Reflections on Reagan’s “Myth of the Great Society” Speech

A good friend recently sent me a link to Reagan’s famous “Myth of the Great Society” (link). Watching it, I was mesmerized as I remembered what a true statesman sounded like. It’s been a long time since we’ve heard a voice like Reagan’s in American politics. What follows are my reflections about where all the “great” economic and political ideas of the past have gotten us.

The ideas Reagan enunciates in the speech are definitely powerful. No surprise, as they echo the ideas of the founding fathers. Forty years after “morning in America,” however, Reagan’s vision appears as impossibly utopian to me as the ideas of the liberals and their Great Society. Both sound great in principle. But then career politicians are charged with implementing them, and these beautiful ideas get perverted away from their noble intentions.

Reagan wanted to shrink government — the image of the Pentagon paying $500 for toilet seats was extraordinarily effective. Cutting taxes seemed like a rational way to “starve the beast” of big government. The idea made perfect sense in principle. I voted for it, enthusiastically. I was only 22 years old and I already felt besieged by taxation. But Reagan & Co. got conned into cutting taxes based on Laffer’s terribly inaccurate “analysis” (more of a groundless assertion) that tax cuts would generate even more tax revenue and “pay for themselves.” This never happened — but conservatives now chant it as if it’s an established truth. Government spending needed to be cut dollar for dollar with the decline in tax revenues — but that was not politically expedient. I think the Gipper would be mortified to learn that, like it or not, he is the founding father of Modern Monetary Theory. A little research confirms that the national deficit exploded higher in percentage terms under Reagan — more than any other president before or after. He accused the Democrats of being “tax and spend” liberals. So we traded “tax and spend” liberalism for “borrow and spend” conservatism. Are we better off? Our country would be technically bankrupt if the Fed and Treasury Dept didn’t collude to monetize most of the new debt. Modern Republicans are convinced that borrowing to spend on social programs is the work of the devil. But they never saw a war that wasn’t worth going into debt for.

Deregulation is another conservative canard. The airlines are the poster child for failed deregulation. The financial services industry, too. Now we shrug when Jamie Dimon admits JP Morgan was “spoofing” gold and silver prices. It’s not cheating. Let’s substitute a gentle word like spoofing; it’s just a funny capitalist joke. JP pays a $1 billion fine and Dimon is still eating takeout from the Ritz in his mansion in the Hamptons. Who pays that fine, ultimately? The bank’s customers and all the “free to choose” day-traders (like me). Wells Fargo regularly cheats its customers, pays fines, apologizes; rinse and repeat. Boeing execs knew their modified aircraft designs would fail — but it would be too expensive to fix. And they punished insiders who tried to blow the whistle. What’s a few plane crashes here and there? Disgusting. But these are the values that have gradually taken hold in our way of life.

Let’s say a few words about our system of for-profit health care. Americans pay the most and obtain some of the worst health outcomes in the world. And that doesn’t include dozens of hours a year spent sifting through paperwork on deductibles and copays. No citizen in any other “first-world” nation has to go through this. If free markets fix problems, why hasn’t the free market lowered costs and improved outcomes in health care? And don’t tell me about the abysmal Canadian health care system. My mother has lived in Canada for the past 21 years. She complains about everything, yet she loves her health care there. It’s the only thing she doesn’t complain about, frankly.

The U.S. has suffered through cycles of deregulation in financial services that have led to costly financial panics, followed by cycles of re-regulation. Both types of cycles have been too extreme. The business costs of these unpredictable de- and re-regulation cycles are profound. Banks now spend billions just figuring out what the endlessly-changing regulations allow. I believe it was Ed Kane who first noted that banks now employ armies of lawyers to engage in “loophole mining,” essentially figuring out how to cheat on any regulation. To me, this is the ultimate cynicism — entities allowed to compete in our gloriously free and prosperous free market without a shred of an intention to abide by any rules whatsoever.

If we’re freer under radically free markets, devoid of regulation and supervision, then one of those freedoms is the freedom to be cheated blind by our largest corporations.

And I’m not saying that semi-socialist nations like France are any better or worse than the U.S. — they are just different. There’s conservative corruption and liberal corruption. Those have now become our choices in the voting booth.

My view is that decades of economic and political philosophy — both conservative and liberal — has done little to improve citizens’ lives. If all these lofty ideas were worth the time and expense it took to develop and promote them, the average citizen would have more optimistic, patriotic feelings about our country than is currently the case.

Why the U.S. Fed Has to Keep Tightening Even Though The Most Reliable Recession Indicator Is Flashing “Game On”

It may be hard to believe, but modern macroeconomics actually has a few theories worth paying attention to. One of these is driving central bank behavior right now, and all indications — thus far — is that U.S. Fed Chairman Jerome Powell is not in the Greenspan-Bernanke-Yellen “cave in to political pressures” mold, and more of a Paul Volcker-type of central banker. And you should care about this because, in the long run, continued tightening of monetary policy is in all of our best interests. Using the two graphs below, I’m going to explain 1.) why Powell is leading the Fed in a better direction than it’s been led in at least 20 years, 2.) why the U.S. economy is most likely going to experience a brief, shallow recession, and 3.) why we should be happy about this.

