One Year To Nowhere

[OriZ 3,157]

What a fun time this is to be a market observer and/or trader. The next few years are going to be very interesting, exciting and full of opportunities on both sides. Before I start I think I should urge everybody that has not done so yet, one more and last time, to go through pages 32-37 of this thread in order to get the proper background and backdrop for things. While my posts in this thread might give the impression that I'm a "permabear", that couldn't be further from the truth. In fact, I have been bullish for most of 2009, and then for all of 2010, 2011, 2012 and 2013, and part of 2014. Throughout this period of time, the S&P500 index gained a whopping 200%. I then became neutral at the end of 2014, and bearish mid 2015. Since mid 2015 the SPX has gained right about 6%. When you compare that with a 200% gain, to me, that's more flat than up.

I said from the beginning this is not going to be a question of time(as in, this could take a while), as much as it is going to be price based forecast(meaning, if it takes 5 years for the market to be down hard that doesn't make me wrong, but if it goes up another 100% in those 5 years and then drops 50% right back to where we are now, then that does). I do not expect to see significantly higher prices than the ones we are seeing now on the S&P500 in coming years. I have given the range of 2200-2300 a long time ago as a possible target and I am sticking to it. Could it end up exceeding it slightly? Sure, but I'm pretty confident it's not like we'll be seeing 3,000 any time soon, and probably not for over a decade.

A short recap of the predictions that can be found throughout the pages of this thread, and have mostly already been recapped in the last 5 pages - I was talking not only about the S&P500, but other financial markets as well, including gold, oil, currencies(mostly dollar), bonds, and even interest rates and politics. Most of these have been spot on so far. Again, I'm not making anything up. Anyone can read these predictions as well as their outcomes, in these pages, and especially 32-37.

Next, now that we got that out of the way lets talk about the present.

While the markets appear convinced that substantial infrastructure spending is forthcoming, the US clearly lacks enough skilled labor in the heavy construction sector to actually implement large scale infrastructure spending projects on the scale being discussed, unless foreign firms were recruited to implement them. Not that a Republican led Congress that leans to the fiscally conservative side would be likely to approve massive new spending in any of the areas being talked about, but even if it did, the first dollar would not likely be spent until well into 2018. Keep that in mind as it will be important later on.

Meanwhile, though it’s widely suggested that repatriating corporate cash held abroad would lead to a huge expansion of new investment, this idea runs into two problems; First, major corporations already have ample access to funding for any project they could reasonably consider. Even if cash is held overseas, it’s rather easy for corporations to effect interest rate swap transactions that effectively make the funds available domestically.

Additionally, providing tax breaks to corporations to repatriate funds is nothing new. The US. did the same thing in 2004. Rather than creating jobs, the funds were used for corporate stock buybacks, acquisitions, dividends and bonuses, while the top corporate beneficiaries actually cut jobs and decreased research spending. So let’s encourage productive investment, particularly where those investments relieve binding economic constraints, expand capacity in useful and sustainable directions, carry spillover benefits for others in the economy, require those who use public funds to have their own capital also at risk, and are likely to produce substantial economic benefits per dollar spent. But let’s not squander a great opportunity for a pro-investment fiscal agenda by imagining that the economy will benefit from massive loosely-conceived infrastructure projects or tax breaks that rely on misleading economic and financial arguments for their public support.

One also has to recognize the difference between the discretionary budget and the mandatory budget. The mandatory budget is made of obligations that can’t really be touched. Social security and medicare chiefly among them. These outlays look like this:

Cutting social security and medicare seem somewhat incompatible with helping the middle class, so consider the mandatory budget fixed.

You then have the discretionary budget. This is where Congress and the president can actually make adjustments in practical terms and guess what? More than half of the discretionary budget is traditionally already allocated to the military:

So if Trump wants to increase military spending and introduce a major infrastructure bill he has only 2 choices: Cut existing programs and/or raise the debt further. What will be cut? More specifically what will be cut to offset the increases in military spending?

The answer is you can’t cut enough to increase military spending, introduce a $1 trillion infrastructure spending bill and cut taxes on top of that. So you must raise debt. Here’s the problem and it’s twofold:

First, the debt is already scheduled to increase going forward. According to the CBO it’s only a matter of time before we hit $30 trillion in debt and that’s with current spending plans. Deficits as far as the eye can see.

And much of these deficits are driven by pension gaps that keep eating holes into the federal budget. But of course discretionary budget items do their bidding as well. As do interest payments on the debt.

And this is all before the new team comes in and wants to introduce the items it has talked about. So the future is clear: Massive additional debt required.

Which brings us to the second part of the problem: Markets want it both ways: Increased deficit, excuse me, stimulus spending, and higher inflation as well.

This will cramp everybody’s style because higher rates require higher financing costs of debt which already run at a clip of $432B annually with close to record low rates. These payment obligations will inevitably rise as rates increase.

Record levels of debt have only been sustainable because of artificially low rates. And it’s not only a government issue. Corporations, thanks to low rates, have also loaded up massively on debt. In fact, net debt to EBITDA is near record highs:

Yet the impact of higher rates may reveal the hidden weakness on balance sheets. From Barron’s:

“Corporations also face their own rate reckoning, with $2 trillion in debt coming due in the next two years. “The increase in borrowing costs will reveal the fallacy that balance sheets are strong and companies are awash in cash,” Steph says. The cash, she points out, is concentrated among the top 25 companies in the S&P 500. The bottom 250 have only $90 billion of the index members’ $1.6 trillion.”

Will this help the economy? Will it expand hiring? Increase CAPEX and investment in the future? Don’t assume so. Goldman Sachs already has the growth market pegged: More buybacks baby.

“A significant portion of returning funds will be directed to buybacks based on the pattern of the tax holiday in 2004,” the team, led by Chief U.S. Equity Strategist David Kostin, write. They estimate that $150 billion (or 20 percent of total buybacks) will be driven by repatriated overseas cash. They predict buybacks 30 percent higher than last year, compared to just 5 percent higher without the repatriation impact.”

It would appear to me that investors are exuberant to have a new theme, any theme, other than watching the Federal Reserve. From a monetary policy front, my view remains that the primary effect of Fed policy in recent years has been to encourage speculative yield-seeking. My own argument in favor of normalizing policy is not that the economy is “overheating” or that inflation is a risk, but primarily that deviations from systematic policy have no economic benefit and impose substantial costs on the economy over horizons that are longer than the Fed seems to contemplate.

There are alot of historically uninformed references to the extended bull markets of the 1980's and the 1950's, in an attempt to justify current market extremes and even expect higher ones. The only problem is the most reliable market valuation measures are presently over four times their 1950 and 1982 levels. The effect of politics on full-cycle and 10-12 year market outcomes is negligible, compared with the impact of valuations.

Much of the recent market response is overdone, and the markets are vulnerable to decided reversals in the opposite direction of recent trends. Extreme valuations already establish the likelihood of near zero 10-12 year S&P 500 total returns, and a 40-60% market decline over the completion of the current cycle. The extended speculation in the recent half-cycle was rooted in monetary distortion and risk-seeking that is now unwinding, and I continue to expect the completion of this cycle within the natural course of action and reaction.

The overall profile of coincident and leading measures remains consistent with a low level churn, not far from levels that have historically been associated with recessions, but not yet breaking down to levels that would raise immediate concerns. Recessions are periods where the mix of goods and services demanded by the economy becomes misaligned with the mix of goods and services currently being supplied. In this context, high inventory/sales ratios, flat-lining year-over-year real growth rates, and expanding dispersion in the financial markets between various sectors and security types strikes me as a warning sign rather than a sign of optimism for the US economy. Again, there will be little fiscal spending impact until 2018 at the very least. To the extent that any is coming, it will exert its effect over time, while financial conditions will have a more rapid effect. Rather than focusing on sectors such as banks, infrastructure, pharma, and transports, investors should be watching the bond markets, particularly if corporate and low-grade bonds join or exceed the deterioration in Treasury debt.

Using the most reliable valuation measures across centuries of data(the chart above), I have allowed myself to extrapolate and attempt to depict what the future of the S&P500 over the coming decade might look like. This is not a prediction. I am not a future teller, but as you can see on the chart even looking back to the past decade + these measures have done quite well. The only times, really, when they have not, is during extremes. These extremes are circled in the next chart but you can spot them in the chart above as well. The green circles mean that the expected return was higher than the one we ended up receiving, which was bullish for stocks in the longer term, and ended up correcting itself. The red circles represent periods of time where the projected returns were lower than the returns provided, which was bearish for stocks longer term, and led to large declines. We are in a red circle now which is a situation similar to that of 2000 and 2007. This is an extremely rough depiction and projection that I took upon myself to create in paint, that in no way is meant to represent or plot the exact course of the market, as that is impossible, but rather give a better general idea as to the direction short, medium and long term, and the road that will ultimately lead to near zero returns over 10-12 years, with at least one, if not two large drops in the interim. This is just one possible scenario that I view as the most likely and is only meant to provide a rough understanding of the current environment.

The thin dashed line is where markets should have been at any given point in time based on these valuation measures. Keep in mind that I only drew them from year end to year end, but in reality, they would have matched even better had it been on a monthly, weekly or daily basis instead of a yearly one. But I only did it to show that they work, always have and always will, like I said with the exception of extremes. Right now, based on these measures, the S&P500 should actually be around 1,600 which is more than 25% lower than current levels. Eventually it will catch up. It might go a little bit higher still first, but, as can be seen(thick black lines) I am expecting by late 2018, maybe early 2019 and possibly sooner to be down at the 1200 level. After that I believe that markets will move back up to new highs, but only marginally higher than the ones we are currently experiencing. Interestingly, this could happen right in time for the next elections, which would prove to be perfect timing. With markets at new highs, we can expect a re-election of the incumbent, in this case Trump and the GOP. Interestingly as well, this rough plot fits well with my view above that whatever effects we might see from the spending, won't be seen till later in 2018, possibly 2019. It just makes perfect sense.

But based on these valuation measures, none of the years that I'm looking at going forward towards 2021 or 2022 seem to bring any significant new highs with them. For 2022 just look at the anticipated 12 year return in blue on 2010(12 years prior) two charts above, and deduct about 2% to account for the dividend yield. You can see that with markets around 1,200 in 2010, the expected return was roughly 5% annually. That would give us a number around 2,155. It means the level of the S&P500 won't much change. Hence, the sideways move I have projected on the chart. Sure, the highs could be a little higher and the drops could actually be even deeper, but I hope we're all still here a decade from now so we can compare this chart to what actually ended up occurring, I think that could prove to be a fun exercise.

