Real Investment Advice is the home of the daily blog and weekly newsletter from Lance Roberts, Chief Portfolio Strategist for Clarity Financial. If you want to understand how money and the economy really work, this is your place to start.
Over the last several weeks, we have been discussing the potential for a market correction simply due to divergences in the technical indicators which suggested near-term market risk outweighed the reward. Then, the White House reignited the “trade war” with China. To wit:
“The “Trade War” is not a good thing for markets or the economy as recently suggested by the President. David Rosenberg had an interesting point on this as well on Friday:
‘Tracing through the GDP hit from a tariff war on EPS growth and P/E multiple compressions from heightened uncertainty, the downside impact on the S&P 500 would come to 10%. I chuckle when I hear economists say that the impact is small- meanwhile, global trade volumes have contracted 1.1% over the year to February…how is that bullish news exactly?’
Remember, at the beginning of 2018, with ‘tax cuts’ just passed, and earnings growing, the market was set back by 5% as an initial tariff of 10% was put into place. Fast forward to today, you have tariffs going to 25%, with no supportive legislation in place, earnings growth and revenue weakening along with slower economic growth.
In the meantime, the bond market is screaming ‘deflation,’ and yields have clearly not been buying the 3-point multiple expansion from the December 24th lows.”
It was due to that analysis, and the trade war, that we made the following recommendations last week to our clients and RIA PRO subscribers. (Try NOW and get 30-days FREE)
“Continuing from yesterday’s discussion on the impact of ‘trade wars’ on various sectors has us beginning to reposition out of some the areas most susceptible to tariffs. Yesterday, we closed out our position in Emerging Markets, and sold 1/2 of our position in Basic Materials.
Today, on the bounce as laid out yesterday, we sold half of our position in XLI (industrials) and XLY (consumer discretionary) and added one-half position in XLRE (real estate) which should be defensive with lower interest rates.“
We still maintain a long-bias towards equity risk. But, that exposure is hedged with cash and bonds which remain at elevated levels. (If you haven’t taken any actions at all recently, read my previous newsletter for Portfolio Management Guidelines)
While the market got very oversold previously, we noted last weekend a bounce was likely.
Unfortunately, that bounce was unable to hold above the 50-dma on Friday which negates the break above it earlier in the week. Importantly, the deeply oversold condition was somewhat reversed which now sets the market up for a potential retest of the 200-dma average over the next couple of weeks. A failure at that level and we have to start having a different conversation about portfolio allocation models.
For now, the market is working a corrective process which is likely not complete as of yet. As we head into the summer months, it is likely the markets will experience a retracement of the rally during the first quarter of this year. As shown in a chart we use for position management (sizing, profit taking, sells) the market has just issued a signal suggesting risk reduction is prudent. (This doesn’t mean sell everything and go to cash.)
There is no “law” that says you have to be “all in” the market “all the time.”
Every good gambler knows how to “size their bets” relative to the “hand they hold.” This is particularly the case when it certainly appears the “bulls are betting on a long shot.”
Betting On A Long-Shot
Last week, we discussed in a lot of detail the re-escalation of the “trade war” and the potential impact to earnings in the quarters ahead. To wit:
“As a result of escalating trade war concerns, the impact in the worst-case scenario of an all-out trade war for US companies across sectors and US trading partners will be greater than anticipated. In a nutshell, an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies by ~11% and, thus, completely offset the positive fiscal stimulus from tax reform.
Fast forward to the end of Q1-2019 earnings and we find that we were actually a bit optimistic on where things turned out.”
“The problem is the 2020 estimates are currently still extremely elevated. As the impact of these new tariffs settle in, corporate earnings will be reduced. The chart below plots our initial expectations of earnings through 2020. Given that a 10% tariff took 11% off earnings expectations, it is quite likely with a 25% tariff we are once again too optimistic on our outlook.”
“Over the next couple of months, we will be able to refine our view further, but the important point is that since roughly 50% of corporate profits are a function of exports, Trump has just picked a fight he most likely can’t win.
Importantly, the reigniting of the trade war is coming at a time where economic data remains markedly weak, valuations are elevated, and credit risk is on the rise. The yield curve continues to signal that something has ‘broken,’ but few are paying attention.”
For the bullish narrative, the earnings growth story is going to become increasingly difficult to ignore. This is particularly the case given that just this past week economic data continues to show weakness. As shown in the following chart, global economic trade has collapsed to levels not seen since prior to the financial crisis.
Of course, since almost 50% of corporate revenue and profits are generated from international activity, it is not surprising to see a problem emerging.
As J. Brett Freeze, CFA discussed on Friday, dissected the key drivers of economic growth: Capital Expenditures.
The graph shows that when the economy is coming out of recession and optimism is budding, capital expenditures as a percentage of the economy are high. Conversely, as optimism wanes, and the economic cycle is long in the tooth capital expenditures peak, trend sideways and then drop sharply. (The data in the graph is normalized using six quarter moving averages and standard deviations as reflected on the Y-axis.)
The 1960s and the current period are unique in that those periods saw a sharp decline in capital expenditures that did not lead to a recession. We know the current episode is a result of a resurgence of corporate optimism due to the election of Donald Trump and importantly, the corporate tax cut that incentivized corporate spending. With much of the tax cut stimulus behind us, the temporary fiscal boost appears to be fading.
Unsurprisingly, all of this data aligns with rising recession risks.
(Important Note: The graph above is based on lagging economic indicators which are subject to huge negative revisions in the future. Therefore, high current risk levels should not be readily dismissed as the recession will have started before the data is revised to reveal the actual start date.)
Here is my point.
If you had been living on Mars for the last 24-months and just reviewed the data above, you would, most logically, assume the market would be down, and probably significantly so.
That certainly isn’t the case, as noted above, with the markets just a couple of percentage points away from their all-time highs. So, despite the data, the resurgence of a “trade war” with China, rising delinquency rates and falling demand for loans, and weak outlooks by businesses, the bulls are certainly “betting on a long-shot” of an outcome that is currently well outside the current data.
In that is the case, then what are the “bulls” betting on? My friend Patrick Hill sent me a good note on this issue.
“In watching Bloomberg, it seems the market is betting on:
1 – The Fed will lower interest rates. The Fed Funds rate forecast shows at least once this year. Interestingly, historically, when the Fed begins lowering interest rates it has been in response to a recession, not a slowdown.
2 – The trade war will not be as bad as thought as Trump and Xi will meet at G20 and resolve everything. But that may not be the case given China’s positioning on Friday:
“The US has completely abandoned commercial principles and disregarded law. Its barbaric behavior against Huawei by resorting to administrative power can be viewed as a declaration of war on China in the economic and technological fields. It is time that the Chinese people throw away their illusions. Compromise will not lead to US goodwill.”
3 – Corporations can continue to churn out revenue growth as China stimulus will help out EM countries and US companies can sell to them
4 – Corporate debt at levels at record highs, and leveraged loans at twice the level of subprime debt in 2008, is of no real concern.
5 – Corporate stock buybacks will continue to provide a bid to the market. (Of course, what happens when sales continue to fall.) Ned Davis research noted their research shows the S & P is up 19 % over what it would not be without buybacks. Buybacks have also made up about 80% of the “bid” to the market.
6 – There is no concern that tariffs will push price inflation higher despite the fact that tariffs will lift costs on both consumers and businesses.
7 – The Fed will respond to any weakness providing a permanent bid the market.
In other words, at the moment, data doesn’t matter to the markets – it is simply “hope” based momentum magnified with a “crap ton” of liquidity (Yes, that is a technical term.)
Doug Kass recently discussed the issue of the current disconnect.
“‘(Very) leveraged strategies involving yield enhancement, allocations based on risk assessment (risk parity) and other volatility targeting funds are contributing factors to a new and heightened regime of volatility that has recently intensified. And so does the popularity and proliferation of passive ETFs and the proliferation of CTA (extreme momentum-based) strategies, exaggerate short term price moves. (Even BlackRock’s Larry Fink has missed this important reason for the market’s sharp advance this year).
There is such a limited discussion of the enormous sums of money that are now being managed by Quants and Pseudo Quant hedge funds, algorithmic trading with MASSIVE leverage, all of which dominates the investing landscape.
The aforementioned strategies (based on momentum and the assessment of asset class risk), embraced by many, work until they don’t and when a trend changes (from up to down) massively levered products (like risk parity) are forced to delever and buy back volatility (to offset their short vol positions) – further exacerbating the move lower.
The problem, of course, is ‘uncovered’ when too many are on the same side of the boat.
A state of stability should not be as trusted as much today as in the past it will likely morph into more frequent episodes of instability – a series of ‘Minsky Moments.'”
This is an important point, stability eventually breeds instability due to the buildup of “complacency.” The entire bullish “bet” currently is that despite a growing laundry list to the contrary, the markets will continue their advance simply waiting for the data to improve.