Exhibit 1 below shows the Unemployment Rate in the U.S. minus the Natural Rate of Unemployment since 1950. Recessionary periods are shaded. Here’s what we learn from the graph: when the unemployment rate dips below the lowest possible rate of unemployment that will not trigger a long-term upward inflationary spiral (the “natural” rate of unemployment), we enter a countdown to the next recession. As the graph shows, this indicator has predicted 9 out of the last 10 recessions. And, thanks to the poorly-timed 2017 tax cuts, which pushed the economy past full output and lowered unemployment below 4%, the recession clock has started ticking once again.

Now, just in case you’re a “9 out of 10 ain’t good enough for me” type of person, I will point out that the 1981-1982 recession, which is the only one in 70 years that was not preceded by the unemployment rate dipping below the natural rate, was Paul Volcker’s second attempt at deliberately engineering a recession to break a vicious inflationary spiral (with a Fed Funds rate greater than 20%, well above the worst inflation rates experienced during those years). Since that recession was artificially induced and almost completely disconnected from market forces, we can give the theory a mulligan, just this once.

The upshot from the graph is that the 2018 unemployment rate of 3.9% is well below the natural rate of unemployment of 4.6%, and, according to the laws of probability, the recession clock has started ticking once again.

Next I’ll explain why all you long-run thinkers out there should be happy about this. Refer to Exhibit 2 below. The green arrows pinpoint the time period when the rate of unemployment falls below the natural rate. The red line is inflation, measured as the GDP deflator. It’s clear what happens when unemployment gets too low: with a time lag, inflation sparks. And, as higher inflationary expectations take hold, they trigger a cascade of natural market forces, resulting in investment and consumer spending pulling back a bit, a slowing economy, and unemployment drifting back up towards (and temporarily overshooting) the natural, non-inflationary rate. These forces help moderate inflationary pressures, and before too long we move on the next period of growing prosperity.

What did we learn from the second graph? It’s in our long-term best interest to harness our post-election activism and pressure elected officials to insulate the U.S. Fed from political pressures. We should applaud Jerome Powell for raising the real Fed Funds rate closer to “normal” levels because higher interest rates will dampen the demand for credit, allow spending and hiring to slow down a little, and give the U.S. economy a brief “time out” — even if that turns into an economic contraction for a quarter or two. Because if we let this happen, by late 2019 or early 2020 we’ll be back in business and enjoying another period of sustainable prosperity.

My view is, if you consider yourself a free-market capitalist, you’ve gotta be tough enough to live through a few “down” quarters now and then so you can profit from many more “up” quarters over the long run. It’s that simple. In our post-election political exhaustion, there’s one more thing we can all do to help the U.S. remain prosperous: write to your Congressperson or Senator and tell them to leave the Fed alone. In my opinion, this is the first time since Volcker that we’ve got a Fed chairman who is thinking long-term. We need to let him do his thing. In a final effort to convince you, I’ll ask you to remember what happened AFTER the Volcker recession — the rate of inflation declined for decades and we enjoyed the Reagan prosperity and a 30-year bull market in stocks.

That’s your Macroeconomics 202 lesson for today.


Categories: Market Commentary

U.S. Stocks Returns: First 22 Months, President Obama vs. President Trump

I thought readers might be curious to see a comparison of the performance of U.S. stocks after each president’s first 22 months in office. The graph below shows that in President Obama’s first 22 months in office, Feb-02-2009 to Nov-21-2010, large-cap stocks (measured as the S&P 500) rose 45%, and small-cap stocks (measured as the Russell 2000) rose 60%. Not too shabby.

The graph shows that stocks have also risen during President Trump’s first 22 months in office, Feb-02-2017 to Nov-21-2018. The Russell 2000 has risen 9% and the S&P 500 is up 16%.

Conclusion: In President Obama’s first 22 months in office, large-cap stock returns were 2.8 times larger than under President Trump, and small-cap stock returns were 6.5 times larger.

Categories: Market Commentary

The Good, the Bad, the Bubble and the Downright Crazy

In this article I will examine current conditions and future trends in the U.S. economy and financial markets. U.S. and global stocks continue to be the standout performers, and thus have garnered most of the headlines. The S&P 500 index has risen 86% over the past five years. In a normal world this would suggest that the U.S. economy has been growing briskly, and is expected to remain hot for some time, which has been the dominant narrative in the media. In terms of longevity, the current economic expansion is definitely one of the best on record. The U.S. economy has been growing for 103 consecutive months as of January 2018, which makes it the third longest expansion ever, and there is a good chance that we will break the record of 120 months set from 1991-2001. But, once we get past the employment numbers, the stock market’s spectacular performance is not well-supported by economic or financial fundamentals, the media’s glowing narrative notwithstanding. This means that one of the following must be true: economic growth and corporate profitability is about to shift into a higher gear; the stock market will suffer a sizable correction or even bear market in the next year or two; or 21st century markets have morphed into a world of pure imagination, where stock valuations can remain disconnected from economic reality forever.

Employment-related statistics are the most unequivocally positive, so that’s a good place to start. The national rates of unemployment (4.1%) and underemployment (8%) are now equal to the rates achieved at the peaks of the last 2 economic expansions. There are a record number of people employed in the U.S., and companies continue to add new workers at a pace not seen in almost 20 years.

The labor force participation rate is one of the few items of concern on the employment horizon. The participation rate is the percentage of work-eligible adults who are employed or looking for work. This rate is now 5% lower than during the expansion of the 1990s. According to the Brookings Institution, labor force participation has fallen most dramatically for veterans and workers with less than a high school education. An increased reliance on disability insurance and a mismatch of worker skills vs. available jobs also affect people’s decision to seek work. Another troublesome point concerns the millennial generation. According to the Pew Research Center, more 18-34 year olds live at home with their parents vs. any other living situation. Not surprisingly, that age range also has the highest rate of unemployment compared with any other demographic. (But don’t worry – survey evidence shows that millennials consider themselves happier and more socially connected than their parents.)