Again, all in all this will lead to 0% returns over the next 10-12 years, not including dividends. Now, another thing that bears repeating again because I keep seeing people say Trump will cause a recession is yes, chances are Trump will deal with a recession, and no it will not be his fault, nor the Republicans, yes it will actually be Obama's fault, and the Federal Reserve, thanks to them it is already baked in the cake. The proof I am not biased about this and would have said it even had Clinton won is because I already said it long before the elections and explained in detail how and why. So I'm warning you all if we enter a recession and I start seeing comments on here that Trump caused it and whoever voted for him, it's their fault, I will have to bump each and every comment I've written about it over the last year.

Exciting times ahead. Enjoy, be careful, and trade/invest smart.

[OriZ 3,157]

Dec 5, 2014:

SPX = 2091

NYSE = 10,408

Dec 5, 2016:

SPX = 2191

NYSE = 10,838

Safe to say we are now two years into the way to nowhere. For all this talk and excitement over new highs, we are looking at an S&P500 level currently higher by less than 5% than exactly two years ago(the reason I picked two years ago even though these weren't the previous highs is because exactly one year ago this thread opened stating we were "one year to nowhere" based on the 2014 levels). The NYSE Composite is about 4% higher than its level in December 2014.

Equities are tracing out an extended two year top formation, at what is currently the third most extreme level of market overvaluation in history. Such enthusiasm about a runaway market “breakout” to the upside which is clearly evident in fresh sentiment extremes - advisory bullishness rising to 55.9% and bearishness down to 21.6% - despite the fact that the S&P 500 Index closed Friday less than 4% above its May 2015 high, and just 1% above its August 2016 high, is a pretty classic sign of this final phase of a bull market. The broader NYSE Composite Index remains below the level it set in July 2014(which was when it has set its all time high), though with a slightly positive return including dividends. It is important to note that the recent all time highs in the market have been achieved despite the fact that less than 2/3 of stocks in the broad market are actually even in an uptrend. Classic, tepid, finishing wave advance.

One of the most fascinating aspects of market psychology is participants’ tendency to get bullish at new highs while folks like myself, who are voicing concerns, get often dismissed or even outright ridiculed. Yes, seriously. All this excitement and new highs talk is all about a mere 5% gain in two years. That, on the heels of a 200% advance in the 5 years prior to that, an advance of which I was completely on board for. No longer. Not to mention many indexes around the world have actually declined in this time. From the beginning I stated that my forecast is not on time but only on price. For example I said this one full year ago:

* While I can not definitively tell you right now when exactly such recession shall begin, I WILL be able to do that once my requirements for a market top are met. So that will be as real time as it gets(again, we're not trying to PREDICT but rather work with tools that allow us to IDENTIFY far enough ahead of time).

* I am shorting the market already, with an expectation for a 40-50% decline from current levels. However, it could still creep up for a while longer if it wants to, but the return will be no more than another 10% on the upside from current levels, which will be ADDED to the total losses in the end so basically not worth the risk.

* The market will have an avg annual return of ZERO for the next decade.

I promise if the market rises another 100% from here over the next 4 years and then drops 50% back to current levels, I won't say "see, I told you so". BUT, if the market goes up another 10% from here over the next year, and then falls 60% by the end of the decade(from that top, and around 50% from current levels) you bet I will say I was right. So that's how it works, and I don't believe it's vague at all. If anything it may seem a little vague because there are of course limitations to trying to "predict" the market and I acknowledge those fully. I won't come here and say I can tell you exactly what the market is going to do tomorrow because I certainly can't.

So about 2 years after I began saying the market is nearing the end of its ascent, we now have 2 years to nowehere. Not 40-60% decline yet, but not much to show for it either.

One of the big technical red flags over the past few years has been weak internal participation. Particularly during the May 2015 highs I noted weakening internal structures that ultimately cumulated in the August 2015 down move. The correction in January and February was no exception.

It is true that ever expanding global central bank intervention has continued to bring price back from the brink after each small correction and even now the latest rally has been brought about by promises of tax cuts, stimulus, etc.

But here again we can note an incredible bifurcation that raises red flags. Most notably most of the gains have really come from financials stocks. Indeed 50% of the $DJIA’s recent gain has come from 2 stocks only: $GS and $JPM. Talk about a thin rally.

Looking at the broader index picture, including the international one, the rally in financials stands out like a sore thumb:

As I have said before, since those May 2015 highs some of the indices have made marginal new highs, but take out the financial rally and things don’t look all that bright, indeed the global picture, despite record central bank intervention, looks highly unimpressive. The following chart shows a 10 year view of the FTSE All World index, which represents about 95% of tradeable global equity market capitalization.

I still expect the S&P 500 to surrender its entire total return since 2000 over the completion of the current market cycle. The interim returns are likely to represent little but temporary paper gains, except for investors who exit. Even in that event, some other investor would then be in the position of holding the bag. The US equity market is unlikely to avoid a roughly $10 trillion paper loss by the completion of this market cycle. The choice is simple: it is between staying in stocks now, and earning a return of 1% including dividends, or waiting for better valuations which will come, and getting a return closer to 10% and perhaps even higher.

However, most people have a fear of "missing out". That fear tends to be even stronger than the fear of losing, that is, until the prospect of losing becomes a reality, and then investors bail at the worst possible time for them. But the reality is there isn't much to miss out on - I expect a rough range of 1,200-2,400 on the S&P500 for most of the coming decade. It could breach this range by a limited amount of points and for a limited amount of time, in either direction, but really we're at the high end of the range for another decade, so what is there to miss out on?

All of the most reliable equity market valuation measures(as measured by their relationship with actual subsequent market returns across history) are offensively overvalued from a long term and full cycle perspective. The most accurate measure - the ratio of US. nonfinancial market capitalization to corporate gross value-added - has now marginally eclipsed its 2015 high, placing it at a level consistent with expectations of S&P 500 12-year nominal total returns averaging less than 1% annually. Excluding dividends which currently stand at around 2%, this would lead to a loss of around 1% annually.

Today I want to further make the case that I have already began making in recent months, that it does not matter who is the sitting president, the direction of the markets is baked in the cake thanks to valuations. By showing how superior valuations are over any exogenous event, I will show once again that not only did Bush not cause the market decline, nor did Obama save the economy, nor will Trump(Or Clinton if she would have gotten elected) actually be responsible for the coming economic downturn.

A century of data is clear that stocks will not be again poised for adequate long term returns until we see a steep retreat in valuations. Even a full normalization of economic activity isn’t likely to change the mapping between current valuation extremes and weak market returns in the years ahead.

The chart below shows MarketCap/GVA on an inverted log scale (blue line, left), along with the actual subsequent S&P 500 12-year nominal total return (red line, right). As previously stated, the current level of valuations, noted by the green arrow, is consistent with expected total returns averaging less than 1% annually in the years ahead.

Notice I also added the names of the presidents. So what can we witness in the above chart? Truman left office January 1953. At the time valuations were implying about a 15% annual return over the next 12 year period(note-this includes dividends). Over the next 12 years the S&P500 index soared over 250%. Those who don't look at valuations could have attributed it to Eisenhower, Kennedy & Johnson, but it was already baked in the cake. Notice that with the rise in the market during Eisenhower's term, it brought valuations to an overbought level that now only implied a roughly 5% annual return over the next 12 years by the time Eisenhower left office. And indeed the S&P500 index rose by less than 100% by 1973, 12 years later.

I added R for republican and D for democrat to the chart so we can clearly see it doesn't matter if it is a republican in office or a democrat. We've had crashes and soars with both; What matters most is valuations. However I will say this - we can see a more frequent tendency of markets to end up in severely overbought levels right before or at the time a democrat leaves office. This can be attributed to the "easy money" policy they tend to support and encourage, as we have seen with Obama and the Federal Reserve in recent years. So while it may seem like under them the economy did great and under the republican that followed it did not, the reality is that Clinton and Obama especially and more recently, but others before them as well, have kicked the can down the road, and left the next president holding the bag, just as I believe Trump will.

So while it would be very easy to blame Nixon and Ford for the declines between 1969 and 1977, we can see that valuations under Kennedy, Johnson and Eisenhower already guaranteed that.

By the time Nixon, Ford & Carter were done, we are looking at valuations that imply a close to 20% annual return; Markets were extremely undervalued and overbearish, the polar opposite of today. The result? A rally attributed to Reagan. Then Bush, and then Clinton still getting sworn in with a healthy annual 10% or so return left in the tank, taking markets all the way into the dot.com bubble. The bubble actually topped and popped several months before Bush took office, and markets started declining. Clinton's era took valuations to an expected negative return over the next 12 years, entirely predictable no matter who the next president was(Gore would have not saved us) or what wars the US was or was not involved in, which is exactly what happened. The S&P500 went from a level of around 1,500 in early 2000, to roughly 1,300 by early 2012. This was all expected in real time, not hindsight, by simply knowing how to use reliable valuations.

And here is a long term chart of the S&P500, with the presidents again.

Note - this may be a little confusing at first, but where you see a president's name is when they LEFT office, and not when they took office. So for example to see FDR's term, you need to look at the area inbetween the Hoover and the FDR arrows. Here's another myth I want to shatter - wars do not affect the market. Some expect markets to crash during times of war. Others say war actually helps the economy. Neither is true. We can see in the chart that the attack on Pearl Harbor and the US joining WWII occurred near the end of a decade long sideways move, which accompanied the Great Depression, which happened right after the crash of 1929. Market bottomed several months after the attack and started rising. By the time the war was over in 1945 and by the time FDR left office, the market was higher. But contrary to popular belief it was not the war that took the US out of the depression as the market bottomed a decade prior, and the economy started coming out of the recession in the late 30's. No, the level of the market in 1945 could have been predicted in 1933 based simply on valuations.

Here is a chart that goes even further back and shows that. There are similar and only slightly less accurate relationships back to the early 1900’s using other valuation measures like the next one, so we can go back even further and look at more presidents:

Going back now two charts above, notice that the Korean War was also during a time of a rising market. Yet, if wars are so good for the economy, how come the Vietnam War happened in a time with the market moving sideways to down? Similar situation with the first Gulf War, also seen on the chart. Notice also that Kennedy being assassinated did nothing to stop the market. So at the end of the day it's just a mixed, random bag, because the market is independent, and any relation to outside events is coincidental.

And again in that chart as well, we can see that there have been 15 presidents; 7 were Democrats, and 8 have been Republicans. While it is true that with all 7 democrats the market was either flat or up, it is also true that it was either flat or up with 6 Republicans. Twice it was down(Hoover and Bush). That's basically statistical noise that proves at the end of the day, it doesn't matter who the president is. Coolidge presided over the 'roaring twenties' bubble that ended up with the collapse of 1929 and the great depression, and Daddy Bush, Reagan, Clinton and Obama presided over other bubbles.