Primarily, this belief is hinged on the idea the Fed will come to the rescue. The problem, as noted previously:
“The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures. In 2008, when the Fed launched into their ‘accommodative policy’ emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.”
If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.
But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.”
“The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the “norm” are negatively extended, confidence is hugely negative. In other words, there is nowhere to go but up.”
That is hardly the case currently as prices have become detached from both the economic and fundamental cycles of the market. The bulls are clinging to narratives to justify excessive valuations and deviations from the norm.
“We live in an investment world in which much of the silly, fairy..
Art and collectibles prices have exploded in the past decade as a result of the extremely frothy conditions created by central banks. Hardly a week goes by without news headlines being made about ugly, tacky, or just plain bizarre works of art fetching tens of millions, if not hundreds of millions, of dollars at auction houses like Sotheby’s and Christie’s (often sold to rich buyers in China or Hong Kong). Make no mistake: we’re currently experiencing a massive art bubble of the likes not seen since the Japan-driven art bubble of the late-1980s that ended disastrously. Two art market records were made in the past week: the $91.1 million “Rabbit” sculpture by Jeff Koons, which set the record for the highest amount paid for a piece of art by a living artist, and the sale of Monet’s ‘Meules’ painting for $110.7 million, which set a record for an Impressionist work.
A sculpture of a silver rabbit by artist Jeff Koons sold at Christie’s auction house in Manhattan Wednesday for $91.1 million, setting the record for the highest amount fetched for a piece of art by a living artist.
Koons’ “Rabbit” surpassed the previous record, which was set just last November when British painter David Hockney’s “Portrait of an Artist (Pool with Two Figures)” sold for $90.3 million. Both totals include the auction house fees.
Art dealer Bob Mnuchin, the father of Treasury Secretary Steven Mnuchin, made the winning bid for the Koons work, Bloomberg reported. Mnuchin made the purchase for a client, according to the report.
The sculpture, which stands just over 3 feet high, is made of stainless steel and based on an inflatable children’s toy, according to the auction house.
“Rabbit” by Jeff Koons is displayed at Christie’s in New York on May 3, 2019. Photo credit: AP
One of the few paintings in Claude Monet’s celebrated “Haystacks” series that still remains in private hands sold at auction on Tuesday for $110.7 million, setting a record for an Impressionist work.
The oil on canvas, titled “Meules” and completed in 1890, is the first piece of Impressionist art to command more than $100 million at auction, said Sotheby’s, which handled the sale.
That also represents the highest sum ever paid at auction for a painting by Monet, the founder of French Impressionism and a master of “plein air” landscapes who died in 1926, aged 86.
“Meules” was one of 25 paintings in a series depicting stacks of harvested wheat belonging to Monet’s neighbor in Giverny, France.
The works are widely acclaimed for capturing the play of light on his subject and for their influence on the Impressionist movement.
“Meules” by Claude Monet is displayed at Sotheby’s New York on May 3, 2019. Photo credit: Reuters
Last month, I wrote about “bubble drunk” millennials in Hong Kong who paid $28 million for Simpsons art:
The Kaws Album’, KAWS. Courtesy Sotheby’s.
Today’s art bubble (like many other bubbles that are currently inflating) formed as a result of the Fed and other central banks’ extremely loose monetary policies after the Great Recession. In a desperate attempt to jump-start the global economy again, central banks cut and held interest rates at virtually zero percent for much of the past decade. The chart of the Fed Funds rate below shows how bubbles form when interest rates are at low levels:
In addition to holding interest rates at record low levels for a record length of time, central banks pumped trillions of dollars worth of liquidity into the global financial system in the past decade:
Assets around the world – from art to stocks to property – have been levitating on the massive ocean of liquidity that has been created by central banks. For example, the S&P 500 has soared 300% since its low in early-2009:
In order to understand today’s art bubble, it is helpful to learn about the art bubble of the late-1980s that ultimately crashed and burned. Throughout the 1980s, Japan had a bubble economy that was driven by debt and bubbles in property and stocks. Japan’s economy was seemingly unstoppable – almost everyone in the West was terrified that Japan’s economy and corporations would trounce ours while destroying our standard of living in the process. Of course, few people knew how unsustainable Japan’s economy was at that time.
As a result of hubris and the enormous amount of liquidity that was flowing throughout Japan’s economy in the late-1980s, Japanese businesspeople and corporations started to speculate in art, often bidding previously unheard of sums that Western art collectors would never have dreamed of paying. For example, Yasuda Fire and Marine Insurance paid a record $39.9 million for Vincent van Gogh’s “Sunflowers” at a London auction in 1987. Ryoei “wild fellow” Saito, Chairman of the Daishowa Paper Manufacturing empire, paid $160 million for the world’s two most expensive paintings – a Van Gogh and a Renoir. At the peak of the art market in 1990, Japan imported more than $4 billion worth of art, including nearly half of all Impressionist art that was on the market. Of course, the art market plunged along with Japan’s bubble economy in the early-1990s.
Vincent van Gogh “Sunflowers” 1888.
Unfortunately, today’s art bubble will burst just like the art bubble of the late-1980s. China, with its massive debt bubble, is currently playing the role that Japan played in the Eighties. While most people are probably not worried about the coming art market bust and won’t be directly affected by it, the point of this piece is to show how the art market acts like a barometer for the amount of froth there is in the global economy and financial markets. When the art market goes ballistic, that is typically a sign that the economic cycle is in its latter stages. We are fast approaching a time when art speculators will deeply regret paying $91.1 million for a steel rabbit sculpture and tens of millions of dollars for Simpsons art.
The recent running of the Kentucky Derby marks the time of year of horse racing’s prestigious Triple Crown and everything that goes along with it. Temperate spring weather, increasingly beautiful spring foliage, ostentatious hats, parties, and of course, the impressive physical prowess of the horses and the jockeys are all part of the season.
It is also a reminder of another race that has been going on, albeit with considerably less pageantry: The race to fund pension plans. This is a different kind of race because it is ongoing and because there aren’t distinct winners. There definitely are losers, however. It is also a race that has driven considerable interest in risky assets such as stocks and private equity.
In a sense, investors are accustomed to racing because it is something of a race to fund a retirement before it happens. The reality that many people wait too long to even start the race, and often don’t contribute enough money once they do start, only highlights the inherent challenges of the exercise.
There is yet another factor in the retirement equation that many investors have not bargained for though: The race has gotten harder over time due to low interest rates. This makes it even harder for investors to reach their retirement objectives and has created incentives for investors to increase risk. The Financial Times reported on how the process started over ten years ago in Japan, where the demographic challenges are even more urgent:
“Banks today offer only token interest rates of 0.1–0.45 per cent and ‘it is necessary to make money work harder’, says Tomoo Sumida, senior economist at Nomura Asset Management. ‘The baby-boomers will live for 20 years after they retire and there is no way they can support themselves without investing,’ says Mr Hirakawa at UBS’.”
The report confirmed that “the search for higher returns has begun” with cash and bank deposits declining as a share of overall household financial assets and stocks and other investments increasing share.
While the search for higher returns is understandable, it often belies the important consideration of risk. Financial assets, after all, are not utilities that consistently provide certain returns. While it is generally true that riskier assets produce higher returns than less risky assets over very long periods of time, they can also underperform for periods easily stretching to ten to twenty or more years. For many investors with comparable investment horizons, such as retirees and those nearing retirement, the historical average long-term returns of financial assets obscure the risk of falling short of their goals.
A better gauge for determining expected returns for stocks over a ten- to twenty-year investment horizon is to infer the returns implied by current prices and expected cash flows. John Hussman regularly performs this exercise and recently concluded that stock valuations “offer investors among the most offensive investment prospects in financial history.”
In his analysis, he also highlights an important difference between now and the tech boom in 2000 when valuations were also exceptionally high:
“An important aspect of current valuation extremes is that they are far broader than what was observed even at the 2000 market peak … Strikingly, the current multiple [median price/revenue ratio of S&P 500 component stocks) is far beyond what was observed at the 2000 peak.
With the exception of stocks in the very highest valuation decile, every other decile is more overvalued today than it was at the 2000 market peak.”
In other words, not only does investing in stocks provide the bleak prospect of low to negative returns over the next several years, but unlike in 2000 when only a few stocks were significantly overvalued, now almost everything is overvalued so there is nowhere to hide. The bottom line is that the chances of hitting retirement goals by searching for higher returns in stocks is extremely low.
The conditions of having under-saved for impending expenses while also confronting an interest rate environment that is adverse to accumulating wealth is one that is also starting to hit pension funds in the US hard. Even though such funds are typically managed by professional investors who can carefully evaluate risk, the reflex reaction of these institutional investors to search for higher returns has been extremely similar.