With the employment picture looking relatively rosy, next we’ll take up the thorny topic of growth, another topic we’ve heard a lot about on both the state and national level. Exhibit 1 shows annualized growth in real GDP since the Reagan era. Growth in the U.S. has been slowing steadily for over 35 years. The text boxes show that the average annual rate of growth has declined by exactly 0.8% per year for each of the four expansions since 1982.

Exhibit 1: Real GDP Growth

One of the basic building blocks of “growth” is the rate at which companies grow their revenues and profits. Exhibit 2 shows that aggregate revenues and profits for all S&P 500 companies grew steadily immediately following the financial crisis. Since 2014, however, S&P 500 revenues have grown at a sluggish pace (1.3% per year), and the profits of these companies have been decreasing at an average rate of –1.1% per year. This is unusual for a period of economic expansion.

Exhibit 2: S&P 500 Revenue and Profit Growth

The S&P 500 is made up of larger, more mature companies, so it would make sense to think that smaller, younger companies are the ones that are growing faster. Exhibit 3 shows the aggregate revenues and profits of companies in the Russell 2000, an index of smaller stocks in the U.S. From 2014-2017 the revenues of these companies have grown faster than their S&P 500 counterparts, at an average rate of 3.9% per year. But, as the exhibit shows, their profits have been stuck in a volatile sideways trend for years. Aggregate profits in 2017 are lower than they were as far back as 2011. Again, these facts contrast with the media’s narrative of a briskly growing real economy.

Exhibit 3: Russell 2000 Revenue and Profit Growth

Exhibit 4, which shows the cumulative percentage rise in the S&P 500 and these companies’ profits since 1982, illustrates why we care if stock prices rise rapidly without support from financial fundamentals like revenues and profits. First, notice how stock valuations have risen faster than profits during the last 3 economic expansions. Further notice that when the disconnect between profits and stock prices grows too large, the market becomes susceptible to bear market corrections or crashes, like the dramatic declines of 2000 and 2008. The graph shows that, as of year-end 2017, the disconnect between corporate profitability and stock valuations has never been greater. If investors ever start to care about valuation, as they always have at some point during past expansions and bull markets, U.S. stocks have a long way to fall before prices sync back up with profits.

Exhibit 4: Growth in the S&P 500 Index and Profits

Of course, another way to repair the profit/stock price disconnect is for profits to start growing faster for an extended period. And, we’ve been told that the recent round of cuts to federal tax rates are the secret sauce that’s going to jolt profit growth into high gear. Based on simple arithmetic, lower taxes have to result in higher profits to some degree. (Citizens of the state of Kansas are still waiting for the “jolt of economic adrenaline” that was promised by their soon-to-be former governor.)

Of course, the best way for businesses to grow is to invest in new long-lived assets and infrastructure that grows their customer base and leads to higher sales. But, despite holding record levels of cash and historically low borrowing rates, U.S. businesses haven’t increased spending on capital goods since 2011 (see Exhibit 5, which shows that consumers’ overall appetite for long-lived purchases, known as durable goods, hasn’t grown either). Instead of spending their cash on new investments, corporations have been buying back their own stock at record levels every year – an easy trick that juices stock prices, but does nothing for future revenues and profits. Incredibly, S&P 500 companies have directed over half their annual profits to buying back their own stock in recent years. Before regulations regarding stock price manipulation were loosened in 1982, companies avoided buying back stock. But stock repurchase has steadily grown in popularity since then, and investment in long-lived assets has declined. These points provide a transition to the information in the next exhibit.

Exhibit 5: Growth in Durable and Capital Goods Orders

Exhibit 6 shows the long history of yields on 10-year U.S. Treasury notes and year-over-year growth in U.S. GDP. It is not a coincidence that the two rates track so closely together, especially starting in 1982. Central bankers (Greenspan, Bernanke and Yellen) have been obsessed with driving interest rates lower for decades, based on the idea that if companies and households could borrow cheaply, they would invest and spend more. But, as the graph clearly shows, the theory hasn’t worked – growth in GDP has declined in lockstep with interest rates as corporations have learned to take the easy way out – they have instead used low borrowing rates to leverage up and buy back stock to the point where long-term investments in capital goods, and thus growth in revenues and profits, has suffered.

Exhibit 6: Growth in GDP and 10-Year Treasury Yields

What this era of low interest rates and loose regulatory oversight has instead given us is distorted markets – and not just in the sense of the stock price/profit disconnect described earlier. What follows is a list of developments that make the most sense when each is preceded by the phrase “it might be a bubble if.” Ready?