Nothing - not the Great Depression, penicillin, World War II, the digital computer, the atomic bomb, Mr Potato Head, the microprocessor, the 1970’s inflation, the Cold War, the breakup of the Soviet Union, the expansion of global trade, the tech bubble, 9/11, the global financial crisis - nothing - has durably changed the mapping between reliable valuation measures and subsequent 10-12 year market returns, so to imagine that stocks are priced as desirable long term investments here is a denial of every lesson of market history.

To attribute to me some constant, dire expectation of imminent collapse is to oversimplify the current facts. Some of these facts are yes, years of speculative yield seeking have established the third financial bubble since 2000, the third most extreme level of general market valuation in history, and the most offensive valuation extreme in history from the standpoint of the median stock. Another fact is that credit burdens have never been higher, and much of that credit is of the covenant-lite variety, issued to satisfy speculative yield-seeking demand (much as low-grade mortgage securities were issued during the housing bubble). But still another fact is that investor attitudes toward risk can substantially affect the outcome of such extremes over shorter segments of the market cycle. The tendency toward risk-seeking has clearly been extended by monetary policy in the half-cycle since 2009, but in the end valuations will still matter, as they always have.

So what do we do with all this info? Well, I took the data from above, and put it all on a chart starting in 1993. The thin purple line is where the market should be based on valuations. The red and blue bars show where the index was and currently is. It was correlated very nicely, with the exception of the period between 97-2000, due to the dot.com bubble. But much like a pendulum, overvaluation leads to undervaluation and vice versa. When price goes too far, it's akin to a rubber band snapping. So by the end of 2003, we actually saw price decline beneath where we would have expected it to be based on valuations. Then it was neatly correlated and then again, departed in 2006. During the Great Recession, price dropped far below what would have been predicted, and then rebounded. As we can see, what happened from there on had nothing to do with Obama - it was simply what one could expect by just examining valuations.

The upward movement in the markets, both in 2004 and 2012, was a "sweet spot" that helped both Bush and Obama win re-election. We have been observing a divergence again over the last couple of years, where the index today should be around 1,600 but instead it is more than 30% higher. The red line depicts what I personally expect should happen from here - a decline to undervaluation, just like the last two times. I'm pretty comfortable with the 1,000-1,200 range. From there the markets should rebound again, just as they have before, and by election time in 2020 there is a good chance we will be right back around current and/or slightly new highs. This could end up working well for Trump. The longer the time span that passes once Trump is sworn in and until the market drops, the less time there will be for the market to move up before the next elections, and the lower the chances for him to be re-elected. If I'm him, I stick a pin in this balloon on my first day in office, or a situation very similar to the one Bush found himself in in 2008 is entirely possible.

If you continue to track the purple line, which, again, has proven its reliability over a century of data, you can see there will not be much, if any, net upward movement in the end, from current levels towards the next 12 years. By the end of 2028, we should be right around 2,000. Could we end up exceeding it by 30% again? Sure, but that's still only 2,600 which is less than 20% above current levels. In 12 years!

But wait, maybe we can extrapolate this even further. As you can see on the valuations charts above, no bottom has ever occurred at under 8-10% implied annual return. That was the case in 2002, it was 12% in 2008-9, and even higher in prior cycles(like the area between 15-20% in the 70s). If we were to expect the market to drop enough to provide for, say, an 8% return over the following 12 years, we would receive the same number I'm already expecting at around the 1,200 level for a bottom. If we extrapolate this further and adjust for dividends, we'll assume a 6% annual rise in the S&P500 between, say, and this will be pretty arbitrary just based on an assumption of expecting this bottom sometime in 2018-2019, to 2030-31. Basically, we can expect the market about 15 years from now to stand somewhere around 2,400. That is shown by the green lines. So, in the end the market will break out to the upside as it always does, but in the meantime, expect very dismal returns.

The next chart shows a possible pattern in play in the NASDAQ. This is a pretty old school classic elliot wave finishing wave sequence of 5 waves within a converging wedge. We can see resistance where numbers 1 and 3 are, and support where numbers 2 and 4 are. We can also see the center line which is currently resistance, and that happens quite often with fifth waves as they are normally weaker than waves 1 and 3. Basically what this means is that if the index declines beneath the support line, currently around the 5,000 mark the pattern will be complete and we will be in for a long decline. Notice I circled the 5th wave, keep that in mind.

If we zoom out we can see the importance of those lines going back decades, as far as the 1980's. During the dot com bubble the index rose well above the line which then became support for a while, but once it fell back under it it's been inside it since.

If we zoom in further than before, and look at the 5th wave(the portion I circled in the chart above), the wave itself is in another similar pattern. The market is a fractal and this shows it best - a wedge within a 5th wave of a wedge. This shows the rise that started earlier this year, and is probably about to exhaust itself. Again, a break of 5,000, and even better a break of 4,200 which was the low of the correction we saw early this year, will cement the fact the trend has turned down.

It is important to emphasize that I didn't draw these lines - the market did. The market obviously thought that these points were important or it would not have hit resistance/support each time. All I did was show these points in a graphic way, but it is the NASDAQ that deemed them important.

For the time being, and as long as patterns are not broken, we should allow for limited further upside. However as stated before, these will be paper gains that will be completely terminated by the completion of this cycle. The cycle will complete itself no matter who the president is.

Edited December 5, 2016 by OriZ

[OriZ 3,157]

The single most extreme syndrome of “overvalued, overbought, overbullish” conditions we identify (see Speculative Extremes and Historically Informed Optimism) was restored last week; a secondary signal at a level on the S&P 500 that’s 4% higher than the syndrome we observed in July. Recall that with one exception, that most extreme variant has only emerged at the market peaks preceding the worst collapses in the past century. Prior to the advance of recent years, the list of these instances was: August 1929, the week of the bull market peak; August 1972, after which the S&P 500 would advance about 7% by year-end, and then drop by half; August 1987, the week of the bull market peak; July 1999, just before an abrupt 12% market correction, with a secondary signal in March 2000, the week of the final market peak; and July 2007, within a few points of the final peak in the S&P 500, with a secondary signal in October 2007, the week of that bull final market peak.

The single exception was a set of signals between late-2013 and early-2014. While we’ve learned not to fight “overvalued, overbought, overbullish” extremes in zero-interest rate environments where market internals are uniformly favorable, we presently observe a situation much like the final peaks of the 1929, 1972, 1987, 2000 and 2007 bull markets, when those mitigating factors were not in place.

Our long-term and full-cycle views remain solidly negative, but our views regarding shorter segments of the market cycle are more flexible than investors may imagine. Our near-term outlook continues to be dependent on the risk-preferences of investors. The best measure of those preferences is the behavior of market internals across a wide variety of securities, industries, sectors, and security types, because when investors are risk-seeking, they tend to be indiscriminate about it. Presently, market conditions are most consistent with a “blowoff” to complete the extended top-formation of the third financial bubble in 16 years. However, an improvement in market internals would encourage us to give a longer leash to this speculation, and we will align our outlook as conditions change.

Drawing the right lesson

Prior market peaks across history had a key regularity: the emergence of extreme “overvalued, overbought, overbullish” syndromes was regularly accompanied or immediately followed by deterioration in market internals, so those syndromes alone were enough to warrant a hard-negative market outlook. Our difficult experience in the recent half-cycle resulted from my insistence in 2009 on stress-testing our methods against Depression-era data, because the resulting methods of classifying market return/risk profiles picked up that historical regularity. Our defensive response to persistently overvalued, overbought, overbullish conditions turned out to be our Achilles Heel in the face of QE. The central lesson was not that overvalued, overbought, overbullish extremes are irrelevant, but that in the face of zero-interest rates, one had to wait for market internals to deteriorate explicitly before adopting a hard-negative outlook. We adapted our approach in mid-2014 to address that issue, which is why we’re keenly focused on market internals here (see the “Box” in The Next Big Short for the full narrative).

Be careful to draw the correct lesson. It’s not that obscene valuations or syndromes of extremely overextended conditions are irrelevant for long-term and full-cycle market outcomes; it’s that the uniformity or divergence of market internals is critical in evaluating shorter segments of the market cycle. Put simply, what concerns us most here is the fact that we’re observing extreme overvalued, overbought, overbullish conditions in combination with unfavorable market internals on our measures, including yield pressures across interest-sensitive securities.

While our short-term outlook may shift with changes in the quality of market action, the long-term and full-cycle market outlook, in our view, is unavoidably disastrous. We’ve long argued, and continue to assert, that the most historically reliable measures of market valuation are far beyond double their historical norms. At current market levels, our estimate for 12-year S&P 500 average nominal total returns has collapsed to just 0.8% annually. Among the valuation measures most tightly correlated across history with actual subsequent S&P 500 total returns, the ratio of market capitalization to corporate gross value added would now have to retreat by nearly 60% simply to reach its pre-bubble average.

Again, we’re open to the possibility that internals could improve enough to signal more extended potential for speculative risk-seeking. As conditions stand today, they mirror those I emphasized just prior to the market losing half or more of its value. The following clip is from my October 2000 research comment.

I expressed similar concerns in late-July 2007. While the S&P 500 peaked a few points higher in October of that year, the overall top-formation was followed by a 55% market collapse. Needless to say, we don’t’ take present conditions lightly, but an improvement in market internals (particularly across interest-sensitive sectors) would shift our near-term views to a much more neutral stance.

I recognize how excruciating it feels not to participate in what seems like a relentless vertical advance. That’s particularly true for hedged-equity strategies when the environment features dispersion across market internals, as it has during this extended top-formation. That’s because even moderate tracking differences between a broad portfolio of individual stocks and the market indices used to hedge them can create unpredictability over shorter segments of the market cycle. Since July 2014, for example, the broad NYSE Composite Index has gone nowhere, while the S&P 500 Index is up nearly 14% (if only temporarily).

As for me, nearly everything I have remains confidently invested across our own disciplines. Confidently, because 1) we know exactly how our present methods, as well as our pre-2009 methods, have performed in complete market cycles across history, and in real-time prior to this half-cycle, and 2) taking both our present and pre-2009 methods to data from recent years, we also know the “counterfactual” - how our discipline could have navigated the markets since 2009, had my stress-testing decision not bared the Achilles Heel that we addressed in 2014. Speculative recklessness is easier to watch, and even live through, when one is able to maintain a historically-informed, full-cycle perspective.

