Financial Market Commentary

The chart below shows the 6-month performance of the SPY (State Street S&P 500 ETF) and MCHI (iShares ETF that tracks large- and mid-cap stocks in China).

These indexes are comparable, representing mainly large and mid-cap stocks in the world’s two largest stock markets. Over the past 6 months Chinese stocks have underperformed the S&P 500 by 38%, which is a staggering divergence. I believe this is largely caused by China’s short-sighted political crackdowns on various entrepreneurial ventures (from fining Jack Ma $4 billion to, more recently, declaring various lines of business (such as “private education” tutoring companies) to be illegal, which instantly incinerated billions of dollars worth of stock).

President Xi’s hardline anti-capitalist stance is likely to soften at some point (more on this below). And, as we know, markets eventually rotate out of one theme and into another, and the best time to pounce on these rotations is when the market switches from bear to bull conditions — the best gains come at the beginning of a cycle. First prediction (made with high conviction): the S&P 500 will suffer a correction (probably not a bear), and recent market activity indicates this may have already begun. If not, it is close to inevitable that we’ll see a sharp correction no later than the semi-predictable Sept/Oct slump (those are the two worst months for stocks historically).

I am basing my market correction call on more than seasonality, however. Based on recent headlines, I am firmly convinced that the more-transmissible Delta variant strain of COVID is going to sweep through the US this fall and cause another economic disruption. It won’t be as bad as 2020, but it will definitely slow growth and raise unemployment. Moreover, the market will do its usual good job of looking forward and anticipating this. The real economic damage will be evident by December, but the market should “get the memo” by September/October, November at the latest. With half the country still unvaccinated, and the major unvaccinated states like Missouri and Florida already in mini-COVID crises, I believe this to be close to a foregone conclusion.

The most important question (as always) is, of course, why do we care? When the market correction begins in earnest global stocks are likely to tank across the board, led by the US (as we have had some of the best gains in 2021 and our stock market is profoundly overvalued). We care because of my second prediction (made with moderate conviction): if China’s stock market gets dragged down a little further by another COVID crunch and US market correction, I think the MCHI has the potential to be a good play when bull market conditions resume (which may take weeks or months, everyone will have to observe market conditions and act nimbly — corrections have been sharp and brief and have reversed promptly in recent years).  

Finally, I present one additional indicator that supports the “overvaluation” hypothesis for US stocks: the above chart of the SPY vs. the TLT (index of the prices of 20 year treasuries) tells an interesting story. First note that 20-year Treasury prices have risen as much as the S&P 500 over the past 3 months (prices up means rates have been falling). Interest rate declines have predicted all the major corrections in this bull market. The bond market has seen through weak economic conditions before the stock market has gotten the memo quite consistently in recent years. As the chart makes clear, the indicator is flashing a warning signal again. If the economy, job market and inflation were as red hot as the Fed claims, rates should be RISING, not falling. As usual, the bureaucratic numbskulls at the Fed are completely wrong — there’s not going to be any tapering of QE. The Fed will be easing by late fall/early winter, and that’s going to send stocks soaring. We live in a QE-infinity world now. Fed stimulus will have to be supplied ad infinitum.

But first, it’s time to buckle up and get ready for a volatile summer/fall season. The correction is coming (and may already have started). I recommend watching the MCHI as a vehicle for diversifying a portfolio during the ensuing bull phase (yes, there will be another bull market!). China’s President Xi can only push his dictatorial impulses so far. If he destroys too much wealth China’s middle class will go berserk. China’s citizens have enjoyed incredible increases in wealth in recent decades and they are not going to go silently back into poverty. Even the usually compliant Chinese are capable of civil unrest at some point, and Xi will stay away from that brink. When we see headlines about Xi softening his anti-free market stance a bit, start watching for signs of a new uptrend in the MCHI. China’s economic miracle is not over, it’s just taking a break due to incredible political stupidity.

I’ve been corresponding with a friend about the dangers of socialism under the Biden administration and thought I would share my latest reply.