  • The bonds of major economic powers like Germany and Japan now have negative yields, all the way out to 5-year horizons. This means that large purchasers of these instruments, like pension funds, are content to tie up their money for as long as five years just to receive zero interest and less than their full principal investment back.
  • The yield on a 10-year Italian government bond is lower than the yield on a similar instrument issued by the U.S. government. That’s Italy we’re talking about – the country that spent all of 2017 bailing out Italian banks.
  • The newly-issued debt of another insolvent country, Greece, has been one of the hottest investments in 2017. Their 10-year bonds were yielding 8% one year ago, but have been bought up with such enthusiasm they now yield only 4.5%, a scant 1.5% premium over U.S. Treasuries of a similar maturity.
  • If you think U.S. stocks have been hot, you should check out Japan, whose stock market is up over 120% over the past 5 years. What’s driven their bull market? The Bank of Japan now owns 10% of their home country’s stock market.
  • And Japan is not alone. The Swiss National Bank has bought up shares of the Swiss stock market in a similar proportion.
  • After their CEOs threatened to fire anyone caught trading in Bitcoin just months ago, J.P. Morgan and Goldman Sachs have done an abrupt about face and are now clearing Bitcoin futures contracts.
  • If you’re in the mood to gamble away your retirement savings, financial markets are ready to support your decision. Special IRA products are being introduced that will allow you to direct your retirement savings into cryptocurrencies like Bitcoin.
  • If Bitcoin is not your thing, Goldman Sachs and Morgan Stanley have begun securitizing student debt, so you can retire fat and sassy based on students’ ability to repay the $1.5 trillion owed in student loans (a number that now grows $100 billion every month). Remember, the last financial crisis was triggered when people stopped paying their subprime mortgages, which had been securitized and sold to pension funds and insurance companies.
  • In addition to buying trillions of dollars in bonds since the financial crisis, the U.S. Federal Reserve accidentally revealed that they have been the number one short-seller of stock market volatility in recent years, in an attempt to make financial conditions appear safer than they really are.

So there you have it. Based on everything you’ve read, you might think I’m recommending that investors hold 100% cash and hunker down for the next crash. But I’m recommending just the opposite. I have never seen a better-justified bubble – global central banks, the financial media, and just about every financial advisor on earth are as bullish as they have ever been. This market has a momentum to it that exceeds even the late 1990s tech bubble. I think investors’ willingness to suspend their disbelief has a long way to run. My prediction is that U.S. and global stocks are going to continue their melt up well into 2018, and possibly longer, and the disconnect between fundamentals and asset values will keep growing. Your guess is as good as mine as to what will trigger the next financial crisis, but it’s coming. It’s just not here yet.

Categories: Market Commentary

Sector Analysis Suggests Investors are Cautious About the Sustainability of the “Trump Rally”

This article examines the sector performance of the U.S. stock market during the “Trump Rally.” Sector performance over the past six months suggests the market’s gains may not be sustainable, as market leadership has been confined mainly to sectors typically associated with a “risk-off” attitude on the part of investors.

Examining the performance of the stock market broken down by sectors can yield insights into the sustainability of the current market trend. Since November 2016, markets have been buoyed by the “Trump Rally,” in expectation of widespread deregulation and other market-friendly policies. The first chart below depicts the Russell 1000 (largest 1000 stocks in the U.S. by market capitalization) vs. the Russell 2000 (next 2000 largest stocks, representing the mid- and small-cap space). When small-cap stocks lead large cap stocks during a bull market phase it’s usually a positive indicator for the sustainability of the rally, suggesting that investors are comfortable taking more risk (as small-cap stocks are generally riskier). When large-cap stocks lead during a bull phase, the implication is that investors are more cautious about the sustainability of the market’s uptrend.

The graph shows that small- and large-cap stocks participated equally in the Trump rally from November through February (up 7% and 8%, respectively). From March through May, however, small-cap stocks have declined by about 2%, with large-cap stocks extending their gains by a modest 1%. Clearly, almost all the gains from the Trump rally occurred during the first 3 months following the inauguration, with the market taking more of a “wait and see” attitude since then.

The next graph below depicts the top 5 performing sectors in the S&P 500 index over the same time period (I still live in a 10 sector world, never having bought into S&P’s decision that real estate is a market sector — for me, real estate remains an asset class — sorry, S&P). Another way investors gauge the sustainability of a market rally is by which sectors are displaying the most leadership. When “risk on” sectors like Financial, Industrial, Technology, Energy, Materials and Consumer Discretionary stocks are leading the charge, it usually indicates high positive conviction on the part of investors. On the other hand, when more “risk off” sectors like Utilities, Consumer Staples and Health Care lead the way, it usually indicates dampened enthusiasm on the part of investors, who are bidding up the prices of these stocks more out of a “flight to safety” mentality.

The returns to the top-performing sectors indicates a mixed story for the current U.S. stock market. While it’s unequivocally positive to see Technology stocks in the lead (up 19% in six months), the remaining sectors among the top performers (Utilities, Consumer Staples and Health Care) are all traditionally “risk-off” sectors, suggesting caution on the part of investors. This means investors have been wading more cautiously into the Trump Rally than we typically see during a bull market phase that has long-term sustainability.

The last graph above depicts the five lowest-performing S&P 500 sectors over the past six months. Industrial stocks, a traditional risk-on sector, have led the way with an overall gain of 8%. Other typical risk-on sectors comprise most of the bottom performers, including Financials, Materials and Energy stocks, which continue to extend their dismal performance from the previous two years.

In conclusion: Sector performance during the Trump rally suggests the market’s gains may not be sustainable, as market leadership has been confined mainly to sectors typically associated with a “risk-off” mentality. If the performance of risk-on sectors such as Financials, Industrials, Materials and Energy stocks were to improve suddenly, it would be a positive sign for the sustainability of the recent bull market trend.