While our near-term views are flexible to changes in market action, that full-cycle market perspective is also critical. The late stage of a half market cycle can encourage investors to do foolish things. Even if market internals improve, there should be no operating without a substantial safety net here (ideally using options, rather than one that relies on stop-loss execution). The market may or may not have precisely completed the advancing half of what is now the third most extreme speculative bubble in history. Yet the repeated lesson of history is that once the market cycle is complete, investors will damn themselves for imagining that chasing the last gasp of the bubble was worth the losses that followed.

Valuation Update

From a long-term and full-cycle perspective, we have strong, historically-informed expectations that the S&P 500 will enjoy total returns of next-to-nothing over the coming 10-12 years, with interim losses over the completion of this cycle that we now estimate in the range of 50-60%. This would not be a worst-case scenario, but only a run-of-the-millcycle completion from the standpoint of current valuation extremes. We expect that every bit of gain investors may enjoy over the near-term will be surrendered over the completion of this cycle. Indeed, we expect that the completion of the current cycle will wipe out the entire total return of the S&P 500 since 2000. None of that would even require the most historically reliable valuation measures to break below their pre-bubble norms.

The chart below shows the ratio of nonfinancial market capitalization to corporate gross value added, including estimated foreign revenues (MarketCap/GVA). The only point in history where valuations were higher and stocks were still in a bull market was between December 1999 and March 2000. To put this into perspective, between the point in December 1999 that valuations reached levels equal to the present, to the subsequent market low in October 2002, the S&P 500 lost 46%. From the actual bull market peak in March 2000 to the subsequent market low in October 2002, the S&P 500 lost 49%. Not much difference. Meanwhile, although the S&P 500 gained nearly 7% between December 1999 and March 2000, the index also experienced an intervening loss of over 9%. Whether or not we’re seeing the final highs here, expect market action to become substantially more volatile.

The following chart shows the same data on an inverted log scale (blue line, left), along with the actual subsequent 12-year nominal average annual total return of the S&P 500 Index (red line, right). Present levels are consistent with 12-year S&P 500 total returns averaging less than 1% annually. There is not a single measure we’ve identified across history that has a stronger correlation with actual subsequent market returns, though several similarly accurate measures have comparable implications. Before investors base their expectations on someone’s assertion that stocks are “cheap” or “reasonable” based on one measure or another, they should demand similar long-term evidence that the measure is actually strongly correlated with subsequent market outcomes.

In summary, the key to understanding the current market environment is to explicitly make a distinction between 1) the long-term and full-cycle market outlook, which is primarily driven by valuations, and 2) the near-term outlook for the current “segment” of the market cycle, which is primarily driven by the risk preferences of investors.

For now, we’re still very much in the “blowoff” camp, but those market internals remain critical. If the speculative bubbles and crashes across market history have taught us anything (particularly the repeated episodes of recklessness we’ve observed over the past two decades), it’s this: regardless of the level of valuation at any point in time, we have to allow for the potential for investors to adopt a psychological preference toward risk-seeking speculation, and no amount of reason will dissuade them even when that speculation has already made a collapse inevitable over a longer horizon. The best we can do is to continuously align ourselves with the market conditions we observe at each point in time.

Despite what we view as obscene valuations, a moderate further improvement in market action (particularly across market internals and interest-sensitive assets) would at least remove our inclination to maintain a hard-negative market outlook, and would move us instead to a neutral view (with material pullbacks then creating the potential for stances that might be described as “constructive with a safety net”). Again, uniformly favorable market internals would signal a potentially extended shift in risk-seeking preferences among investors, and while we need not join such speculation, we also should not fight it if it emerges. There’s no need to make forecasts about near-term outcomes. We only need to align ourselves with prevailing conditions as they emerge.

Presently, wicked valuations are coupled with still-unfavorable market internals on our measures, and have now been joined by the most extreme “overvalued, overbought, overbullish” syndrome of conditions we identify. The same combination prevailed at the 1929, 1972, 1987, 2000, and 2007 market peaks. Still, we’re quite aware that investor preferences might shift more durably, and we can accommodate that potential by monitoring those preferences through the market action that they generate. For now, market conditions remain consistent with the speculative “blowoff” of an extreme late-stage bubble peak.

Economic fancies and basic arithmetic

The past several weeks have brought an enormous amount of loose economic analysis encouraging investors to expect a meaningful surge in economic growth and corporate profits. Most of this hope rests on projections of higher deficit spending and increased domestic investment. It might benefit investors to consider these arguments more closely, and with greater focus on a century of economic evidence than on the verbal arguments of enthusiastic talking heads.

While there is a strong correlation between growth in gross domestic investment and growth in real GDP, the slope of that relationship is only about 0.2, meaning that even if the growth rate of real gross domestic investment was driven from the recent growth trend of zero all the way back to the previous post-war growth rate of 3.5%, the overall impact on real GDP growth would only be about 0.7% annually, placing the level of U.S. real GDP about 2.8% higher 4 years from today than it would otherwise be. That’s not an annual growth rate, but a cumulative gain.

Granted, if even a 0.7% boost to annual GDP growth was sustained, it would have a major impact on long-term living standards over a 20-30 year period. But investors have a screw loose if they believe that the overall prospects for GDP growth over the coming 4 years have changed significantly. Even the market rally since the election has substantially exceeded any incremental gains in economic output (and by extension earnings) that can be expected over the coming 4 years.

Let’s do some arithmetic here. The primary determinants of GDP growth over time are 1) growth in total employment plus 2) growth in real output per hours worked. There’s a little bit of cyclical variation due to changes in average hours worked, but that difference only shows up meaningfully during recessions. In practice, nearly all of the variation in GDP growth over time is explained by the sum of employment growth plus productivity growth.

Let’s look at each.

Employment growth

As of November 2016, U.S. civilian employment stood at 152.1 million jobs, with a civilian labor force of 159.5 million people, resulting in a 4.6% unemployment rate. By 2024, the Bureau of Labor Statistics projects the U.S. labor force to reach 163.8 million. Given existing U.S. demographics, even if we assume an unemployment rate in 2024 of just 4%, civilian employment would reach 157.2 million jobs in 2024, resulting in an average annual growth rate for civilian employment of just 0.4% annually over the coming 8 years. Conversely, a return to an unemployment rate of even 6% in 2024 would leave the growth rate of employment over the next 8 years at less than 0.2% annually.

While the assumptions about the future unemployment rate may be affected by policy, the fact is that slower U.S. population growth, coupled with an aging population, place substantial limits on labor force growth, which will leave U.S. GDP growth almost entirely dependent on changes in productivity. The Bureau of Labor Statistics notes that “as the population ages, more workers will enter older age cohorts, which have lower participation rates. This will cause the projected overall participation rate to decline. This slower population growth, combined with the declining participation rate, will result in slower growth in the labor force through 2024.”

From a demographic perspective, the number of U.S. workers per retiree has been progressively declining, from more than 7 workers per retiree in the 1950’s, to 4 workers per retiree today. Over the next 20 years, that figure will decline to an estimated 2.5 U.S. workers per retiree by 2035. The BLS observes “The leading edge of the baby boomers (those born in 1946) became eligible for early Social Security benefits at age 62 in 2008 and reached full retirement age at 66 in 2012. In 2024, the baby-boom cohort will be ages 60 to 78, and a large number will already have exited the labor force. During the 2014-24 period, the growth of the labor force will be due entirely to population growth, as the overall labor force participation rate is expected to decrease even further by 2024.” That means that there will be more claims against the output of U.S. workers than ever before.

The claims being racked up against the future output of U.S. workers are of long-term concern, not only as a result of demographics, but also as the result of unproductive spending and a growing national debt. Given that every dollar of the national debt also represents an asset to someone else, my friend Robert Huebscher recently quoted an analyst who asked why we don’t call it our “national savings account.” Well, the reason is that 45% of the publicly-held debt is owned by foreigners, and the remaining debt held by the U.S. public represents future transfers of purchasing power - claims of some U.S. citizens on the future output produced by others. The original savings have already been spent, and the debt represents the claims by those who financed the spending on the future output of others.

Sure, you can devalue those claims through inflation, but only if the debt is in the form of long-maturity bonds (which is why the recent discussion of issuing 50-100 year Treasury bonds seems understandable but also a bit nefarious). At shorter maturities, inflation just raises the interest rate that the government has to pay when the shorter-term debt is rolled over. Though the weighted-average maturity of Treasury debt is currently longer than normal, the average is still only 5.8 years, and half of the debt will have to be rolled over by 2019, at whatever interest rates emerge in the interim. Ultimately, debt implies a future transfer of purchasing power, and provides only a few choices. Either you raise adequate tax revenue, or you denominate the debt in long-term bonds and devalue them through inflation, or you default, or you violate the social contract made with those who don't hold paper claims (e.g. Social Security beneficiaries) in preference for those who do.

Had the borrowing resulted in productive investment, future output would be easily available to meet those claims. Instead, what’s going on is a quiet dilution of future living standards. That’s only going to be reversed by thoughtful policies, focused more on long-term productivity than near-term gains. Even massive debt-financed spending will not help unless the projects are intentionally designed to durably enhance the long-term productivity of the U.S. economy, to avoid duplicative capacity, and to relieve constraints that threaten to become binding in the future (personally, I remain convinced that renewable energy should be central to that list).

Productivity growth

Let’s look at that second piece of the growth puzzle, which is productivity growth. Decades of financial distortion and malinvestment have had cumulative effects that can only be reversed by decades of productive capital accumulation. It’s here where Wall Street’s exuberance is most evident. Even assuming massive and productive new spending initiatives were financed by increasing the existing $930 billion annual deficit that is now being run across federal, state and local government (the federal deficit currently accounts for about $430 billion of that annually), the impact over a small number of years would be quite limited as a percentage of GDP. The differences in growth that actually matter are those that only become significant over decades.

Since the 1940’s, the 8-year growth rate of U.S. labor force productivity has rarely exceeded 3%, and the recent trend has been progressively lower. Over the past decade, productivity growth has declined from a post-war average of 2% to a growth rate of just 1% annually, with growth of just 0.5% annually over the past 5 years. The gap between dismal productivity and the most productive economic environment in U.S. history is only about 2.5% annually.

If one studies the productivity figures, there have actually been two peaks in U.S. productivity growth during the post-war period. One was in the decade leading up to the late-1960’s, which was driven by a legitimate expansion in the productivity of U.S. workers, as measured the capacity of labor to produce output. This was something of a “golden age” for the U.S. in terms of improved living standards. There was a second, lesser peak in the decade leading up to 2003. But the reason for that surge in “productivity” was much different.