The only real difference is that the search for higher returns by institutional investors is even more vigorous, which is evidenced by many of them going even further out on the risk curve by increasing allocations to private equity. Grants Interest Rate Observer reports on one of the biggest players in the space in its April 5, 2019 edition:
“‘So, if I could give you a one-line exact summary of this entire presentation, it would be: We need private equity, we need more of it and we need it now,’ Ben Meng, GIG of the California Public Employees’ Retirement System, said at the pension plans’ Feb. 19 investment committee. ‘So, let’s talk about the first question. Why do we need private equity? And the answer is very simple, to increase our chance of achieving the seven-percent rate of return‘.”
Grants describes the decision-making logic:
“What’s a fiduciary to do? You can hardly meet a 7% investment hurdle with a 10- year Treasury yielding 2.5%, much less with a 10-year bund yielding negative 0.05%. The same low rates, of course, have decreased the cost of leverage and flattered the size of projected future cash flows—well and good for private equity’s cosmetic appeal.”
The case for private equity has more than just cosmetic appeal. The environment in which institutional funds make allocation decisions is culturally amenable to the strategy as Rusty Guinn reveals in a piece entitled, “Deals are my art form“:
“But if you want to understand, by and large, how big pools of capital make big decisions about how much of their plan will be allocated to private equity, venture capital, private real estate, hedge funds, alternative premia (and everything else), you must focus on the interactions that take place between the CIO office, the consultants and the board.
Asset owner boards are dominated by politicians, lawyers and businesspeople. Deal people. People for whom – like the Donald – The Deal is their art. Understanding the decision-making process of large pools of capital means understanding the deals! meme.”
In the challenging context of relatively high required returns, Guinn illustrates how the proclivity towards deal-making at the highest levels of institutional decision-making manifests itself:
“Consultants and some CIO offices that are targeting higher necessary returns are increasingly anchored to the asset classes that these assumption-driven models like. Why? Because every strategic asset allocation meeting for the last 5 years began, and every strategic asset allocation meeting for the next 10 years will begin with something akin to the following: Well, to meet our real return targets with these assumptions, we’d have to allocate 100% to either private equity or emerging markets! Ha ha ha! Of course, doing that would be imprudent, but…
Yeah, ‘but.’ Because by this time, the conversation has been framed. And in hundreds of rooms filled with truly smart, truly ethical, truly honest and well-meaning people infected with the deals! meme, private assets will not just feel like the understandable and straightforward strategy, they will look like the right and sensible and prudent thing to do as fiduciaries.”
While the high level of interest in private equity can be explained by the deal! meme and its cultural amenability, something else is going on to compel institutional investors to overcome its obvious shortcomings. And the critiques of private equity are widespread, harsh, and compelling.
For example, Grants quotes Daniel Rasmussen, who has written extensively on the subject. He asks, “Why would you, in aggregate, buy disproportionately levered companies at disproportionately high prices in a very late stage of a bull market?” He answers, “That doesn’t seem like a very good idea. But when you call it private equity and take away the mark to market, suddenly it is a thing that everybody wants.”
James S. Chanos, founder and managing partner of Kynikos Associates, L.P., also speaks out against private equity in Grants. He thinks the value proposition of private equity will start undergoing the same kind of scrutiny that has been applied to hedge funds the last five to ten years. Specifically, Chanos thinks asset allocators will start to question why they are increasing allocations to an asset class “that over the long run seems to be matching at best public-market indexes with reduced liquidity, higher fees after a monstrous rise in corporate valuations and a once-in-a-generation drop in interest rates.”
AQR Capital Management also recently published its own evaluation of private equity and also found the approach lacking in merit. The AQR report assesses, “Our estimates [of returns on private equity] display a decreasing trend over time, which does not seem to have slowed the institutional demand for private equity.” They too suspect that the “return-smoothing properties of illiquid assets in general” may be part of the appeal to certain investors.
John Dizard summarizes the value proposition of private equity in the Financial Times:
“If stock volatility is scary, lever up the portfolio with borrowed money, stop marking to market, and call it ‘private equity’. Problem solved.“
Whether it is individual investors increasing exposure to stocks or institutional investors increasing exposure to private equity, it is clear that the search for higher returns has evolved into a heated competition. The competition though, is based on a fallacy. When Guinn describes the pension conversation as being “framed”, he means that it is unduly and artificially constrained in its consideration of possible solutions.
Ben Inker from GMO elaborates on exactly this scenario by noting, “Risk is not merely a function of the volatility of the investment portfolio but also of the relationships between the investment portfolio, the liability, and the nonportfolio assets.” While changes can be made to the liability variable by renegotiating retirement benefits, Inker focuses on the importance of considering contributions:
“But most pension fund managers tend to stop there, failing to fully take into account the assets outside of the portfolio that are relevant to the overall problem – the potential of the fund sponsor to make additional contributions to the pension portfolio when needed.”
The appropriate allocation of financial assets to a retirement plan depends partly on the expected returns of those assets, but only partly. It also depends on the level of retirement benefits desired and on contributions (and asset volatility and investment horizon). As a result, undue focus on returns is a false choice. The bad news is that many institutional pension plans have little or no ability to reduce benefits or increase contributions. The good news is that individuals normally have a great deal more flexibility to manage through a low return environment.
Just how little flexibility many institutions have in regard to pension funding is illuminating. Grants captures this with the testimony by James P. McNaughton, assistant professor of management at the Kellogg School of Management, to a House of Representatives subcommittee dealing with the pensions crisis:
“While approximately 60% of multiemployer plans are currently certified in the green zone in recent PBGC reports, that number would drop to around 7% if discount rates were based on current corporate bond yields. In other words, on an annuity purchase basis, only 7% of plans have 80% of assets needed to purchase annuities for their participants.”
This describes fairly clearly the predicament that pension fund managers are in. Only 7% of multiemployer plans are funded well enough to honor their promises with a very high likelihood of success. All the others are stuck between a rock and hard place: They can either try to renegotiate the promises by reducing pension benefits (which is difficult politically) or they can increase allocations to riskier assets and significantly increase the risk of losses.
Such incredibly poor funding levels reveal a number of important things about the investment landscape. For one, the response by many institutions to chase returns, increase leverage, and obscure volatility has all the makings of desperation. As Grants points out, “If you expect big, perhaps unreasonable, things from your p.e. allocation, it’s because you need them. You want to believe.” It sounds more like someone down on their luck going to a loan shark than it does a high-quality decision-making process.
As it happens, some private equity funds even seem to be playing the role of loan shark. The Financial Times reports that despite the increasingly problematic value proposition of private equity and the pressure on fees almost everywhere, some funds are actually raising their performance fees in what appears to be a form of surge pricing:
“Investors seem to have a weak hand when it comes to negotiating terms. Large institutions — under pressure to seek yield in a low interest rate environment — do not complain about terms because they fear being cut back or being excluded from a popular fund.”
This raises an interesting possibility that also reflects on today’s investment environment. Typically, large institutional investors have been considered “smart money”. As a result, other investors look to them for information content, clamoring to benefit from whatever they are doing. When institutional investors go progressively further out on the risk spectrum, it sends a signal that that might be a “smart” thing to do.
But what if the “smart money” isn’t so smart anymore? It’s not to suggest that the people running institutional funds are any less intelligent but rather that they are more desperate. They aren’t chasing returns so much because they think it is a great investment decision but because they believe they have to do something, and they don’t have a choice. Insofar as this is the case, their search for higher returns signals an increasingly desperate race that is likely to end badly. It is one that should be avoided, not emulated.
John Dizard sums it up well, barely containing his revulsion:
“Prof Siegel and his followers have been telling people what they want to hear, though he no doubt believes it himself. I believe the collective opinions, policies and investment decisions based on the high equity return cult will lead to social, economic and political disaster.“
This suggests another important thing about the investment landscape. The pension funding crisis is a very big and interconnected issue that will affect everyone. There is already talk of legislation to rescue multiemployer pension plans that fail. Any effort to do so will set a dangerous precedent of redistributing tax income to bail out mismanaged plans. John Mauldin expects there to be pain and describes how it will likely affect incomes: “As with the federal debt, some portion of this unfunded pension debt is going to get liquidated in some manner. Any way we do it will hurt either the pensioners or taxpayers.”
In a similar sense, Grants describes (in its August 10, 2018 letter) how the pension funding crisis will likely affect risk assets:
“The fancy prices that the p.e. firms pay for listed companies (or the neglected and undermanaged subsidiaries thereof) contribute to the lift in public-market equity averages. The returns that p.e. has earned, and—it is hoped—will earn again, support an immense structure of debt. Unwarranted expectations concerning p.e. returns raise false hopes for deeply underfunded pension funds. In short, private equity is everybody’s business.”
So, this season for horse racing serves as a useful reminder that the race to fund pension plans is on but promises to be a much uglier affair. As such, it also serves as a reminder for investors to carefully align the risks of their assets with their investment horizons. Otherwise, they may end up chasing returns in a thankless race.