Categories: Market Commentary

TIAA-CREF Warns That Negative Interest Rates are Coming

In all seriousness, I propose that Congress modify the Fed’s mandate to include a monetary policy version of the Hippocratic oath: First Do No Harm. Just following that simple precept would lead to an immediate reversal of the ZIRP/NIRP policies that have plagued the global economy since the Greenspan-Bernanke-Yellen triumvirate unleashed their war on savers and retirees 35 years ago. (The next step is to permanently reduce our reliance on excessive debt, but first things first.)

This morning I received a message from TIAA-CREF informing me, and all plan participants, to begin taking negative yields into account as we consider our future asset allocations. The message is available to the public at the following URL: TIAA-CREF Interest Rate Message.

The main points are summarized in the following screenshots from the web page:

TIAA-CREF-Negative-YieldsTIAA-CREF-Negative-Yields-2Regular readers of this blog know that I have been predicting continuation of the Fed’s “all talk, no action” strategy for over a year now, with articles such as Deflation is the Main Reason the Fed Will Raise Rates Later Rather than Sooner (Mar. 27, 2015) and The Fed Won’t Raise Rates Until Deflationary Trends Reverse (Oct. 28, 2015). The main reason for the excess chatter and lack of actual rate increases was explained on Dec. 14, 2015: Leading Indicators Suggest U.S. Economic Activity Approaching Stall Speed. Today we received confirmation that the U.S. economic activity is trending toward the rest of the world with an unusually honest headline from

US-Economy-Grew-0.8-PercentAlthough Bloomberg tried to spin this news as positive:

US-Economy-Grew-Morewhich is truly pathetic. Personally, I have never been able to solve a problem until I address the problem directly. I urge the highly-paid PhDs at the Fed to do the same. Combined with the imminent arrival of negative yields in the U.S. (joining Japan and much of Europe), the exhibit  below completes the story. It’s a graph of the Baltic Dry Index (an index of global shipping activity) over the past 5 years. The blue arrow shows the 2.5-year trend. For the directionally-challenged, it’s DOWN. For the aspiring chartists, the index has made 3 lower highs over the period, and has started to form a fourth.

Baltic-Dry-May-2016There’s a global recession and we can’t avoid it. Accept the reality of the situation. The one good thing that can come out of our economic slump is that it’s relatively easy to remove the main cause: central bankers around the world clumsily manipulating free markets and achieving ever-worse outcomes!

Categories: Market Commentary

The Great Central Bank Permabubble

A considerable amount of time has passed since the financial crisis of 2008 and the “great recession” that followed. March 2016 marks the seventh year since the economy began its long, slow recovery and the current bull market in stocks began.

The current economic recovery and stock price gains have been accompanied by a considerable degree of skepticism, however. Many have argued that we’re in the least-respected bull market in history, and discredited naysayers with nicknames like “permabear” and “Dr. Doom.” In this article I will take a long-term view of the pros and cons regarding the past and current state of the U.S. economy and financial markets, explain why such a wide range of opinions prevail among analysts, investors and the financial media, and identify the main force that propelled stock prices to record levels in 2015.

We’ll start by considering Figure 1, which shows the long-term growth rates of corporate profits, stock prices, gross domestic product (GDP, the value of all goods and services produced in the U.S. over time), and new orders for capital and durable goods (spending on big-ticket items by businesses and consumers). Following the 1991 recession, orders for capital and durable goods grew rapidly, with profits and stock prices following along until the late 1990s. Although spending by consumers and business continued at a brisk pace until 2000, it is now widely-recognized that the stock values had crossed over into “bubble” territory, which happens when stock prices rise without accompanying growth in fundamentals (such as corporate profits). Because the excess technology investments of the late 1990s did not lead to further increases in profits, stock prices retreated into bear market territory in 2000, with the events of 9/11 prolonging the decline all the way into early 2003.


Figure 1

The bull market of the early 2000s seemed poised to right the wrongs of the previous bull, as this time capital and durable goods orders grew proportionately with stock prices, and corporate profits grew even faster – what could go wrong? It turned out that markets had yet another lesson to teach, because profits and stock prices had received significant tailwinds from dual bubbles in real estate and credit. In 2008 the bear caught up with markets again, and the carnage in both the economy and financial markets was more severe than anything seen in the 2000-2003 bear market.

Free markets are resilient, however, and starting in 2009 profits and stock prices rebounded once again. This time prosperity seemed to be on more solid footing until late 2012, when signs of a cooling economy began to surface (note the slowdown in spending on capital and durable goods). Profits and stock values continued surging ahead for two more years, but in 2015 volatility began spilling over from global markets. Since then profits and stock prices have declined, capital goods orders have stagnated, and durable goods orders have fallen sharply. This leads to our first question: after all the lessons that were supposedly learned in the previous two market bubbles, how is it possible for profits and stock prices to surge ahead to new highs without support from basic economic fundamentals like spending by businesses and consumers?


Figure 2

To answer this question, let’s examine Figure 2, which takes a closer look at long-term growth in key fundamentals such as consumer spending, personal income, retail sales and wages and salaries. Even a casual glance at the graph makes one thing clear – during the bull markets of the 1990s and early 2000s, these economic fundamentals all grew at nearly identical rates, as expected. During the 2008-2009 recession, however, the relationship among these fundamentals suffered a key interruption that has yet to be corrected. Although personal income and consumer spending declined before resuming their upward trend, retail sales and wages and salaries fell by much more, and have continued growing on a slower trajectory throughout the current economic expansion. The fastest-growing component of personal income since 2009 has been – drumroll, please – transfer payments – essentially checks from the government, which is not consistent with expanding prosperity. It’s clear that profits and stock prices are not getting any help from standard fundamentals.