As I detailed in my November 2003 comment, titled The U.S. Productivity Miracle (Made in China), part of U.S. productivity growth actually represents the import of foreign labor by U.S. multinational companies. A significant portion of what we "import" from foreign countries actually represents intermediate goods produced by foreign affiliates of U.S. companies, which we incorporate into our final output. But we don't count those foreign jobs when we calculate productivity (and the deduction to GDP on account of imports is generally smaller than the corresponding loss of U.S. employment), so foreign outsourcing has the effect of boosting measured productivity. As a result, I observed at the time that most of the productivity "miracle" in the decade leading up to 2003 could be explained by import growth in excess of consumption growth:

“Import growth captures both the 'true' part of productivity growth (since increased capital investment typically requires an expanding current account deficit) as well as the illusory part of productivity growth (resulting from the failure to account for foreign labor input in the productivity numbers). In both cases, it is misplaced optimism to expect rapid and sustained growth in U.S. productivity when the U.S. current account is already at a record deficit.”

Measured U.S. productivity, not surprisingly, has collapsed since then, and while the current account (essentially the U.S. trade balance) has narrowed as a fraction of GDP, it remains substantially negative.

The plausible range of potential GDP growth

Given these facts, the range of potential GDP growth rates over the coming 4-8 year period is much more constrained than investors may recognize. On the low side, but ignoring the possibility of outright recession, maintaining the current 0.5% productivity growth rate, coupled with built-in labor force demographics and a 6% unemployment rate in 2024, would result in a real GDP growth rate averaging less than 0.7% annually over the coming 8 years. Investors seem to believe that faster economic growth is a “lock,” but after a 7-year economic expansion with slow productivity growth and a 4.6% unemployment rate, there’s quite a good likelihood that growth will slow substantially even without a recession. Even including discouraged workers, the U-6 unemployment rate is now just 1.4% above its pre-crisis trough.

On the more optimistic side, if successful policies were to produce a full normalization of productivity growth to the post-war norm of 2% annually, coupled with an unemployment rate of just 4% in 2024, real GDP growth would average 2.4% annually over the coming 8-year period. Finally, if we assume a sustained explosion in productivity growth to 2.8% annually, joining the highest quintile of historical U.S. productivity growth rates for any 8-year period, and assuming an unemployment rate of just 4% in 2024, the result would still be real U.S. GDP growth averaging just 3.2% annually over the next 8 years.

Combining the plausible ranges of employment and productivity growth in the coming years (but ignoring the possibility of outright recession), the likely bounds of average U.S. economic growth over the coming 8 years range between 0.7% annually to an extremely optimistic 3.2% annually, with a likely midpoint of less than 2% annually for real GDP. That figure aligns with the central tendency of long-run real GDP growth expectations from the Federal Reserve, which recently fell to 1.85% annually.

Look, one of my strongest economic views is that the U.S. absolutely requires a greater focus on encouraging productive investment at every level of the economy (see in particular Eating our Seed Corn and Judging Economic Policy). If our economy could grow even 1% faster over a 20-year period, the resulting 20% boost to future living standards would be an extraordinary long-term achievement. But this idea that the new administration will produce some near-term economic renaissance amounting to more than a few percent in cumulative output gains in the coming years reflects a breathtaking lack of historically-informed perspective, not to mention the inability to add two numbers together.

The problem is that even the most wildly optimistic prospects for incremental economic growth are likely to leave the level of real GDP no more than 10% higher, 4 years from now, than it otherwise would be. I strongly doubt we’ll see even that much incremental growth.

If anything, my expectation is that the policies of the incoming administration are more likely to result in constrained economic growth rather than expansion. The reason is basic arithmetic. On the labor front, there’s not a great deal that can be done about the demographics of an aging population, but with regard to incremental changes, it would appear better to ease the projected constraints through immigration, particularly favoring workers inclined to address the needs of that aging population (e.g. personal services and low-intensity health care). As for other industries, I’ve observed before that infrastructure projects on the scale of those being discussed would actually have to be implemented with foreign labor (as many of the largest U.S. construction projects have been in recent years), since heavy construction workers represent a rather small segment of the U.S. labor force.

Meanwhile, on the productivity front, U.S. parent companies with foreign affiliates currently employ more than one foreign worker for every two U.S. workers. The main function of those foreign workers is to expand foreign sales rather than to cut costs by replacing U.S. jobs, but some of the output produced abroad is in the form of intermediate goods that are imported into the U.S. and show up as part of our “final output.” The result is a boost to our measured productivity. I don’t see this as inherently “good” or “bad,” it’s just a fact. One of the problems with cost-driven outsourcing, though, is that the foreign workers often face repressive conditions.

Free trade has clear gains for U.S. consumers, and also benefits companies that shift jobs overseas, but there does seem to be a tendency for workers in both countries to receive an inequitable share of these gains. That said, to the extent that the incoming administration takes a punitive approach to foreign outsourcing and free trade more generally, my expectation is that it will also restrain the productivity component of U.S. GDP growth.

Let's be clear. The economic gains and market returns that emerged during the Reagan Administration began from a starting point of 10.8% unemployment, a current account surplus, and market valuations that - on the most historically reliable measures - were less than one-quarter of present levels. However one views Reagan's overall legacy, he also led by setting an example of personal dignity and an abiding optimism that encouraged the good in others. The present situation shares none of those features.

So the arithmetic of economic expansion - employment growth plus productivity growth - seems unlikely to be helped by the current policy direction, aside from rather short-lived effects. Frankly, the proposed Cabinet more resembles a self-advocacy group for billionaires, corporations and war-advocates than a team of informed and civic-minded policy-makers. My increasing concern is that we won’t see much from the incoming administration that doesn’t involve intimidation, misuse of power, self-dealing, and attempts to use discretionary edict - as a substitute for equal protection and legislative process. We already observe glimpses of that, which deserve attention regardless of one's political views.

There are certainly areas of desperation, including unemployment among minority youth and individuals with disabilities, but at the current unemployment rate of 4.6%, my impression is that the "jobs crisis" in this country is actually better described as an incomecrisis, because wages and salaries as a share of total income have rarely been lower. An administration comprised of corporate billionaires isn't likely to change that. Higher productivity growth, sustained over a few decades, would have a profound impact on future living standards, but to expect an economic boom of anything but the short-lived variety is to rely on arithmetic that doesn't add up.

In any event, the problem for investors is that whatever increment we could possiblyobserve in GDP growth pales in comparison to the fact that the most historically reliable market valuation measures are far more than double their historical norms.

Even if investors expect economic growth and inflation to normalize, they’d better expect valuation measures to normalize as well. The tradeoff there is that under very optimistic assumptions, higher growth, faster inflation, sustained record profit margins, and lower taxes might combine to push nominal earnings a cumulative 30% beyond their recent record highs over the next 4 years. But normalizing growth and inflation would also put pressure on valuation multiples to normalize, because current multiples rely almost entirely on a zero-interest rate world. Historical norms for the most reliable measures are less than half of present levels. The basic arithmetic is then: 1.3 x 0.5 = 0.65, which would still leave the S&P 500 35% lower by 2020.

Put simply, the fanciful hopes for a near-term economic renaissance are vastly overstated, and are inconsistent with the most basic arithmetic of economic growth. Moreover, even the most optimistic hopes for future growth, if realized, would only change the trajectory of the U.S. economy by a few percent over the course of the next four years. For investors, the fact remains that the most historically reliable valuation measures remain far beyond double their historical norms, and a retreat in valuations over the completion of the present market cycle is likely to overwhelm any incremental economic growth that investors might expect.

https://www.hussmanfunds.com/wmc/wmc161212.htm

[OriZ 3,157]

Rather like a parrot, I have been repeating for about 2 years now that the market is in a bubble. The trouble with bubbles is, that much like a pendulum, euphoria leads to overvalued, overbought and an overbullish market like the one we have now(as well as in the most recent memories, 2000 and 2007), but the panic that follows once the bubble bursts will lead to an undervalued market(similar to 2009, 2003 and many other times in the 20th century before that). While the market may seem to be strong to the casual observer, continuously pushing to new highs in recent months, once you examine internals the picture is a little different. For example - despite most indexes being up over 0.5% and making fresh new highs again this past Friday, this was more due to the weighing than the health of the market, as more stocks were actually down than up. Today again, with the Dow finishing up(for the 15th session in a row) more stocks in the broad market were actually down than up, and more significantly than Friday.

I have shown last week that the NASDAQ is at long term resistance and here we see with the S&P500 as well, 9 touches in the last couple decades at the red resistance line I have drawn in this chart. Once again, it is the market that decided this line is important, not me. Despite recent impressive paper gains we have to remember they are nothing but paper gains and they will undoubtedly be wiped out by the end of the cycle.

I have also drawn other, albeit less important lines(thinner black lines) that basically show the same thing. We have support at the lows of 2012 and 2016, and resistance right around current levels. The little arrows represent the distance between price and its 100 day moving average. Usually, much like mean reversion, price will strive to "reconnect" with its MA. As we can see, since 2011 there has not been a reconnect, and the difference that can be measured now is almost as high as its ever been before a major reconnect - around 700 points currently. Going back, at the bottom in 2009 you can see it was around 550 points whereas at the top in 2007 it was a mere 350 points. You can't see it in this particular chart but around the 2000 highs it was around 750 points, which was the highest ever. So that is one more indication of how overvalued and how high and far beyond the norm this market has pushed.

And lastly, at the bottom of the chart we can see momentum. Despite new highs, there is a major divergence with momentum, very similar to that which can be seen in 2000, it's actually worse this time around, and much worse than the one at the 2007 top. This is also classic behavior of a 5th and final wave in any cycle before we can expect a sizeable(40-60%) correction.

INTEREST RATE UPDATE:

I have, for years, been saying that the FED won't hike, despite constant talks to the contrary by pundits and others. The first time that I finally said we will see one hike, based on T-Bills, was last December. The FED ended up hiking that month indeed, and expectations were for 4 more hikes this year to which in this very thread I said they will not happen. And so far they have not. Several weeks ago I said it is finally looking like they might actually pull the trigger, again, this December. My last pre-FOMC meeting forecast is.....yes, there will be a hike to 0.5% this week.

[OriZ 3,157]

INTEREST RATE UPDATE:

I have, for years, been saying that the FED won't hike, despite constant talks to the contrary by pundits and others. The first time that I finally said we will see one hike, based on T-Bills, was last December. The FED ended up hiking that month indeed, and expectations were for 4 more hikes this year to which in this very thread I said they will not happen. And so far they have not. Several weeks ago I said it is finally looking like they might actually pull the trigger, again, this December. My last pre-FOMC meeting forecast is.....yes, there will be a hike to 0.5% this week.

http://www.cnbc.com/2016/12/14/fed-raises-rates-for-the-second-time-in-a-decade.html

[OriZ 3,157]

Interesting read.