Just a week ago, I was still fairly comfortable with the bullish argument. Note that I did not say that I was a bull, or a bear, or any other market animal. What I saw on the charts, and yes, from the fundamental side, was still supportive of higher prices in the near-term.
My argument to readers/listeners was that the S&P 500 hit a very likely, and yes, logical, place where those looking to cash out might do so.
That’s a fancy way to say the index hit resistance. And naturally, the next step was to look for a likely place for this pullback to find support.
Could it be the 38.2% Fibonacci from the December low? That would be roughly an 8% decline from peak prices in May. Hmmm… that seems a bit hefty for a garden variety pullback. That’s more like a correction if we are to believe the concocted cutoffs pushed by the media (10% is a correction, 20% is a bear market). I prefer to call then farkakteh cutoffs. (I like that this word was in MS-Word’s spell check).
So what’s next? Well, Monday morning as the Dow is down 500 or so on the latest on-again, off-again trade talks with China, the S&P is down about 4% from its peak. That seems reasonable for a pullback. No, I am not calling a bottom here, just looking for likely places that might occur.
Lo and behold, there is support there from October, November and December interim highs. But when emotions rule – more than usual – these are but mere suggestions of support. I certainly would not buy based solely on that.
One thing that caught my eye over the past week was that these opening morning dumps have mostly been reversed as the days wore on. Again, no forecast of that but if it happens yet again then we have to admit that there is still a good desire to buy stocks, despite the news.
Market breadth really did not deteriorate much. Not too much money flowed out of the major ETFs. And gold is not moving higher. All things that right now are not so bad for stocks.
But keeping with money flows, each peak over the past year has been trending lower, even though prices made similar or higher highs. That’s not great.
My conclusion? It is close to decision time. The pullback is still in line with a rising trend from December and is still above the 200-day average. But I need some sort of signal that the upside reversal is at hand because I also see a downside bowtie crossover perhaps a few days away. If that happens, then I will have to re-evaluate my stance.
As a long-time glasses and contact lens wearer, I am quite qualified to define this word. It means being able to see what’s right in front of me but not what’s out there farther away. You may call it “nearsighted.” As a side note, I’ve had cataract surgery on both eyes and no longer need any corrections. I won’t say it has helped my market forecasting but I am quite happy with the results, otherwise.
Anyway, we often zero in on the S&P 500 as the go-to index we use in prognosticating. As some now look for a potential triple top here (I disagree with that characterization, but that is for another time), the same pattern is not evident in other major indices. The Dow is close to having three similar peaks. NYSE composite? No. Russell 2000? No. Transports? No. And even my “four horsemen” sectors (tech, housing, retail and financial) are not even close to this formation.
Therefore, it is hard for me to say that “the market” hit resistance and fell away. Yes, the S&P 500 is the big daddy of market cap but it is also rather at the mercy of international trade. And right now, everyone seems to have their panties in a bunch over China. Without getting sucked into the politics, the Chinese stock market looks a lot weaker than the domestic market and that tells me they have a weaker hand to play.
The numbers here still look pretty good (yeah, fundamental dabbling). And as long as Congress is in full gridlock mode, that is usually pretty good for stocks, too.
Therefore, I am hopeful but waiting for a sign that the buyers are back for real. If not, this is not a falling knife I’m willing to catch.
At the beginning of this year, I was at dinner with my wife. Sitting at the table next to us, was a young financial advisor, who was probably in his mid-30’s, meeting with his client who appeared to be in his 60’s. Of course, the market had just experienced a 20% correction from the previous peak and the client was obviously concerned about his portfolio.
“Don’t worry, there is always volatility in the market, but as you can see, even bear markets are mild and on average the market returns 8% a year over the long-term.”
Here is the chart which shows the PERCENTAGE return of each bull and bear market going back to 1900. (The chart is the S&P 500 Total Return Inflation-Adjusted index.)
Here is the narrative used with this chart.
“The average bear market lasts 1.4 years on average and falls 41% on average.-The average bull market (when the market is rising) lasts 9.1 years on average and rises 476% on average.”
While the statement is not false, it is a false narrative.
“Lies, Damned Lies, and Statistics.” – Mark Twain
Here are the basics of math.
If the index goes from 100 to 200 it is indeed a 100% gain.
If the index goes from 200 back to 100, it is only a 50% loss.
Mathematically it would seem as if an investor is still 50% ahead, however, the net return is actually ZERO.
This is the error of measuring returns in terms of percentages as it masks the real damage done to portfolios during a decline. To understand the real impact of bull and bear markets on a portfolio, it must be measured in POINTS rather than percentages.
The chart above exposes the basic realities of math, loss, and time. What becomes much more apparent is that bear markets tend to destroy most or all of the previous advance and has done so repeatedly throughout history.
Importantly, what was not being discussed between the advisor and his 60-something client was simply the risk of “time.”
There are many financial advisors, commentators, experts, and social media gurus who have never actually “been invested” during a real “bear market.” While the “theory of ‘buy and hold'” sounds good, kind of like MMT, in practice it is an entirely different issue. The emotional stress of loss leads to selling even by the most “die hard” of individuals. The combined destruction of capital and the loss of time is the biggest issue when it comes to individuals meeting their retirement goals.
The following chart the real, inflation-adjusted, total return of the S&P 500 index.
Note: The green lines denote the number of years required to get back to even following a bear market. It is worth noting the entirety of the markets return over the last 118-years occurred in only 4-periods: 1925-1929, 1959-1968, 1990-2000, and 2016-present)
That comment corresponds to the next chart. As noted, there have currently been four, going on five, periods of low returns over a 20-year period.
“Unless you have contracted ‘vampirism,’ then you do NOT have 90, 100, or more, years to invest to gain “average historical returns.” Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have about 30-35 years to reach their goals. If that period happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are severely diminished.
What drives those 12-15 year periods of flat to little return? Valuations.
Just remember, a 20-year period of one-percent returns is indistinguishable from ZERO with respect to meeting savings goals.”
In other words, the most important component of your investment success depends more on WHEN you start rather than IF you start.
That brings me to my second point of that nagging problem of “time.”
Time Is An Unkind Companion
While it is nostalgic to use 100+ years of market data to try and prove a point about the benefits of “buy and hold” investing, the reality is that we “mere mortals” do not have the life-span required to achieve those returns.
“Despite the best of intentions, a vast majority of the ‘bullish’ crowd today have never lived through a real bear market.”
I have been managing money for people for a very long time. The one simple truth is that once an individual has lost a large chunk of their savings, they are very reluctant to go through such an experience a second time. This is particularly the case as individuals get ever closer to their retirement age.
Let’s remember that our purpose of investing is to:
“Grow savings at a rate which maintains the same purchasing power parity in the future and provides a stream of living income.”
Nowhere in that statement is a requirement to “beat a benchmark index.”
For most people, a $1 million account sounds like a lot of money. It’s a big, fat round number. The problem is that the end number is much less important than what it can generate. The table below shows $1,000,000 and what it can generate at varying interest rate levels.
30-years ago, when prevailing rates were substantially higher, and living standards were considerably cheaper, a $1,000,000 nest egg was substantial enough to support retirement when combined with social security, pensions, etc.
Today, that is no longer the case.
Since most investors only have 20 to 30-years to reach their goals, if that period begins when valuations are elevated, the odds of success falls dramatically.
This is why “time” becomes such an important determinate of success.
In all of the analysis that is done by Wall Street, “life expectancy” is never factored into the equations used when presenting the bullish case for investing. Therefore, in order to estimate future inflation-adjusted total returns, we must adjust the formula to include “life expectancy.”
RTR =((1+(Ca + D)/ 1+I)-1)^(Si-Lfe)
Ca = Capital Appreciation
D = Dividends
I = Inflation
Si = Starting Investment Age
Lfe = Life Expectancy
For consistency, we will assume the average starting investment age is 35. We will also assume the holding period for stocks is equal to the life expectancy less the starting age. The chart below shows the calculation of total life expectancy (based on the average of males and females) from 1900-present, the average starting age of 35, and the resulting years until death. I have also overlaid the rolling average of the 20-year total, real returns and valuations.
Importantly, notice the level of VALUATIONS when you start investing has everything to do with the achievement of higher rates of return over the investable life expectancy of an individual.
There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.
As shown in the chart box below, I have taken a $1000 investment for each period and assumed a real, total return holding period until death. No withdrawals were ever made. (Note: the periods from 1983 forward are still running as the investable life expectancy span is 40-plus years.)
The gold sloping line is the “promise” of 6% annualized compound returns. The blue line is what actually happened with invested capital from 35 years of age until death, with the bar chart at the bottom of each period showing the surplus or shortfall of the goal of 6% annualized returns.
In every single case, at the point of death, the invested capital is short of the promised goal.