This leads to our second question: can we identify the factor that enabled profits and stock prices to achieve new highs when basic economic fundamentals were growing much more slowly?


Figure 3

Figure 3 introduces the villain in our story: debt. Despite the poignant lessons of the 2000s credit bubble, and the apparent deleveraging in the Federal and corporate sectors from 2008-2010, debt levels remain excessive, and have given corporate profits and stock prices a considerable boost in their march to new all-time highs. Figure 3 depicts the obscene explosion in student debt since 2009, which shows how free markets are always ready to invite new borrowers to the party when old borrowers are tapped out. We’ll have more to say about the “apparent” deleveraging in a moment, but first let’s pose our third question: how has it been possible for debt levels to remain so high since 2009 – especially when we were supposed to be unwinding a credit bubble?


Figure 4

Figure 4 provides a long-term view of interest rates, inflation and commodity prices. First, half the answer to our previous question can be found by tracing the trajectory of interest rates. The U.S. Federal Reserve Bank, for reasons too obscure for the rest of us to understand, have persisted in their mistake of keeping interest rates too low for too long. The accompanying low cost of borrowing has led to yet another debt bubble – the U.S. and global economies have been drowning in excessive debt for years. Figure 4 also shows some of the unintended damage to another factor considered crucial for modern economies: inflation, or in this case, the lack of it. The global commodity index shown in the graph (based on everything from oil to aluminum to copper) has crashed and taken energy-dependent economies down with it. For now, bankruptcies have been manageable because, with interest rates still so low, it costs little to extend and restructure the terms of existing debt contracts.

Figure 4 also shows the “spread” of interest rates that markets are requiring from low-quality debt (rated BBB) vs. higher-quality Treasuries. Notice how the spreads have widened to levels associated with previous recessions, although still not close to the crisis levels of 2008. Why does this matter? Because credit and stock market bubbles don’t pop simply because asset prices are overvalued – they pop when investors suddenly become risk averse, sell out of risky assets and find safe havens in which to invest. The rise in credit spreads indicates that markets have been concerned with repricing risky debt since early 2015, and these concerns have spilled over into the prices of all risky assets, including stocks.


Figure 5

Figure 5 introduces our last perspective. When describing trends in corporate and consumer debt in Figure 3, I had referred to the slight deleveraging by business as “apparent” – now I’ll explain further. All of the debt in existence today doesn’t show up on the chart, because over $4 trillion of public and private debt now resides on our own Federal Reserve Bank’s balance sheet, conveniently out of sight – at least for awhile. Most readers have probably heard the term “QE,” short for “quantitative easing,” thrown around in the last few years. Figure 5 shows what QE means. In addition to its obsession with low interest rates, the Fed has used its powers to buy up a substantial amount of the excessive debt in financial markets. Notice how the Fed begins implementing this highly unconventional support for markets in late 2008, and how stock prices begin responding in March 2009. The rest of the story is told by the graph itself. When the Fed is buying debt and injecting more liquid assets back into the banking system, some of the excess liquidity may get loaned out, but most of it winds up chasing stocks and other risky assets. The size of the Fed’s balance sheet and U.S. stock prices have been rising in lockstep since 2009. Stock prices haven’t been rising because economic fundamentals are growing, they’ve been rising because global central banks have pumped over $20 trillion of liquidity into financial markets, and they all plan to accelerate these programs in 2016.

Only the U.S. Federal Reserve says it doesn’t like this game anymore, and to prove it, they raised interest rates a paltry 0.25% in December. The market’s extended tantrum over this rate increase should tell you all you need to know about markets in 2016. If the Fed keeps raising rates, as they’ve promised, expect the tantrums to continue all year. If, on the other hand, economic and financial conditions weaken precipitously, the Fed may very well find itself rejoining forces with all the other major central banks around the world, which continue depressing interest rates. In case you haven’t heard, Japan, Denmark, Sweden and Switzerland are all quite proud of their negative interest rate policies, yes, you read that right, and some are already forecasting that the U.S. Fed will be forced to follow along within another year or two.

So, if you’ve found the recent volatility in markets entertaining . . . you’re in luck. My prediction is that stock, bond and commodity prices, not to mention the grand wizards at the Federal Reserve Bank, have more surprises in store for us in 2016 and beyond. Buckle up.

Categories: Market Commentary

Leading Indicators Suggest U.S. Economic Activity Approaching Stall Speed

In this article I will assess the strength of U.S. economic activity by analyzing the components of The Conference Board’s (hereafter “the CB”) Leading Economic Index, along with a few additional indicators. Overall, the analysis indicates a significant slowdown in U.S. economic activity, and the possibility of a recession in 2016, based on: 1) lack of growth in consumer and capital goods orders, 2) a range-bound stock market and flattening yield curve, 3) a multi-year trend of slowing sales growth, 4) unsustainable increases in business and consumer borrowing, 5) an elevated inventory-to-sales ratio, 6) commodity price deflation and 7) the complete exhaustion of Federal Reserve monetary policy.