There is a growing consensus that monetary reform is necessary. Eight years after the 2008 financial crisis and the extraordinary measures taken—most notably near-zero interest rates, frequently changing forward guidance, and hundreds of billions of dollars in asset purchases—the goals of insulating the Federal Reserve from political pressures and creating a more predictable, accountable, rules-based monetary policy are widely held.

Yet in a recent Journal op-ed, Neel Kashkari, president of the Minneapolis Fed and the newest member of the Federal Open Market Committee, joined the debate by arguing against rules-based reform. Those in favor of reform, he said, want the Fed to “mechanically follow a simple rule” and “effectively turn monetary policy over to a computer.”

This is a false characterization of the reforms that I and many others support. In those reforms the Fed would choose and report on its strategy, which would neither be mechanical nor run by a computer.

To understand why reform is needed, recall that the Fed moved away from a rules-based policy in 2003-05 when it held the federal-funds rate well below what was indicated by the favorable experience of the previous two decades. The results were not good. The excessively low rates brought on a risk-taking search for yield and excesses in the housing market. Along with a breakdown in the regulatory process, these actions were a key factor in the financial crisis and the Great Recession.

During the panic in the fall of 2008, the Fed did a good job in its lender of last resort capacity by providing liquidity and by cutting the fed-funds rate. But then the Fed moved sharply in an unconventional direction by purchasing large amounts of Treasury and mortgage backed securities, and by holding the fed-funds rates near zero for years after the recession was over.

These policies were ineffective. Economic growth came in consistently below what the Fed forecast and much weaker than in earlier recoveries from deep recessions. Such policies discourage lending by squeezing margins, widen disparities in income distribution, adversely affect savers and increase the volatility of the dollar. Experienced market participants have expressed concerns about bubbles, imbalances and distortions.

Because this 12-year period represents a deviation from the more rule-like and predictable monetary policy that worked well in the 1980s and ’90s, many are calling for the Fed to normalize and reform. Normalization now appears to be the intent of the Fed, but the pace has been slow and uncertain. Nobel Prize winners, former Fed officials and other monetary experts have signed a statement in support of legislation proposing such reform.

Mr. Kashkari, by contrast, argues that a rules-based approach would shackle Fed policy makers, forcing them to “stick to” a rigid rule “regardless of economic conditions.” That too is false. The Fed could change or deviate from its strategy if circumstances changed, but the Fed would have to explain why. And he wrongly claims that rules cannot take account of changes in productivity growth.

Mr. Kashkari’s argument against rules-based strategies focuses on the “Taylor rule,” which emerged from my research in the 1970s and ’80s and has been used in virtually every country in the world. The rule calls for central banks to increase interest rates by a certain amount when price inflation rises and to decrease interest rates by a certain amount when the economy goes into a recession.

Mr. Kashkari ignores the hundreds of research papers that have been written on the effectiveness and robustness of such a rule and refers only to one study by “my staff at the Minneapolis Fed,” which reports that unemployment after the 2008 financial crisis would have been higher with such a rule.

Yet in a recent empirical study, Alex Nikolsko-Rzhevskyy of Lehigh University and David Papell and Ruxandra Prodan of the University of Houston divided U.S. history into periods, like the 1980s and ’90s, where Fed policy basically adhered to the Taylor rule and periods, like the past dozen years, where it did not. Unemployment was 1.4 percentage points lower on average in the Taylor rule periods, and it reached devastating highs of 10% or more in the non-Taylor rule periods.

Studies such as this are more realistic because they evaluate policy as a continuing contingency strategy—the essential characteristic of monetary rules—rather than as a one-time policy change, as with the Minneapolis Fed’s study. Moreover, Fed calculations that only look at macroeconomic effects of low rates overlook their negative microeconomic effects on bank lending found by economists Charles Calomiris of Columbia University and David Malpass of Encima Global.

Had the Fed not deviated from rules-based policy before the crisis, unemployment would not have increased so much. Mr. Kashkari questions this view by referring to other countries with crises, but he overlooks studies by Rudiger Ahrend at the Organization for Economic Cooperation and Development and by Boris Hofmann and Bilyana Bogdanova at the Bank for International Settlements which found below-rule interest rates in other countries that were connected to crises.

Unconventional monetary policies with near-zero rates have spread to other central banks, causing a break in the rules-based international monetary system. As a result, governments are intervening more frequently in exchange markets, often in nontransparent ways that raise suspicions of currency manipulation. Reform by the Fed would catalyze international monetary reform, benefiting the United States.

Mr. Kashkari finishes off with a non sequitur that a Fed without a rules-based strategy is a less interventionist Fed. History shows the opposite. Recent unconventional monetary policies have raised concerns that the Fed is being transformed into a multipurpose institution, intervening in particular sectors and allocating credit. Setting a clear monetary strategy will help the Fed be a limited-purpose institution, which is appropriate for an independent agency of government.

Mr. Taylor, a professor of economics at Stanford University and senior fellow at the Hoover Institution, previously served as undersecretary of Treasury for international affairs. Parts of this op-ed are based on his Dec. 7 testimony at the House Financial Services Subcommittee on Monetary Policy and Trade.

http://www.wsj.com/articles/the-case-for-a-rules-based-fed-1482276881

[OriZ 3,157]

“Happiness isn’t good enough for me! I demand euphoria!”

- Bill Watterson, Calvin & Hobbes

There are several instances across history when valuations have broken well-beyond their historical norms, as the speculative “animal spirits” of investors have scrambled off like greased pigs at a rodeo. Those speculative episodes were typically concluded by one of two events: 1) a combination of overvalued, overbought, overbullish conditions appearing as a joint syndrome, or 2) deteriorating uniformity and widening dispersion of market internals across a broad range of individual securities, industries, sectors, and security-types, indicating a subtle shift among investors toward risk-aversion (when investors are risk-seeking, they tend to be indiscriminate about it).

Indeed, in market cycles across history, those two events were regularly “stuck together,” in the sense that overvalued, overbought, overbullish extremes were typically either accompanied or closely followed by deterioration in market internals. That regularity turned out to be our Achilles Heel in the half-cycle since 2009. After admirably navigating previous complete market cycles, I insisted on stress-testing our methods against Depression-era data in 2009. The resulting methods picked up the fact that overvalued, overbought, overbullish extremes were consistently associated with market losses across history, and we responded by taking a hard-negative market outlook when they appeared. The problem in the half-cycle since 2009 was that zero interest rates - and specifically short-term interest rates below about 10 basis points - acted as a kind of “solvent” that separated the two events, and encouraged yield-seeking speculation by investors long after extreme overvalued, overbought, overbullish conditions had emerged. In the presence of zero-interest rate policy, one had to wait for market internals to deteriorate explicitly before adopting a hard-negative market outlook.

We presently observe the third most overvalued extreme in history based on the most reliable valuation measures we identify, in the presence of 1) the most extreme “overvalued, overbought, overbullish” syndrome we identify, and 2) explicitly deteriorating market internals. Based on a composite of measures best correlated with actual subsequent market returns across history, other two competing extremes were 1929 and 2000.

After more than three decades as a professional investor, it’s become clear that when investors are euphoric, they are incapable of recognizing euphoria itself. Presently, we hear inexplicable assertions that somehow euphoria hasn’t taken hold. Yet in addition to the third greatest valuation extreme in history for the market, the single greatest valuation extreme for the median stock, and expectations for economic growth that are inconsistent with basic arithmetic, both the 4-week average of advisory bullishness and the bull-bear spread are higher today than at either the 2000 or 2007 market peaks. In the recent half-cycle, extreme bullish sentiment and deteriorating market internals also preceded the near-20% decline in 2011, yet extreme bullish sentiment was also uneventful on a few occasions when interest rates were in the single digits and market internals were intact. That distinction is critical. The zero-rate “solvent” that allowed overvalued, overbought, overbullish extremes to detach from deteriorating market internals and downside risk is now gone, and investors should understand that subtlety.

As a side note, among popular alternatives, Investors Intelligence publishes one of the better surveys of bullish/bearish sentiment, while the AAII survey is far noisier. For our part, we focus on a slightly different balance, between trend-sensitive and value-conscious investor groups. As I detailed in Lessons From the Iron Law of Equilibrium:

“When prices are unusually elevated relative to the norm, it’s almost always because trend-followers (and other price-insensitive buyers) are ‘all in.’ Those positions are - and in fact have to be - offset by equal and opposite underweights by value-conscious investors. A sudden increase in the desired holdings of trend-sensitive traders has to be satisfied by inducing a price increase large enough to give value-conscious investors an incentive to sell. Conversely, a sudden decrease in the desired holdings of trend-sensitive traders has to be satisfied by inducing a price decline large enough to give value-conscious investors an incentive to buy. Any tendency of investors to buy on greed and sell on fear obviously amplifies this process.

“From this perspective, (and one can show this in simulation), what we’re really interested in is not the balance between bulls and bears per se, but the balance of sentiment between trend-sensitive and value-conscious investors. Market tops emerge when trend-followers are beating their chests while value-conscious investors are nursing bruises from their shorts. Market bottoms are formed when trend-followers wouldn’t even touch the market, and value-conscious investors are bleeding from all of the falling knives they’ve accumulated.”

Valuation update

Over a century ago, Charles Dow wrote “To know values is to comprehend the meaning of movements in the market.” To offer a long-term and full-cycle perspective of current market conditions, I published a chart last week of the ratio of nonfinancial market capitalization to corporate gross value added, including estimated foreign revenues (what I’ve called MarketCap/GVA), and a second chart relating that measure to the actual 12-year S&P 500 total returns that have followed. From present valuation extremes, we expect 12-year S&P 500 total returns averaging just 0.8% annually, with a likely interim market collapse over the completion of this cycle on the order of 50-60%. Valuations are poor tools to gauge near-term market outcomes, but they are both invaluable and brutally honest about potential consequences over the complete market cycle. They also offer a consistent framework to understand market fluctuations. Recall for example, my April 2007 estimate of a 40% loss to fair-value, and then following that 40% loss, my late-October 2008 comment observing that stocks had become undervalued. Over the complete market cycle, valuation is quite a strong suit for us.