The difference between “close” to goal, and not, was the starting valuation level when investments were made.
This is why, as I discussed in “The Fatal Flaws In Your Retirement Plan,” that you must compensate for both starting period valuations and variability in returns when making future return assumptions. If you calculate your retirement plan using a 6% compounded growth rates (much less 8% or 10%) you WILL fall short of your goals.
The Next Bear Market Will Be The Last
After two major bear markets since the turn of the century, a vast majority of “baby boomers” are woefully unprepared for retirement. Dependency on social welfare is at record highs, individuals are working far longer into retirement than at any other point in history, and after a decade long bull market many investors have only just recently gotten back to where they were 10-years ago.
It is from this point, given valuations are once again pushing 30x earnings, that we review the expectations that individuals facing retirement should consider.
Expectations for future returns and withdrawal rates should be downwardly adjusted due to current valuation levels.
The potential for front-loaded returns going forward is unlikely.
Your personal life expectancy plays a huge role in future outcomes.
The impact of taxation must be considered.
Future inflation expectations must be carefully considered.
Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
The yield chase over the last 10-years, and low interest rate environment, has created an extremely risky environment for investors. Caution is advised.
Expectations for compounded annual rates of returns should be dismissed in lieu of variable rates of return based on current valuation levels.
Importantly, chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely realize.
For the majority of individuals today facing, or in, retirement the two previous bear markets have left many further away from retirement than they ever imagined.
The next one will destroy those goals entirely.
Investing for retirement, should be done conservatively, and cautiously, with the goal of outpacing inflation, not the market, over time. Trying to beat some random, arbitrary index that has nothing in common with your financial goals, objectives, and most importantly, your life span, has tended to end badly for individuals.
For the last several years, there has been a tremendous amount of activity and hype in the tech startup arena. In addition to the tens of thousands of startups that been founded in recent years, there are over three-hundred new “unicorn” startups that have valuations of $1 billion or more. Most of these unicorns came of out virtually nowhere and amassed tremendous valuations despite hemorrhaging cash, which is a tell-tale sign of a bubble. The recent announcement of a new Silicon Valley stock exchange for “hot startups, particularly those that are money-losing” is an indication of the amount of hubris and hype there is in the startup arena right now –
Long-Term Stock Exchange CEO Eric Ries
The U.S. Securities and Exchange Commission approved the creation of the Long-Term Stock Exchange, or LTSE, a Silicon Valley-based national securities exchange promoting what it says is a unique approach to governance and voting rights, while reducing short-term pressures on public companies.
The LTSE is a bid to build a stock exchange in the country’s tech capital that appeals to hot startups, particularly those that are money-losing and want the luxury of focusing on long-term innovation even while trading in the glare of the public markets.
The stock exchange was proposed to the SEC in November by technology entrepreneur, author and startup adviser Eric Ries, who has been working on the idea for years. He raised $19 million from venture capitalists to get his project off the ground, but approval from U.S. regulators was necessary to launch the exchange.
The tech startup bubble formed as a result of the Fed and other central banks’ extremely loose monetary policies after the Great Recession. In a desperate attempt to jump-start the global economy again, central banks cut and held interest rates at virtually zero percent for much of the past decade and pumped trillions of dollars worth of liquidity into the global financial system. The chart of the Fed Funds rate below shows how bubbles form when interest rates are at low levels:
Loose global monetary policy led to an explosion of venture capital activity over the past several years:
Trillions of dollars worth of central bank-created liquidity has been sloshing around the globe looking for a home and a portion of it found its way into unicorn companies that are worth billions of dollars each:
Today’s unicorns are equivalent to dot-com companies in 1999 and will have the same fate, unfortunately. Though some of the unicorns will survive and become successful in the longer-run like Amazon and eBay, there is going to be a tremendous shakeout that is going to slash valuations and weed out the Pets.coms and Webvans. Thousands, if not tens of thousands, of tech startups are going to fold when this bubble bursts. The abysmal performance of two recent high-profile unicorn IPOs, Lyft (down nearly 50% since its IPO) and Uber, may be a sign that air is starting to come out of the unicorn bubble. It will be interesting to see if the Long-Term Stock Exchange will be able to go live before the unicorn bubble bursts.
This article is the first part of a two-part article. Due to its length and importance, we split it to help readers’ better digest the information. The purpose of the article is to define money and currency and discuss their differences and risks. It is with this knowledge that we can better appreciate the path that massive deficits and monetary tomfoolery are putting us on and what we can do to protect ourselves.
How often do
you think about what the dollar bills in your wallet or the pixel dollar signs
in your bank account are? The correct definitions of currency and money are crucial
to our understanding of an economy, investing and just as importantly, the
social fabric of a nation. It’s time we tackle the differences between currency
and money and within that conversation break the news to you that deficits do
matter, TRUST me
At a basic
level, currency can be anything that is broadly accepted
as a medium of exchange that comes in standardized units. In current times,
fiat currency is the currency of choice worldwide. Fiat currency is paper notes,
coins, and digital 0s and 1s that are governed
and regulated by central banks and/or
governments. Note, we did not use the word guaranteed to describe the role of
the central bank or government. The value and worth of a fiat currency rest solely on the TRUST of the receiver of the
currency that it will retain its value and the TRUST that others will accept it
in the future in exchange for goods and services.
Whether its yen,
euros, wampum, bitcoin, dollars or any other currency, as long as society is
accepting of such a unit of exchange, trade
will occur. When TRUST in the value of a currency wanes, commerce becomes
difficult, and the monetary and social
prosperity of a nation falters. The history books overflow with such examples.
Maslow and Currency
diving into the value of a currency, it is worth considering the role it plays
in society and how essential it is to our physical and mental well-being. This point
is rarely appreciated, especially by those that push policies that debase the
his famous pyramid to depict what he deemed the hierarchy of human needs. The
levels of his pyramid, shown below, represent the ordering of physiological and
psychological needs that help describe human motivations. When these needs are met, humans thrive.
up the pyramid by addressing their basic, lowest level needs. The core needs,
representing the base, are physiological needs including food, water, warmth
and rest. Once these basic needs are met,
one then seeks to attain security and safety. Without meeting these basic physiological
and safety needs, our psychological and
self-fulfillment needs, which are higher up the pyramid, are difficult to come
by. Further, as we see in some third-world countries, the social fabric of the
nation is torn to shreds when a large part of the population cannot satisfy their basic needs.
In modern society,
except for a few who live “off-the-grid,” fiat currency is the only means of
attaining these necessities. Possession of currency is a must if we are
to survive and thrive. Take a look back to the opening paragraphs and let’s
rephrase that last sentence: possession and
TRUST of currency is a must if we are to survive and thrive.
It is this
most foundational understanding of currency that keeps our economy humming, our
physical prosperity growing and our society stable. The TRUST backing the
dollar, euro, yen, etc. is essential to our financial, physical and
why we should not assume that TRUST is a permanent condition.
Deficits Don’t Matter…. or Do They?
the imperative connection between currency and TRUST and its linkage to trade
and commerce along with our physical and mental well-being,
we need to explore the current state of the United States government debt
burden, monetary policy, and the growing belief
that deficits don’t matter.
debt never matures, it is rolled over. Yes, a holder of a maturing Treasury bond
is paid in full at maturity, however, to secure the funds to pay that holder,
the government issues new debt by borrowing money from someone else. Over time, this scheme has allowed deficits to expand,
swelling the amount of debt outstanding. Think of this arrangement as taking
out a new credit card every month to pay off the old card.
below shows U.S. government debt as a percentage of GDP. Since 1967 government debt has grown annually 2% more than GDP.
Data Courtesy: St. Louis Federal
debt at a faster rate than economic growth (as shown above) is limited. To
extend the ability to do this requires declining interest rates, inflation and
a little bit of financial wizardry to make debt disappear. Fortunately, the
U.S. government has a partner in crime, the Federal Reserve.
As you read about
the Fed’s methods to help fund deficits, it is important to consider the
actions they routinely take are at the expense of the value of the currency. This warrants repeating since the value of the currency is what supports TRUST
in the currency and allows it to retain its
helps the government consistently run
deficits and increase their debt load in three
The Fed stokes moderate inflation.
The Fed manages interest rates lower
than they should be.
The Fed buys Treasury and mortgage securities
(open market operations/QE) and, as we are now witnessing, monetizes the debt.
Fed’s charter, Congress has mandated the Fed promote stable prices. To you and me, stable prices would likely mean no inflation or deflation. Regardless of what you and I think, the Fed interprets
the mandate as an annual 2% rate of inflation. Since the Fed was founded in 1913, the rate of inflation has
averaged 3.11% annually. That rate may seem
inconsequential, but it adds up. The
chart below illustrates how the low but consistent rate of inflation has
debased the purchasing power of the dollar.
Data Courtesy: St. Louis Federal
in 1913 can essentially be paid off with .03 cents today. Inflation has
certainly benefited debtors.