The analysis method is to individually rank each Conference Board indicator -1, 0, or +1 (negative, neutral or positive, respectively) and to average these rankings two ways. The first way treats each indicator equally, while the second uses the weighting system employed by the CB. The possible range of scores is from -100%, which would represent a severe recession, to +100%, which would represent robust expansion. The summary table below previews the results of the analysis. According to the equally-weighted method, past, present and future economic activity in the U.S. has been hovering close to stall speed — neither expanding nor contracting (0% diffusion index values). Using the CB’s weightings, which more heavily emphasize manufacturing activity, interest rates and consumer sentiment, the U.S. economy is expected to remain in a sluggish, slow-growth mode for the first half of 2016 (a 23% diffusion index value corresponds to slow growth). If business activity continues decelerating, however, the economy will most likely slip into recession sometime in 2016.

Unweighted-Diffusion-Index Weighted-Diffusion-Index

The most heavily-weighted component is the Average Length of the Manufacturing Workweek (weight = 27.8%), shown below with the Average Length of the Construction Workweek. The manufacturing workweek has averaged 41.8 hours — exactly — for the past 8 months (which raises questions about the validity of the reported data). The length of the construction workweek is also at multi-year highs.


In the chart below, I compare the manufacturing workweek to total manufacturing employment. Despite my doubts about the accuracy of the workweek data, the increase in manufacturing employment since 2010 convinces me to rank this indicator +1.


The second leading indicator is the ISM’s New Manufacturing Orders Index, weight = 16.5% (notice that the first two indicators make up 44% of the weightings in the CB’s Leading Index). The ISM index has recently plunged below the contractionary level of 50, which earns it a ranking of -1. (The recent downtrend in this indicator casts further doubt on the accuracy of the manufacturing workweek numbers — declining activity should be accompanied by a declining average workweek).


The University of Michigan’s Consumer Sentiment Index (weight = 15.5%) has also exhibited unusual behavior, spiking sharply higher despite 1) increased financial market volatility, 2) contradictory and confusing announcements by the Federal Reserve Bank, and 3) increased geopolitical tensions. Despite all that, I will give the indicator the benefit of the doubt and assign it a score of +1.


Interest Rate Spread Between the 10-year T-Note and the Fed Funds Rate (weight = 10.7%). This indicator is really a proxy for the slope of the yield curve. A steeply-sloped yield curve indicates economic expansion, while a flat or inverted yield curve indicates slowdown or contraction. The curve has recently flattened as longer-term rates have slumped and short-term rates have risen slightly, in anticipation of the long-awaited Fed Funds increase. The 2% spread is typical for the middle of an economic expansion, but with the Fed’s central planners maniacally pinning the Fed Funds rate at zero for the past 7 years, the indicator cannot be rated higher than zero.


Manufacturers’ New Orders for Consumer Goods (weight = 8.1%). Nominal and real Durable Goods Orders (deflated by the Personal Consumption Expenditure Index, or PCE) are shown below. After climbing sharply during the years following the last recession, the indicator has contracted sharply in 2014-2015. Moreover, the inflation-adjusted series shows zero growth over the past 15 years. The indicator therefore merits a score of -1.


The Conference Board’s proprietary Leading Credit Index is replaced by The Chicago Fed’s National Financial Conditions Index (weight = 7.9%). Lower levels indicate “looser” borrowing conditions. Access to credit remains easy, especially for this stage of an economic expansion, so I’ll rate this indicator +1.


The +1 rating is on the generous side, however, as demonstrated by the following graph depicting total borrowing by U.S. businesses and consumers. Both have increased at historically high rates since 2010, a trend which is not sustainable. (Total business credit is an official CB lagging indicator.)


The ratio of consumer credit to personal income, another CB lagging indicator, is at an all-time high of 22.5%, further confirming the unsustainability of the debt binge. It’s unpleasant to contemplate the effect on U.S. consumers’ spending power if the Fed raises rates, and payments on all adjustable-rate loans for consumers rise.


Level of the S&P 500 (weight = 3.8%). After rising dramatically since 2009, the S&P 500 has remained in a trading range for all of 2015, while volatility has increased sharply. I will generously assign this indicator a score of zero.


Manufacturers’ New Orders for Capital Goods (weight = 3.6%). Capital Goods orders show a contraction similar to Durable Goods, and the inflation-adjusted Capital Goods Orders index has been in a 15-year downtrend. The indicator earns a score of -1.


Initial Unemployment Claims (weight = 3.3%). Unemployment claims continue trending lower. What could be the problem? As the chart shows, consistent readings below 300,000 usually occur late in a business cycle expansion. This indicator therefore rates a score of zero.


Building Permits for New Private Housing Units (weight = 2.7%). This indicator continues advancing, but remains far lower than the levels achieved in each of the two prior expansions. I will therefore rate the indicator zero.


A summary of the individual scores for each leading indicator and their weighted and unweighted averages are shown below. This marks the third year in a row that my ranking of the Leading Indicators has been in decline. Overall, the analysis implies that economic momentum will continue declining through at least the first half of 2016. For the first time since 2009, the U.S. economy is showing signs that it may slip into recession sometime in 2016.


Additional concerns. Despite all the excessive borrowing described above, U.S. GDP growth has barely averaged +2.0% during the current expansion.


Another concern arises due to the behavior of the inventory-to-sales ratio, which will hamper GDP growth in future periods as businesses reduce production and liquidate excess inventory at reduced prices.


Global deflation is one of my most serious concerns. The chart below shows the 1-year price change for oil, coal, copper, aluminum, lead, zinc and nickel. All are negative, with declines ranging from -12% and -45%.


Agricultural commodities are also in a deflationary spiral, as shown below. Although cotton and cocoa exhibit slight increases in price (after declining in 2014), the prices of corn, oats, wheat, soybeans and coffee are in a long-term decline, ranging from -7% to -30% year-over-year. Deflation is an unmistakable sign of global economic weakness.