Similarly, as I wrote at the March 2000 bubble peak:

“Investors have turned the market into a carnival, where everybody ‘knows’ that the new rides are the good rides, and the old rides just don’t work. Where the carnival barkers seem to hand out free money for just showing up. Unfortunately, this business is not that kind - it has always been true that in every pyramid, in every easy-money sure-thing, the first ones to get out are the only ones to get out... One of the things that you may have noticed is that our downside targets for the market don’t simply slide up in parallel with the market. Most analysts have an ingrained ‘15% correction’ mentality, such that no matter how high prices advance, the probable maximum downside risk is just 15% or so (and that would be considered bad). Factually speaking, however, that’s not the way it works... The inconvenient fact is that valuation ultimately matters. That has led to the rather peculiar risk projections that have appeared in this letter in recent months. Trend uniformity helps to postpone that reality, but in the end, there it is... Over time, price/revenue ratios come back into line. Currently, that would require an 83% plunge in tech stocks (recall the 1969-70 tech massacre). The plunge may be muted to about 65% given several years of revenue growth. If you understand values and market history, you know we’re not joking.”

As it happened, the S&P 500 lost half of its value by the October 2002 low, while the tech-heavy Nasdaq 100 Index lost an oddly precise 83% of its value.

With regard to the advancing half-cycle since 2009, I can be reasonably criticized for my insistence on stress-testing our methods in response to the global financial crisis (which we anticipated, but that also produced outcomes that were "out of sample" from a post-war perspective). My well-intended fiduciary inclination inadvertently shot us in the foot, because the resulting approach to classifying market return/risk profiles embedded a regularity of both Depression-era and post-war market cycles that, in this cycle, was disrupted by zero-interest rate policy. Our mid-2014 adaptations resolved that issue. Though I’m convinced that our methods have ultimately come out stronger, the criticism is legitimate, as is criticism about the time it took to disentangle and address the underlying issue. That said, investors are entirely misguided if they believe that those challenges in this cycle give them a "free pass" to ignore obscene valuations. If investors rule out the potential for the S&P 500 to lose 50-60% of its value over the completion of this cycle, they’re actually ruling out an outcome that would be wholly run-of-the-mill from a historical perspective, given current valuation extremes. They’re also ignoring that my previous risk estimates in prior cycles were devastatingly correct.

Disciplined investing isn't easy (and whenever it seems like it is, you're about to learn a costly lesson). The market has been in a more than two-year top-formation with internals lagging the major indices, with investors chasing high-beta stocks (those with amplified sensitivity to market fluctuations), and with rather shallow corrections from a full-cycle perspective. All of that has been a headwind for value-conscious hedged-equity strategies, but it won’t prevent the completion of this market cycle. Indeed, our impression is that the recent swing by investors from active to passive investment strategies represents nothing but performance-chasing, at a point where valuations imply historically low prospective 12-year returns for a conventional portfolio mix. If history is a guide, nobody will remember the patience, discipline, and tolerance for frustration that were required to avoid or to benefit from the 50-60% market loss that we estimate over the completion of this cycle. A focus on market internals may help, but even the less-extended 2000 and 2007 peaks were frustrating for us. As John Kenneth Galbraith wrote decades ago about the Great Crash, “Only a durable sense of doom could survive such discouragement.” Meanwhile, distinguish full-cycle outcomes from immediate outcomes. They can often be two quite different objects.

While MarketCap/GVA is an apples-to-apples measure with a correlation of about 94% with actual subsequent 12-year S&P 500 total returns, the ratio of market capitalization to GDP compensates for its slightly lower reliability by providing a more extended historical view. The completion of every market cycle in history has taken this ratio at least 40% below present levels, and generally much lower. The chart below shows MarketCap/GDP on an inverted log scale (blue line, left scale) versus actual subsequent 12-year S&P 500 average annual total returns (red line, right scale). Current valuations are consistent with expectations of S&P 500 nominal total returns averaging scarcely 1% annually over the coming 12-year horizon. Outside of value-conscious, historically-informed, risk-managed, full-cycle investment disciplines, I’m not terribly excited about the 10-12 year investment prospects for either stocks or bonds. But given a 10-year Treasury yield of 2.6%, I expect Treasury bonds to outperform the S&P 500 over that horizon.

Internals deteriorate further

As for recent market action, under cover of a negligible pullback in the S&P 500 last week, our measures of market internals deteriorated materially. Notably, declines on the NYSE outpaced advances by nearly 2-to-1, an imbalance that’s usually associated with a weekly market loss closer to -1.5%; corporate debt weakened; the number of issues registering new lows expanded past levels last seen when the major indices were materially lower; and Friday registered a high-volume reversal characteristic of previous buying climaxes.

A week ago, we observed the single most extreme syndrome of “overvalued, overbought, overbullish” conditions we identify (see Speculative Extremes and Historically Informed Optimism); a secondary signal at a level on the S&P 500 4% higher than the syndrome we observed in July. With the exception of set of signals in late-2013 and early-2014 (when market internals remained uniformly favorable as a result of Fed-induced yield-seeking speculation), an overextended syndrome this extreme has only emerged at the market peaks preceding the worst collapses in the past century. Prior to the advance of recent years, the list of these instances was: August 1929, the week of the bull market peak; August 1972, after which the S&P 500 would advance about 7% by year-end, and then drop by half; August 1987, the week of the bull market peak; July 1999, just before an abrupt 12% market correction, with a secondary signal in March 2000, the week of the final market peak; and July 2007, within a few points of the final peak in the S&P 500, with a secondary signal in October 2007, the week of that bull final market peak.

Last week also produced enough internal dispersion to generate a confirmed “Hindenburg Omen.” I discussed this widely-misunderstood signal the last time we observed it (see the section of my August 10, 2015 comment titled “When Hindenburg Omens are Ominous”). That instance was quickly followed by a decline of over 11% in the S&P 500 over the next two weeks. Part of that discussion is reprinted below:

“I’ve frequently noted that Hindenburg ‘Omens’ in their commonly presented form (NYSE new highs and new lows both greater than 2.5% of issues traded) appear so frequently that they have very little practical use, especially when they occur as single instances. While a large number of simultaneous new highs and new lows is indicative of some amount of internal dispersion across individual stocks, this situation often occurs in markets that have been somewhat range-bound. Still, when we think of market ‘internals,’ the number of new highs and new lows can contribute useful information. To expand on the vocabulary we use to talk about internals, ‘leadership’ typically refers to the number of stocks achieving new highs and new lows; ‘breadth’ typically refers to the number of stocks advancing versus declining in a given day or week; and ‘participation’ typically refers to the percentage of stocks that are advancing or declining in tandem with the major indices.

“The original basis for the Hindenburg signal traces back to the ‘high-low logic index’ that Norm Fosback created in the 1970’s. Jim Miekka introduced the Hindenburg as a daily rather than weekly measure, Kennedy Gammage gave it the ominous name, and Peter Eliades later added several criteria to reduce the noise of one-off signals, requiring additional confirmation that amounts to a requirement that more than one signal must emerge in the context of an advancing market with weakening breadth. Those refinements substantially increase the usefulness of Hindenburg Omens, but they still emerge too frequently to identify decisive breakdowns in market internals. However, one could reasonably infer a very unfavorable signal about market internals if leadership, breadth, and participation were all uniformly negative at a point where the major indices were still holding up. Indeed, that’s exactly the situation in which a Hindenburg Omen becomes ominous.”

As I noted in the August 2015 instance, a situation where fewer than 60% of stocks are above their 200-day average typically defines sufficiently weak participation to give a confirmed Hindenburg Omen substantial bite. Currently, that figure is about 68%, so intrepid speculators insistent on scaling past Dow 20,000, red flags be damned, can at least monitor participation. For our part, it turns out that these syndromes also typically bite when we observe unfavorable market action on our own measures. In contrast, we observed several instances in 2013 and early-2014 that were not accompanied by broader internal deterioration or weak participation, and those signals were ineffective. Suffice it to say that under most conditions, Hindenburg signals in their raw form are of little use, but when they are complemented by other measures of internal dispersion and extremely overvalued, overbought, overbullish syndromes, they do tend to live up to the “omen” part.

Emphatically, our pointed concerns about market risk would quickly ease to a neutral outlook if our measures of market internals were to become favorable. Again, the reason is that overvaluation typically gives way to sharp market losses only during segments of the market cycle when investors have subtly shifted toward risk-aversion. Since risk-seeking speculators tend to be indiscriminate about that speculation, the best measure we’ve found to infer those risk-seeking or risk-averse preferences is the uniformity or divergence of market action across a broad range of internals.

So while our long-term (10-12 year) expectations for S&P 500 returns remain near zero, and we now expect a 50-60% market retreat over the completion of this cycle (an outcome that would be only run-of-the-mill from present valuation extremes), our expectations about more immediate market outcomes will remain heavily driven by the quality of market action we observe at each point in time. Presently, those measures are hostile, which is why we’ve got red flags waving, but a shift toward favorable uniformity across our measures of market internals would defer those concerns. Put simply, market conditions don’t forecast or require a near-term market collapse. Rather, they are currently permissive of a market collapse, and on average, market returns under such conditions have historically been quite negative until those conditions have cleared.

https://www.hussmanfunds.com/wmc/wmc161219.htm

[OriZ 3,157]

t's increasingly clear that pensions can't rely on investment returns to pad their coffers the way they used to.

The biggest U.S. pension fund appears to recognize this. The chief investment officer of the $303 billion California Public Employees' Retirement System just recommended that it lower its annual assumed rate of return to 7 percent from 7.5 percent, which will require workers to contribute more money to the plan.

This is a good sign because it finally shows some grasp of reality. Unfortunately it points to a substantial amount of pain ahead for workers, who will inevitably have to pay more into their pensions in the very near future. And that pain could be even worse because expectation of a 7 percent annualized return is still too high.

Calpers is often thought of as a trailblazer for other public pensions, which collectively had a 7.5 percent assumed rate of return on their assets as of 2015. The California fund is big, but it pales in comparison to the estimated $3.6 trillion of assets in state and local government retirement systems as of 2015, according to the National Association of State Retirement Administrators. If all of these funds were to reduce their return assumptions by a mere half percentage point, as Calpers is doing, it would likely require employees to offset the difference by billions of dollars a year.

Not-So-Great Expectations

U.S. public pension funds have steadily reduced their expected rates of return on their assets

Source: Wilshire Consulting

As small as the 0.5 percentage point adjustment is, it's still too big for California employees to absorb all at once. That's why the fund's CFO, Cheryl Eason, proposes starting with a reduction in the assumed rate of return to 7.375 percent in the 2017-18 fiscal year and then lowering it from there.