Interest Rate Management
better part of the last decade, the Fed
has imposed price controls that kept interest
rates below what should be considered normal. Normal, in a free market economy,
is an interest rate that compensates a lender for credit risk and inflation.
Since Treasury debt is considered “risk-free,” the predominant risk to Treasury
investors is earning less than the rate of inflation. As far as “risk-free”, read our article: The
Mind Blowing Concept of Risk-Free’ier.
If the yield
on the bond is less than inflation, as has recently been the case, the
purchasing power and wealth of the investor declines
in the future.
below highlights how U.S. Treasury real rates (yields less CPI) have trended
lower over the past forty years. In fact, over the last decade, negative real rates are the norm, not the exception. When investors are
not properly compensated by the U.S. Treasury, the onus of government
debt is partially being put upon
investors. We have the Fed to thank for their Fed Funds (FF) policy of negative
Data Courtesy: St. Louis Federal
Fed Balance Sheet
The Fed uses
its balance sheet to buy and sell U.S.
Treasury securities to manage the money supply and thus enforce their interest
rate stance. In 2008, their use of the balance sheet changed. From 2008 through
2013, the Fed purchased nearly $4 trillion of Treasury and mortgage-backed
securities in what is called Quantitative Easing (QE). By reducing the supply
of these securities, they freed up
liquidity to move to other assets within the capital markets. The action
propped up asset prices and helped keep interest
rates lower than they otherwise would have been.
Since 2018, they have reversed these actions by
reducing the size of their balance sheet in what is called Quantitative
Tightening (QT). This reversal of prior action essentially makes the benefits
of QE temporary. However, if they fail to reduce it back to levels that existed
before QE was initiated, then the Fed permanently monetized government
debt. In plain English, they printed money to extinguish debt.
As we write
this article, the Fed is in the process of ending QT. Based on the Fed schedule
as announced on March 20, 2019, the balance sheet will permanently end up $2.28
trillion larger than from when QE was initiated.
To put that in context, the balance will have grown 269% since 2008, as compared
to 48% economic growth.
Data Courtesy St. Louis Fed
the Fed employs to manage policy as described
above, all involve using their balance sheet to alter the money supply
and help the Treasury manage its deficits. We can argue the merits of such a policy, but we cannot argue a basic economics
law; when there is more of something, it is worth less. When something of value is created out of thin air, its
point is debt too onerous, deficits too large and the Fed too aggressive such that
TRUST is harmed? No one knows the answer
to that question, but given the
importance of TRUST in a fiat currency regime, it would be wise to avoid
actions that could raise doubt. Contrary to that guidance, current fiscal and
monetary policy throws all TRUST to the wind.
Prelude to Part 2
grow and government debt becomes more onerous, the amount of Fed intervention
must become greater. To combat this growing problem, both political
parties are downplaying deficits and pushing the Fed to do more. In part 2 we
will explore emerging fiscal mindsets and what they might portend. We will then
define money, and with this definition, show why the difference between
currency and money is so important.
The global economy is apparently facing a significant problem. Inflation’s gone missing! Central bankers can’t seem to stoke it no matter how deftly they act. Neither lowering interest rates to zero (and less) nor endless amounts of Quantitative Easing (QE) appear to make any difference. This, we’re told, is a problem that is equally as serious as it is perplexing. However, this position puzzles me. What if it’s not inflation that’s lacking, but rather our understanding of it? More importantly, might this disconnect have significant ramifications for investment portfolios?
In my opinion, there are two ways in which inflation is misunderstood. The first stems from misapplying a commodity-based monetary standard practice to a fiat convention. The second potential error is placing too much importance on unit prices as an economic signal. It’s possible, I think, that both had a hand in producing the 40-year secular decline in interest rates.
Inflation Is A Currency Phenomenon
Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” The Merriam-Webster dictionary defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.” Here, we can see that inflation is a relative term. It compares the value of goods and services to money.
While these definitions are commonplace today, they are in fact modern redefinitions. Inflation was first used to describe the value of (paper) currency compared to a monetary standard, not to goods and services. Emperors clipping coins didn’t devalue money per se. The standard, which was typically defined as some unit weight of commodity metal, remained constant. Rather, they merely lessened the monetary value of each coin in circulation. Hence, it took more currency to purchase the same goods and services. The same held true for paper currencies convertible into gold. Lowering exchange rates reduced their purchasing power. This was inflation. To clarify Dr. Friedman’s definition, inflation is not a monetary phenomenon, it’s a currency phenomenon!
Inflation Was Lost In Translation
Today, however, we operate under a fiat monetary standard. There is no physical definition of a dollar apart from the currency itself. A dollar is simply what someone else is willing to accept for it in trade. Given that governments create the fiat currencies used in commerce (currencies, not money!), it follows that monetary authorities would require some metric to assess if the quantity produced is optimal.
Enter the modern—and in my view, flawed—concept of inflation. It’s determined by tracking the change of the average price of a basket of goods. There are many different indices with many different mixes of goods and services, with many different kinds of adjustments made. Inflation’s use in monetary policy is to provide policymakers with an objective signal with respect to the amount of currency in circulation.
“In the earlier definition, inflation is something that happens to the circulating media at a given price level; in the later definition, an inflating currency is defined to exist when it produces a rise in the general price level, as suggested by the quantity theory. What originally described a monetary cause came to describe a price effect.” [Emphasis is mine.]
The attempt to bring objectivity to an arbitrary, fiat system is valiant. It is, however, flawed. Put aside the issues of measurement and representation of the popular indices (hedonic adjustments anyone?). Defining monetary value in terms of tangible goods and services ignores the most fundamental fact about human wealth and prosperity creation; and it’s hiding in plain sight.
Deflation Is The Hallmark Of Prosperity And Progress
There’s no surer way to scare a macroeconomist than to utter the word “deflation.” This euphemism for falling prices conjures up thoughts of economic depression, breadlines, unemployment, and poverty. Thus, deflation must be avoided at all cost it is thought. This fear has apparently short-circuited the critical thinking mechanism of some very bright people. None seem to realize that, by our modern definition, deflation is the hallmark of prosperity and progress.
Just think for a moment. The dramatic fall in general prices is a corollary to wealth. Affordability yields abundance, comfort, and joy. Who doesn’t want more and better goods and services at an exponentially cheaper cost? (Well, macroeconomists I suppose, but I bet most are compartmentalized on this subject.)
One study demonstrates this very fact by scaling food costs to the value of unskilled labor. It found that prices exponentially fell for basic needs.
The time price (i.e. nominal price divided by nominal hourly wage) of our basket of commodities fell from 47 hours of work to ten … .
The unweighted average time price fell by 79 percent … .
Put differently, for the same amount of work that allowed an unskilled laborer to purchase one basket of the 42 commodities in 1919, he or she could buy 7.6 baskets in 2019 … .
The compounded rate of ‘affordability’ of our basket of commodities rose at 2.05 percent per year … .
Put differently, an unskilled laborer saw his or her purchasing power double every 34 years … .”
This becomes more starkly apparent if you remove money from the equation altogether. Consider this: Go back far enough and everyone was a subsistence farmer (or hunter/gatherer). In other words, virtually 100% of an entire population’s time and effort was spent on producing the basic necessities for survival. Today, less than 5% of those in developed countries work in agriculture. The other 95% produce everything else that improves our lives.
Now that’s some massive deflation, at least according to our modern definition! Were these horrible times? Hardly so! Deflation, it turns out, is present throughout all prosperous periods of human history. Of course no one called this deflation because, quite frankly, it’s not. True inflation is a currency phenomena. It has nothing to do with the value of goods and services.
Using the modern inflation concept in monetary policy simply makes no sense. Deflation is desirable. It’s inflation we should fear. A rise in general prices can only result from wealth destroying shortages or the imposition of unnatural competitive barriers (i.e. regulation and tariffs). The invisible hand ensures just this.
Inflation’s Usage Is Misplaced
Putting this aside for a moment, macroeconomists apply inflation inconsistently. It can connotes both economic growth (good) and monetary debasement (bad). What I find most bizarre though, is for exactly 2.0% inflation to be monetary panacea despite its arbitrary origin.
“’It was almost a chance remark,’ [former Reserve Bank of New Zealand Governor] Mr. Brash said in a recent interview. ‘The [2% inflation target] figure was plucked out of the air to influence the public’s expectations.’”
Furthermore, the importance that macroeconomists place on unit prices is misplaced in my view; that is if one is interested in monitoring economic conditions.
Inflation in macro is assumed to be information-laden. To practitioners, it signals tightening economic conditions such that prices rise. Falling prices, on the contrary, indicate excess “slack”; that resources are under-utilized and a cause for alarm. Perhaps most silly is the belief that price declines prevent consumers from spending. If this were truly the case few would own TVs and other consumer electronics; the Industrial Revolution would have stopped dead in its tracks.
