has not been fully discounted.

A more visual way of recognizing the primary trend is by means of analyzing the technical picture, especially using a longer-term perspective.

The following graph indicates how the Dow Jones Industrial Index has been mapping out a series of lower lows and fallen below its 200-day moving average (often seen as an indicator of the primary trend). The shorter term 50-day moving average is trending down and provides an early indicator of what is in store for the longer-term average. The Index has just dropped below its November low on increased volume, serving as further confirmation of a downtrend.

Source: StockCharts.com

The chart below shows the percentage of stocks on the NYSE that are trading above their 200-day moving averages. As of yesterday’s close the reading was 28.1%. This is the lowest reading in five years and indicates that more than seven out of every 10 stocks are in primary downtrends. Although the current level appears low, the number has fallen as low as 10% at previous bear market bottoms (such as 2002).

Source: StockCharts.com

Next is the 10-year graph of the NYSE Composite Index (based on monthly data), indicating the price trend together with the MACD oscillator. The failed year-end rally in December witnessed the histograms falling below the zero line (see blue circle) for the first time since the start of the bull market in 2003. (The previous MACD sell signal was given eight-and-a-half years ago in July 1999.)

Source: StockCharts.com

Turning to a monthly graph of the Dow Jones Industrial Index, a similar picture emerges when using the 14-month RSI oscillator. This indicator is overbought at levels above 70 and oversold below 30. The RSI’s trend is now falling for the first time since the bull market commenced in 2003.

Source: StockCharts.com

My assessment of the above is that there is more weakness for the stock market ahead. Although the market is oversold on a short-term basis, I would be very reluctant to take long positions in the face of what I believe is a market topping out and embarking on a primary downtrend. I therefore concur with Nouriel Roubini, professor of economics at New York University, when he says: “… a lousy stock market in 2007 will look good compared to an awful stock market in 2008.”

I wrote a series of bearish articles on the stock market (and bullish on gold) during the latter months of 2007 of which the last one on December 17 was entitled “Is this the end of the stock market party?”. Mr Market has provided the answer and it is a rather discomforting one. Yes, “the trend is your friend”, but only if you heed Mr Market’s warnings and appreciate that the stock market is in a downtrend. Be inordinately cautious with your investment strategy.

Source: Unknown

Tags: Adage, Bear Market, Blog, Carol King, Chart, Comradeship, Day Traders, Default Risk, Dow 30, Economics, Economy, Fallout, Gloom, Gold, Important Point, Investment, Investment Strategy, Life Swings, Markets, Miscellaneous, New York University, Nouriel Roubini, NYSE Composite, Pear, Prieur, professor of economics, Profit Margins, Rally, Recession, risk, S Song, Solace, Stock Market, Term Perspective, Term Trends, Trading, Valuations, Winter Spring Summer
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