I must agree with you on the dangers of expanding socialism. Sadly, the GOP had their turn at bat from 2017-2018 when they controlled all three branches of the federal government, but never took a serious look at any of the most expensive socialist entitlements: Medicare, Social Security and Quantitative Easing. It was borrow-and-spend as usual, and predictably, retirees and bankers continued feasting at the public trough while the deficit soared. And I couldn’t believe it when Trump and the GOP-controlled Senate went along with the big stimulus giveaway earlier this year. What were they thinking? Another $3 trillion down a rat hole, as Grover Norquist would say. Even worse, just as conservative theory would predict following a government handout, the lazy liberals are filing for unemployment again. New unemployment claims have risen for the past 2 weeks — it’s an outrage. I predict their next ploy will be to complain that they can’t pay their rent. Don’t they understand the economic principle of creative destruction? They should just move to California with the rest of the homeless and be thankful for the warm winters and the blessed freedoms enshrined in our constitution.

But not to worry, elections have been swinging red/blue, red/blue for decades, so the GOP should get another chance at abolishing these abominable socialist programs in 4 short years. With Trump or Pence back in the White House they can finally ram Judy Shelton in as Fed President and she can restore us to the gold standard. I’m confident she will easily solve the pesky problem of reducing the M2 money supply by $14.5 trillion, give or take, since M2 is now 30 times greater than the market value of all U.S. gold reserves (about $500 billion), and the value of the two accounts must be equal at all times under the gold standard. In the long run people will agree that the global depression caused by the sudden contraction of the money supply is a small price to pay for finally being able to live like free people, the way the founding fathers intended.

Best, Rob.

George Orwell (best known for the dystopian novel “1984”) went to Spain in the late 1930s to help the Leftists resist the Fascists, where he fought in combat. After a vicious and bloody civil war, the Fascists prevailed. Their victory depended on extensive support from the rising Nazi regime. The Leftists were hopelessly outgunned as Britain, the U.S. and other nations refused to offer meaningful counter support.

There are many similarities to Europe in the 1930s and the situation in which the U.S. currently finds itself, and these are deeply disturbing. I write this essay to counteract the mindset I perceive among liberals that if Democrats prevail in the 2020 election, “the nightmare will be over.” Things will undoubtedly get immediately worse if the Republicans win, but if the Democrats win, I predict that surprisingly little will change, and this will result in tremendous frustration. Republicans will simply use the stacked federal court system to resume McConnell’s strategy against Obama: oppose absolutely everything Democrats try to accomplish.

My aim in writing this essay is to wake people up to the uncomfortable fact that a “cold civil war” has already started, and that there are only two choices once a war begins: fight or surrender. Democrats are going to have to gird themselves for a long, long fight. Orwell recognizes that many individuals are deeply averse to fighting because:

It is an inescapable fact that in order to fight one has to degrade oneself.

I respect many things about former president Obama, but his “when they go low we go high” perspective proved to be ultimately impractical. Obama was abused and disgraced by McConnell in the Merrick Garland matter. I could not respect his decision to simply surrender to McConnell, nor, for that matter, will I ever understand Al Gore’s thinking when he meekly conceded an election that he would have won, had the vote counting continued. Going forward, it will be necessary to embrace Orwell’s admonition that

It is better even from the point of view of survival to fight and be conquered than to surrender without fighting.

Democrats need to evolve into fighters, every bit as fierce as the fanatical far right — or it will be game over for U.S. democracy. Even if Trump is defeated in the 2020 election, the fighting is going to go on for a long time. Let’s consider some similarities between today and the late 1930s as described by Orwell:

The only propaganda line open to the Nazis and Fascists was to represent themselves as Christian patriots saving Spain.

And thus our modern-day far right employs a strategy that depicts the left as inhuman radicals from whom the nation must be saved. The well-known talking points are that the left wants to take away God and guns from the working class and capitalism from the high-earning one percenters. Orwell further writes:

Everyone believes in the atrocities of the enemy and disbelieves in those of his own side, without ever bothering to examine the evidence. And there was hardly a single case when the Left and the Right believed in the same stories simultaneously.

Which leaves Orwell with a feeling we also grapple with today:

It often gives me the feeling that the very concept of objective truth is fading out of the world.

And, right on cue, the far right has reintroduced the idea of “alternative facts.” Their desire to purge government of scientific expertise is eerily reminiscent of Orwell’s observation that

Nazi theory indeed specifically denies that such a thing as ‘the truth’ exists. There is, for instance, no such thing as ‘science’. There is only ‘German science’, ‘Jewish science’ etc. The implied objective of this line of thought is a nightmare world in which the Leader, or some ruling clique, controls not only the future but the past. If the Leader says of such and such an event, ‘It never happened’ – well, it never happened.

Thus Americans are bombarded with messaging from the Trump administration that there is no coronavirus pandemic, masks don’t help stop the spread, we’re “rounding the corner” even though we have a record number of new cases, climate change isn’t real, and on and on ad nauseum.