Lost on these economists is that prices are just one tiny piece of the economic machinery. Companies change them for a whole slew of reasons. In fact, not only should prices fluctuate, they do because they are effects.
Getting Micro With The Macro
While on the surface this inflation perspective appears logical, it lacks a basis in reality. For inflation to carry significance, prices should be of paramount concern to businesses. After all, macroeconomics is merely the aggregation of the micro. Analyzing commercial activities reveals that this is simply not the case.
Consider this: Businesses seek to maximize profit (or cash flow). Profits are a function of both revenues and expenses. While important, prices are just one component of the profit algorithm.
Profit ($) = price ($ per unit) x volume (units) – costs ($)
From this equation it should be abundantly clear that a company’s fortune rests upon more than unit prices. In fact, profits might rise despite prices falling. This routinely happens when companies expand capacity or increase productivity (i.e. lower unit costs). Lower prices facilitate higher volumes which can increase efficiency. This combination often leads to greater profits, which is the ultimate goal .
True, falling prices might indicate a lack of demand. But often times they times don’t. The same applies for the economy writ large.
Profound Investment Implications
In summary, I find the treatment of inflation to be flawed in two ways. First, defining monetary stability in terms of goods and services is inconsistent with its original conception. Inflation simply has no relevance in a fiat currency regime due to the lack of an objective standard. Secondly, the fixation on unit prices for assessing macroeconomic health seems disconnected from microeconomic realities.
Today’s lack of inflation is not a problem; it’s prosperity. So long as markets and people are left free to create and work, deflation will likely persist. We should expect (and welcome) inflation target undershoots in spite of policymakers concocting all sorts of crazy theories and policies in order to stoke it. (Thank goodness!)
The investment implications are potentially profound. What if these misunderstandings underpin the secular decline in interest rates? If so, it seems likely that markets will continue to incorrectly process the incoming inflation data given how institutionalized inflation is in investment frameworks. This should present profitable opportunities for the rest of us. Perhaps the undershooting of inflation targets—and other related trends—will persist as the growth we’re enjoying continues. In that case, I, for one, look forward to disappointing inflation readings for years to come … for both my wallet’s and investment portfolio’s sake.
In 2009, I shared 2 words on Facebook that I felt would shape the future of our social and economic discussions:
Socialism & Nationalism.
Not trying to be a smarta**, however, I told you so.
A shallow economic recovery (one of the weakest post-WW2), since the Great Recession, intervention by the Fed and persistent greed from U.S. corporations that place shareholders and senior executives above all else, have blossomed dissatisfaction with the very heart of our system.
In 2012, I outlined in my book Random Thoughts of a Money Muse, how I believed the financial crisis would permanently alter the focus of C-Suite executives and corporate boards. My thought was publicly traded companies would operate in a state of permanent recession regardless of business cycle, and lastingly consider employees as ‘excess baggage,’ thus seek to reduce headcount whenever possible. I also wrote that wage growth would remain stagnant and employees would bear a greater burden of healthcare costs through high-deductible insurance plans.
No, I’m no psychic. My personal corporate employment experience post-financial crisis forced me on a path of painful self-discovery. Creative pay cuts, cancerous morale where motivational speak sounded more like threat of unemployment (BE THANKFUL you have a job), crushing sales targets, outright lies to the frontlines meant to keep clients in an imploding proprietary product, compelled me to re-shape my views about the company and jumpstart additional research into corporate behavior. At a contentious arbitration, I vocalized how I went from the custodian of the clients’ dreams to custodian of shareholder dreams. That’s not what I signed up for. I am and always will be a fiduciary and advocate for clients first.
Jonathan Tepper wrote in his eye-opening tome “The Myth of Capitalism:” Today, votes for Sanders, Trump and Brexit are the expression of discontent by the “Newly Poor.” They feel the system is rigged against them and future is not as bright as the past.
Historian Will Durant warned that societies fall apart when inequality is too severe.”
The market now pays attention to extreme views which reinforces my belief that socialism has crept into conventional thought. There was a time when markets would ignore outlier political sentiments. The recent example of healthcare stocks trashed in fear of Medicare for all initiatives tells me the market, as a leading indicator, believes our capitalist structure is being questioned. The cracks are beginning to spring leaks.
Here are 4 charts that outline how the private sector has helped to nurture the seed of socialism in our American soil.
Surprisingly, Warren Buffett believes that stock buybacks represent an excellent use of capital. A passionate believer in value has now been converted into a momentum-growth market participant. There was a time in our history that stock buybacks were illegal. Considered stock price manipulation (which it is). So, what’s changed? Today, it’s a prevalent form of financial engineering. Corporations purchase shares in the open market, artificially boost EPS, decrease float and ultimately drive stock prices higher. Not coincidentally, CEO compensation lives and dies by stock share price.
If you’re investing periodically in index or other mutual funds in a 401(k) or another type of company defined-contribution plan, stock buybacks have indeed been a tailwind to your net worth.
The richest households have experienced a full gale force of appreciation in risk assets thanks primarily to record stock buybacks and unorthodox central bank policies such as quantitative easing and persistently low short-term interest rates. In addition, less than 42% of small businesses – those with two to 99 employees – offer any kind of retirement benefits which means their employees may not participate in market returns at all.
Keep in the mind, the wealth of the bottom 90% of the population is in primary residences. Houses with mortgages which require income to make payments. In other words, to many Americans, rising household incomes and the appreciation of home prices, not the possibility of future gains in the stock market, fuel the faith in prosperity envisioned by the American dreamers. House prices rose post-Great Recession. However, wealth grew more vigorously at the top of wealth distribution than in the middle, due to the increase in stock prices.
Which leads me to chart #2.
Abigail Disney, the grandniece of Walt Disney was on CNBC in April lamenting over Disney CEO Bob Iger’s $65.6 million 2018 paycheck, calling it “insane.” Her tweet from April 21st has been retweeted 12,958 times and liked by over 42,000.
Let me very clear. I like Bob Iger. I do NOT speak for my family but only for myself. Other than owning shares (not that many) I have no more say in what happens there than anyone else. But by any objective measure a pay ratio over a thousand is insane. https://t.co/O34OjXd6rr
According to the Economic Policy Institute which examines trends in CEO compensation, in 2017, the average CEO of the 350 largest U.S. firms received $18.9 million in total compensation – a 17.6% increase over 2016. Worker compensation remained flat.
From the EPI:
“The 2017 CEO-to-worker compensation ratio of 312-to-1 was far greater than the 20-to-1 ratio in 1965 and more than five times greater than the 58-to-1 ratio in 1989 (although it was lower than the peak ratio of 344-to-1, reached in 2000). The gap between the compensation of CEOs and other very-high-wage earners is also substantial, with the CEOs in large firms earning 5.5 times as much as the average earner in the top 0.1 percent.”
Listen, CEOs, senior managements, deserve big pay and incentives. I get it. However, one needs to ponder whether they’re worth 312 to 1. I don’t think so. What do you think? Is Abigail Disney correct to rail about Iger’s pay package?
Ironically, in March, Disney World increased ticket prices by 23%. A one-day ticket will now set us back a lofty $159. What is a middle-class family going to do? Will they pay up? Probably. Despite consistent price hikes every year, park attendance continues to hit new records. As customers we just deal with the financial hit, shift items around in the budget, use credit, to make memories with our children.
Profligate compensation and price disparities not only raise the ire of those with socialist interest. Believers in the capitalist system consider them questionable, too.
What about the current state of household income? Sentier Research known for its thorough analysis of trends in household income, reported in March that median household income is now 3.5% higher than back in January 2000. Stagnation in household incomes finally broke after 18 years, which is good news.
However, the long-term financial distress to middle class wage earners may take decades to recover. The lingering financial vulnerability has done tremendous damage to the confidence in the American system, especially among post-Baby Boomer generations who feel their lives may never be as prosperous as their parents.
Chart #3 is an eye-opener, courtesy of Lance Roberts.
There is a marked deterioration in the willingness of corporations to share their prosperity with employees. The gaps of profits to employees and corporate unwillingness to share the wealth have never been so wide.
Lance’s analysis helped me to personally understand what I experienced at my former employer post-Great Recession. I lived these charts. I’m certain many readers have experienced the same. In my opinion, the interminable focus on shareholders over employees is one of the reasons extreme or outlier political views have become more widely accepted.
Last, The New School’s Schwartz Center for Economic Policy Analysis has undertaken eye-opening research which dives deep into the reality of U.S. retirement readiness. Teresa Ghilarducci, the Director of SCEPA along with her team, has been banging the drum hard over retirement inequality among lifetime earnings quintiles.
Low and moderate wage earners have experienced a dramatic deterioration in retirement wealth due to the death of pensions. However, there’s damage in every quintile which proves to me how defined contribution plans such as 401ks have failed a majority of Americans as primary retirement savings vehicles regardless of the impressive bull run in markets over the last 10 years.