Finally, one of my new official concerns is the blatantly positive bias of the U.S. financial media, which has now been fully captured by corporate interests. The age of objective journalism is over. Consider this Bloomberg headline from December 11:


The headline makes it sound as if sales are ripping higher. After considering the trend in retail sales growth depicted below, however (declining from 2012-2015), a more accurate headline might be “Retail Sales Growth Slows To Zero”:


Summary. The Conference Board’s Leading Economic Indicators have deteriorated significantly over the past year. Lack of growth in consumer and capital goods orders, a range-bound stock market and flattening yield curve, slowing sales growth, unsustainable increases in business and consumer borrowing, an upward-trending inventory-to-sales ratio, deflation in physical and agricultural commodities and the utter exhaustion of both conventional and unconventional Federal Reserve monetary policy all suggest that the 6-year economic expansion is running out of steam. A significant probability exists that the U.S. economy will slide into recession sometime in 2016.

Categories: Market Commentary

The Fed Won’t Raise Rates Until Deflationary Trends Reverse

We all love to say “I told you so,” but gloating is difficult when the news is this bad. Back in March 2015, I published an article entitled Deflation is the Main Reason the Fed Will Raise Rates Later Rather than Sooner. As the exhibits below will confirm, deflationary pressures persist, thus the Fed will most likely not be raising rates in December 2015, either. The mainstream media is high on hopium when it asserts that raising rates is the default decision for December. Unless there is a significant turnaround in the trends presented below, rates will remain at current levels until at least April 2016.


Corn and cocoa are the only two major agricultural commodities to finish the trailing 12 month period at slightly higher average prices. Oats, wheat and cotton prices declined modestly, and soybeans and coffee are both down over 35% from a year ago.


The story is worse for physical commodities. Aluminum, copper, nickel, zinc and lead have suffered price declines of -10% to -30% in the past year.


A one-year history of Bloomberg’s commodities index confirms the trend. The global economy has been experiencing widespread declines in the prices of both agricultural and physical commodities for several years. These trends are not consistent with global growth and prosperity. Every central bank in the world is easing its monetary policy except the U.S. Federal Reserve. The Bank of China has recently announced new monetary stimulus efforts on consecutive days. The Bank of Japan openly admits it has extended quantitative easing to include the outright purchases of equity securities (which is more of a monetary madness than a policy). The European Central Bank also laid out plans for another massive round of quantitative easing recently (although Mario Draghi is fast becoming known as the boy who cried “QE”).

It is not plausible that the U.S. Fed will act against these trends. As reported by Bloomberg, Janet Yellen managed to obtain near unanimity (9-1, with only Lacker dissenting) from the FOMC to continue monitoring the situation and reconsider raising rates at its December meeting.

One last exhibit below — the Baltic Dry Index (also from Bloomberg), a measure of global shipping activity, managed to show some improvement from June-August. But the index has trended down for the past 2 months, as the global market selloff quickly dampened business confidence.


And before you get too excited about that November 2014 “high” in the Baltic Dry, examine the chart below. Global shipping activity has been in a downtrend for at least the past 5 years:


The world is not only a long way from “normalized” interest rates, we are a long way from the kind of robust business environment under which any central banker would seriously consider so much as starting the normalization process. Here is the question we should be asking: How weak can the domestic and global economy be if most major central banks are easing further, and a 0.25% increase in the Federal Funds rate is unthinkable?

Categories: Market Commentary

Sector Analysis Reveals Investors’ Waning Appetite for Risk

Analyzing returns to stocks by sector can reveal information about investors’ desire to either take on or avoid additional risk exposure. The chart below shows that the top-performing S&P 500 sectors since May 2015 include defensive sectors such as Utilities, Consumer Staples and Health Care. Investors typically rotate into these safer sectors when they anticipate increased market volatility and sluggish economic conditions, which turned out to be a good call. It’s definitely been a “sell in May and go away” summer thus far.


The worst-performing S&P 500 sectors include Industrials, Information Technology, Materials and Energy stocks. Investors typically rotate into these stocks when they anticipate lower market volatility and brisk economic activity. The continued decline in Materials and Energy raises the possibility that these sectors are now somewhat oversold, with the chance for a potential “relief rally” later in the year.


The chart below shows the CBOE’s implied volatility index (VIX), sometimes called the “fear index,” although when volatility languishes as it has for most of the past 4-year rally in stocks, it can also be thought of as a “complacency index.” The spike in volatility from August 24 rivals those from early 2010 and late 2011, but is still much lower than the volatility observed in late 2008 and early 2009, during the heart of the financial crisis. If the VIX quickly returns to a sub-20% reading, it would signal a return to more of a “risk-on” mentality in Q3. On the other hand, stocks are unlikely to begin a significant uptrend if the VIX remains elevated.


Overall, sector activity shows that investors had been positioning themselves for a steep correction since May. Whether or not the selling continues into bear territory or remains confined to a quick correction likely depends on the Federal Reserve’s September interest rate decision. If the Fed hesitates and postpones their long-telegraphed rate increase, expect stocks to rally sharply this fall — especially the most beaten-down sectors. If the Fed proceeds and raises rates in September, however, the recent increase in volatility is likely to continue, and a sustained market rally is much more unlikely.

Data from S&P’s Capital IQ.


Categories: Market Commentary