Orwell goes on to reflect — incredulously — that in the 1930s Europe had de facto accepted the reintroduction of slavery on the continent when nations passively stood by and allowed the Nazis to round up entire populations and send them to forced labor camps. According to Orwell, the inaction of European powers reveals an important aspect of human nature:

We believe half-instinctively that evil always defeats itself in the long run. We don’t grasp its full implications, because in our mystical way we feel that a régime founded on slavery must collapse. But it is worth comparing the duration of the slave empires of antiquity with that of any modern state. Civilizations founded on slavery have lasted for such periods as four thousand years. Those hundreds of millions of slaves on whose backs civilization rested generation after generation have left behind them no record whatever.

Democracy, by comparison, remains a short-lived experiment. If the far right manages to thwart representative democracy and steal the 2020 election, will history recall the rage of the Black Lives Matter movement, or that another candidate had the audacity oppose Trump at all? Even as I write this, the Sunday morning liberal media are squawking about how “history will look back on this moment with shame.” Don’t be so sure; as Orwell reflects:

In the whole of Greek and Roman history, how many slaves’ names are known to you?

Orwell further noted the disappointing fickleness of liberal intellectuals following a defeat:

One feature of the Nazi conquest of France was the astonishing defections among the intelligentsia, including some of the left-wing political intelligentsia. The intelligentsia are the people who squeal loudest against Fascism, and yet a respectable proportion of them collapse into defeatism when the pinch comes. They are far-sighted enough to see the odds against them, and moreover they can be bribed.

This further reinforces my belief that Democrats need to condition themselves to a long, uncomfortable struggle.

What conditions allow fascists to win so many hearts and minds? Orwell noted that it is most important for fascists to win over the aristocrats (or in our case, the high-earning one percenters) by inspiring hatred among citizens:

When one thinks of all the people who support or have supported Fascism, one stands amazed at their diversity. The hatred which the Spanish Republic excited in millionaires, dukes, cardinals, play-boys and what-not would in itself be enough to show . . . they are all people with something to lose, or people who long for a hierarchical society and dread the prospect of a world of free and equal human beings. The simple intention of those with money or privileges is to cling to them. In essence it was a class war.

And Republicans’ messaging is designed to inspire fear by constantly (and falsely) reminding their followers that liberals want to take away their God, their guns and their capitalist system.

Orwell further points out that it doesn’t matter whether or not you want to be in a war once the conflict has already started:

There is always the temptation to say: ‘One side is as bad as the other. I am neutral’. In practice, however, one cannot be neutral, and there is hardly such a thing as a war in which it makes no difference who wins.

The far right knows this and knows it well; better than the Democrats, I fear. Remember the lessons of McConnell vs. Obama and Bush vs. Gore. Republicans’ conduct may have been despicable, but they won those battles — and they are scarily close to winning again. It is extremely important to remember that, even if the far right loses the 2020 election, they will not slow their efforts to subvert representative democracy and replace it with a pseudo-totalitarian, minority-rule government that answers mainly to white Christians.

In closing, I offer two quotes from Santayana’s “The Life of Reason” (Volume 1, 1905-1906):

Those who cannot remember the past are condemned to repeat it.

Fanaticism consists in redoubling your efforts when you have forgotten your aim.

The far right has no shortage of fanatics, and they are already busy redoubling their efforts. Win or lose, they are going to keep coming. The question is whether or not the left can muster the required staying power to supersede the fanaticism of the far right. This is what it will ultimately take. Over one hundred years ago, immediately following World War I, the poet W.B. Yeats reflected that

The best lack all conviction, while the worst are full of passionate intensity.

And it’s all happening again, right under our noses. There are no sidelines to stand on. History shows that it’s wrong to think that “it can’t happen here” or that “evil is self-defeating.” Sadly, evil has often prevailed, in antiquity as well as modern times. It is vital for everyone to accept that it will require an extended and often exhausting effort to re-create the type of country (and world) that truly free people want to live in. Without an ironclad commitment, freedom and democracy will continue to be trampled, perhaps irrevocably. Take a deep breath. November 3rd is not the end of anything.

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.

 

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.

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 21^st 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.

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.

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 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.

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 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.

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.

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.

 

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:

Regular 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 CNBC.com:

Although Bloomberg tried to spin this news as positive:

which 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.

There’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!

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.

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?

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 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 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 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.