Two major stock market derails along with a decade to break even after the financial crisis, lack of financial literacy, poor savings skills, oh, and the ability to tap plan account balances for loans and down payments for primary residences (which I believe is fiscally irresponsible), have proven that defined contribution plans should have remained a compliment to pensions as originally envisioned, not a replacement.
Per SCEPA’s analysis, among workers in the bottom fifth of the earnings distribution, the share of those with no retirement wealth increased from 45% to 51% between 1992 and 2010.
Workers are grouped below into five tiers of lifetime earnings. The share of total retirement wealth held by the top fifth of earners held steady from 1992 to 2010 at around half of all retirement assets. The lowest-earning quintile, meanwhile, held only 1 percent of retirement wealth in 2010, down from 3%.
Even WITHIN quintiles, the top 10% of savers held 10-20 times the retirement wealth of the bottom 10%.
Retirement inequality can compel workers to vote their dissatisfaction for mainstream political candidates within their respective parties.
Corporate America has prospered enough to benefit both shareholders and employees. They have failed to do so. Shortsightedness and outright greed have allowed outlier political views to prosper enough for markets to pay attention.
Capitalism will always prevail over socialism. The proof is in the prosperity and growth we enjoy in America when compared to all other nations.
However, the C Suite’s bastardized definition of capitalism isn’t the answer. Nor is cloying regulation and massive Federal Reserve intervention appropriate responses.
If these conditions persist, be prepared for continued unwelcomed surprises to emanate from voting booths across America.
In June of 2018, as the initial rounds of the “Trade War” were heating up, I wrote:
“Next week, the Trump Administration will announce $50 billion in ‘tariffs’ on Chinese products. The trade war remains a risk to the markets in the short-term.”
Of course, 2018 turned out to be a volatile year for investors which ended in the sell-off into Christmas Eve.
As we have been writing for the last couple of weeks, the risks to the market have risen markedly as we head into the summer months.
“It is a rare occasion the markets don’t have a significant intra-year correction. But, it is a rarer event not to have a correction in a year where extreme deviations from long-term moving averages occur early in the year. Currently, the market is nearly 6% above its 200-dma. As noted, such deviations from the norm tend not to last long and “reversions to the mean” occur with regularity.”
“With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. Again, this is why we discussed taking profits and rebalancing risk in our portfolios last week.”
Well, that certainly didn’t take long. As of Monday’s close, the entirety of the potential 5-6% decline has already been tagged.
The concern currently, is that while the 200-dma is critical to warding off a deeper decline, the escalation of the “trade war” is going to advance the timing of a recession and bear market.
Let me explain why.
The Drums Of “Trade War”
On Monday, we woke to the “sound of distant drums” beating out the warning of escalation as China retaliated to Trump’s tariffs last week. To wit:
“After vowing over the weekend to “never surrender to external pressure,” Beijing has defied President Trump’s demands that it not resort to retaliatory tariffs and announced plans to slap new levies on $60 billion in US goods.
CHINA SAYS TO RAISE TARIFFS ON SOME U.S. GOODS FROM JUNE 1
CHINA SAYS TO RAISE TARIFFS ON $60B OF U.S. GOODS
CHINA SAYS TO RAISE TARIFFS ON 2493 U.S. GOODS TO 25%
CHINA MAY STOP PURCHASING US AGRICULTURAL PRODUCTS:GLOBAL TIMES
CHINA MAY REDUCE BOEING ORDERS: GLOBAL TIMES
CHINA ADDITIONAL TARIFFS DO NOT INCLUDE U.S. CRUDE OIL
CHINA RAISES TARIFF ON U.S. LNG TO 25% EFFECTIVE JUNE 1
China’s announcement comes after the White House raised tariffs on some $200 billion in Chinese goods to 25% from 10% on Friday (however, the new rates will only apply to goods leaving Chinese ports on or after the date where the new tariffs took effect).
Here’s a breakdown of how China will impose tariffs on 2,493 US goods. The new rates will take effect at the beginning of next month.
2,493 items to be subjected to 25% tariffs.
1,078 items to be subject to 20% of tariffs
974 items subject to 10% of tariffs
595 items continue to be levied at 5% tariffs
In further bad news for American farmers, China might stop purchasing agricultural products from the US, reduce its orders for Boeing planes and restrict service trade. There has also been talk that the PBOC could start dumping Treasurys (which would, in addition to pushing US rates higher, could also have the effect of strengthening the yuan).”
The last point is the most important, particularly for domestic investors, as it is a change in their stance from last year. As we noted when the “trade war” first started:
The only silver lining in all of this is that so far, China hasn’t invoked the nuclear options: dumping FX reserves (either bonds or equities), or devaluing the currency. If Trump keeps pushing, however, both are only a matter of time.”
Clearly, China has now put those options on the table, at least verbally.
It is essential to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. As you can see, there is a high correlation between fluctuations in the Yuan and treasury activity.
One way for China to both penalize the U.S. for tariffs, and by “the U.S.” I mean the consumer, is to devalue the Yuan relative to the dollar. This can be done by either stopping the process of sanitizing transactions with the U.S. or by accelerating the issue through the selling of U.S. Treasury holdings.
The other potential ramification is the impact on interest rates in the U.S. which is a substantial secondary risk.
China understands that the U.S. consumer is heavily indebted and small changes to interest rates have an exponential impact on consumption in the U.S.. For example, in 2018 interest rates rose to 3.3% and mortgages and auto loans came to screeching halt. More importantly, debt delinquency rates showed a sharp uptick.
Consumers have very little “wiggle room” to adjust for higher borrowing costs, higher product costs, or a slowing economy that accelerates job losses.
However, it isn’t just the consumer that will take the hit. It is the stock market due to lower earnings.
Playing The Trade
Let me review what we said previously about the impact of a trade war on the markets.
“While many have believed a ‘trade war’ will be resolved without consequence, there are two very important points that most of mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs.”
While the markets have indeed been more bullishly biased since the beginning of the year, which was mostly based on “hopes” of a “trade resolution,” we have couched our short-term optimism with an ongoing view of the “risks” which remain. An escalation of a “trade war” is one of those risks, the other is a policy error by the Federal Reserve which could be caused by the acceleration a “trade war.”
In June of 2018, I did the following analysis:
“Wall Street is ignoring the impact of tariffs on the companies which comprise the stock market. Between May 1st and June 1st of this year, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”). For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.”
The red dashed line denoted the expected 11% reduction to those estimates due to a “trade war.”
“As a result of escalating trade war concerns, the impact in the worst-case scenario of an all-out trade war for US companies across sectors and US trading partners will be greater than anticipated. In a nutshell, an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies by ~11% and, thus, completely offset the positive fiscal stimulus from tax reform.”
Fast forward to the end of Q1-2019 earnings and we find that we were actually a bit optimistic on where things turned out.
The problem is the 2020 estimates are currently still extremely elevated. As the impact of these new tariffs settle in, corporate earnings will be reduced. The chart below plots our initial expectations of earnings through 2020. Given that a 10% tariff took 11% off earnings expectations, it is quite likely with a 25% tariff we are once again too optimistic on our outlook.
Over the next couple of months, we will be able to refine our view further, but the important point is that since roughly 50% of corporate profits are a function of exports, Trump has just picked a fight he most likely can’t win.
Importantly, the reigniting of the trade war is coming at a time where economic data remains markedly weak, valuations are elevated, and credit risk is on the rise. The yield curve continues to signal that something has “broken,” but few are paying attention.
With the market weakness yesterday, we are holding off adding to our equity “long positions” until we see where the market finds support. We have also cut our holdings in basic materials and emerging markets as tariffs will have the greatest impact on those areas. Currently, there is a cluster of support coalescing at the 200-dma, but a failure at the level could see selling intensify as we head into summer.
The recent developments now shift our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.
As a portfolio manager, I must manage short-term opportunities as well as long-term outcomes. If I don’t, I suffer career risk, plain and simple. However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the current market environment.
Assuming that you were astute enough to buy the 2009 low, and didn’t spend the bulk of the bull market rally simply getting back to even, you would have accumulated years of excess returns towards meeting your retirement goals.
If you went to cash now, the odds are EXTREMELY high that you will outpace investors who remain invested in the years ahead. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,” but when the next “mean reverting event” occurs, the decline will destroy most, if not all, of the returns accumulated over the last decade.
China understands that Trump’s biggest weakness is the economy and the stock market. So, by strategically taking actions which impact the consumer, and ultimately the stock market, it erodes the base of support that Trump has for the “trade war.”
This is particularly the case with the Presidential election just 18-months away.
Don’t mistake how committed China can be.
This fight will be to the last man standing, and while Trump may win the battle, it is quite likely that “investors will lose the war.”