“We believe this schedule would give employers time to plan their budgets and minimize the impact to them as well as to those active members,” Eason said Tuesday at a board meeting in Sacramento, according to Bloomberg's John Gittelsohn.

The California pension fund's decision would require as much as $2 billion in annual state payments by the time of full implementation in 2020, according to a Los Angeles Times article citing a member of Gov. Jerry Brown's budget staff. By the time Calpers gets that assumed rate of return down to 7 percent, as its CFO recommends, the fund may very well be thinking about lowering expectations even further.

For years, pensions have been ratcheting back their forecasts for how much they stood to earn on their assets. They've been delivering underwhelming returns in recent years, even in the face of a tremendous rally in stocks fueled by central bank stimulus.

Petering Out

Future returns are expected to be lower in coming years after several big years of gains

Source: S&P 500, Bank of America Merrill Lynch index data

2016 data is through Dec. 21

Since the end of 2008, U.S. stocks have rallied more than 14 percent a year while dollar-denominated bonds delivered about 4 percent annualized returns.

Those same stimulus efforts suppressed bond yields to the lowest levels on record, pushing these pension funds to take more risk to achieve their desired returns. While U.S. bond yields are starting to rise, they're still way below their pre-crisis average. It's hard to see how they'll shoot up as quickly as some are expecting without more significant economic recoveries in Europe and Japan and stimulative fiscal policies in the U.S.

HITTING NEW LOWS

So pensions are still facing a bleak outlook. U.S. investment returns over the next 20 years are likely to be lower by several percentage points each year than those in the two decades ended in 2014, according to a McKinsey & Co. report earlier this year.

There's an estimated $1.9 trillion shortfall in U.S. state and local pension funds. It's difficult to see how these retirement systems are going to plug the gap with wishful thinking in markets. Sooner or later, workers and taxpayers are going to have to foot the bill and it's going to be unpleasant.

https://www.bloomberg.com/gadfly/articles/2016-12-22/calpers-rings-warning-bell-for-3-6-trillion-of-pensions

[OriZ 3,157]

As I have been detailing in the last 7 pages of this thread, presidents don't chart the course of equity markets nor do they have such a huge impact on the direction of the economy. However it appears that these days dialectic truth is sorely missing in the public narrative, but such is the nature of bubbles. In fact, it was the lessons of 2007 when Wall Street led investors right off the cliff with overly rosy projections that proved not only can Wall Street be wildly off the mark, but that it is their seeming mission to get investors to add money to the pile until the bitter end, consequences be damned.

 

 

 

As you already know I consider markets to be in an artificial liquidity driven bubble. What is a bubble? In markets it’s generally a period when the majority of participants adopt an excessively positive and unrealistic outlook about the future and are ignoring underlying fundamentals. They are willing to pay a big premium for assets based on beliefs that ultimately turn out to be false and are ignoring the current state of actual reality and/or any warning signs. The perceived state of a possible positive future trumps(pun intended) everything else. Ultimately the recognition of actual reality deflates the bubble and reverts the premium to a more balanced state. This process can take years to pan out.

Another key ingredient of a bubble: Naysayers are ignored and mocked as there is no apparent path but up. As usual people are getting euphoric and bullish at all time highs. We are back in a period that sends the following message to investors: If you ever sell anything you are an idiot. If you hedge anything you underperform, and you must buy any tiny dip or you won’t get in. Corrections, bear markets and risk are a thing of the past. It’s a dangerous message and perhaps more dangerous than ever as the structural and technical picture continues to point to massive risk expansion to come.

In the last months of his term, Bush faced the burst of the real estate bubble blown by Greenspan and Congress. Fortunately for Obama, he arrived soon after the crisis, inflated a new bubble with Bernanke and managed for eight years to blame Bush and absolve himself of all responsibility for the state of the US economy. Now, in light of the increase in yields, Trump is the one who may end up paying the price for the bursting of the Obama/Bernanke bubble. Perhaps the only way for Trump, if he wants to get out of this trap and win a second term, is to embrace the next crisis.

And the crisis will come. After eight years of zero interest rates, the US economy simply will not be able to adapt to a significant increase in yields - a rise that has already been going on in recent weeks. The real estate market, consumer credit, auto loans, corporate bonds (including stock buybacks) financing the budget deficit and the $20 trillion in federal debt, all rely on very low interest rates, and all of them were built and swelled over the past 8 years. Hard to believe that the US economy can go from zero interest rates to one built on normal rates, without experiencing a crisis along the way.

How serious will this crisis be? One can't exactly say, but we must remember that at the height of monetary expansion in the Bush/Greenspan era in 2003, the rate stood at 1-2% and stayed at that level for three years. If this policy helped create the crisis in 2008, how will the crisis that is the the result of 8 years of zero interest rates look?

The stock market today plays around with the idea that Trump's measures to boost the economy may cancel out the effect of the increase in yields. This is false hope, as Trump faces serious opposition in Congress from Democrats certainly, but possibly in the Republican Party. After all, he is not an integral part of the party. But even if Trump will succeed in implementing some of his measures, and even if he could apply just the best part in many of his ideas - these steps will take a long time to pass, and even longer to influence - perhaps even years. The rise in US yields will override all the good things that Trump is trying to do.

In addition, keep in mind the business cycle since 2008 is among the longest in US history since 1850. In other words, it is likely that the recession will come during Trump, one way or another.

As I have recently pointed out in another thread, once the unemployment rate dips beneath 5% it usually tends to climb back up in the following years towards 8-10% at the very least. It is part of the normal cycle as the market becomes saturated and is usually accompanied by a recession. It can be seen very well in this chart:
http://www.macrotrends.net/1316/us-national-unemployment-rate

It usually reverses course between 3.5% and 5% and with the exception of the 1960's, it took no longer than 3.5 years(and in most cases less time than that) for the US to enter a recession once beneath the 5% threshold. Considering valuations right now resemble the late 90's(3.5 years to a recession) rather than the 60's(5.5 years) and the unemployment rate reached 5% one full year ago, I think it would make sense to expect another recession within the next 2.5 years. 

Another piece of data I have pointed out is that the length of time between recessions in recorded history ranges from 2 to 11 years. However that range narrows down to just 4-9 years in the past century. We are now 8 years out of the last recession, meaning that if Trump makes it through the next 4 years without one, he will Trump(pun intended), or defy statistics and accomplish what no other president in recorded history has ever accomplished. That would mean going 12 years without a recession.

When we observe the greatest follies of our predecessors, the episodes of speculative madness that come most immediately to mind are the pre-crash bubble peaks of 1929, 2000, and to a lesser extent, 2007. Unfortunately, we are in the midst of yet another episode of equivalent speculative madness, but one that will only be recognized in hindsight, and in the recollections of our children. They too are likely to take pride in a feeling of superior knowledge, forgetting the same lessons, and eventually creating another bubble and collapse of their own. The herd mentality is human nature. As in 2000-2002 and 2007-2009, when the S&P 500 collapsed by 50% and 55% respectively, we’ll likely see that herd mentality expressed on the downside soon enough. That also is human nature.

The stock market bubble that ended with the September 1929 peak began in August 1921, running just a few days beyond 8 years in duration. The bubble that ended with the March 2000 peak began in October 1990, running fully 9 years and 5 months in duration. Those two episodes represent the longest bull markets in U.S. history. The current half-cycle began at the March 2009 low, and has now run 7 years and 10 months in duration, making it the third longest advance in history, placing it just 2 months short of the 1929 instance, but a full year and 7 months short of the 2000 instance.

Then you also add the valuation picture into the mix.

 

Never has a president avoided a recession, following a 2 term presidency. 100% of all 2 term presidencies have been followed by a recession. When you combine a run that is way over extended historically from a time perspective, coupled with the second highest valuations in history(and the highest if you look only at the median stock price as the main reason for overvaluation leading up to 2000 was the technology sector whereas now it is alot more broad based), an unemployment rate that has almost nowhere to go but up, a market that from a technical perspective is extremely overbought, and has many technical as well as internal divergences, you get a recipe for disaster. Simply put, Trump has virtually a less than one half of one percent chance not having the pleasure of presiding over one. For Trump to buck all these trends would be quite remarkable, and - unlikely. Yes, I know, he is bringing jobs back. But as good as the recent 12,000 jobs are for those employed and their families, it is a drop in the ocean considering in 2016 an average of 5.2 million job hires were made each month, with 5 million separations. Netting +200k a month. 

https://www.bls.gov/jlt/news.htm

Sure, it could maybe help the unemployment rate by about 0.5% IF he is successful at what he wants to do(including his infrastructure projects), so say instead of going as high as 10% it will only be at 9.5%. But there is no reason to believe Trump's policies will meaningfully affect the unemployment rate, let alone lower it much further. 

Don't get me wrong, I said it before and I'll repeat it: A crisis will not be Trump's fault, nor will I judge him for or on it. The mere recession is not what I will be looking at. What will affect my opinion on his presidency will be how he reacts to it though. If he does the same thing Bush and Obama did, it will lose him some points with me. That is where his true test will be. I have written more about it here:

Speaking of consumer confidence(thanks for the idea naitch!) consumer confidence is at levels that were rarely exceeded outside of the dotcom bubble. Record levels of anything are records for a reason. It is the point where previous limits were reached. Therefore, when a ‘record level’ is reached, it is NOT THE BEGINNING, but rather an indication of the MATURITY of a cycle. While the media has focused on employment, record stock market levels, etc. as a sign of an ongoing economic recovery, history suggests caution.  

There are many measures of consumer confidence but two of the most widely watched are the University of Michigan (UofM) and Conference Board (CB) surveys. Since the election both measures have independently soared sharply as “hope” has emerged that President elect Trump can cause real economic change through tax reform, infrastructure spending and the return of jobs back to America. It’s a tall order to fill and there is much room for disappointment, but for now, “hope” is in the driver’s seat and according to the latest readings consumer sentiment has reached levels not seen since the turn of the century.

The chart below is a composite index of the average of the UofM and CB survey readings for consumer confidence, consumer expectations, and current conditions. The horizontal dashed lines show the current readings of each composite back to 1957..

 

Within 2-3 years and sometimes less, of every other time these levels were hit, the US was in a recession. Considering the stock market usually tops several months before entering an official recession, we can expect it to top any time in the next 2.5 years. That is the optimistic scenario. Alas, here is the caveat. Even 2.5 years don't mean there will be much to see in gains. It will most likely just continue the current slow churn marginally higher, and then get cut by half. Not really worth the risk.

Importantly, as noted above, high readings of the index are not unusual. It is also worth noting that high readings are historically more coincident with a late stage expansion, and a leading indicator of an upcoming recession, rather than a start of an economic expansion.

The next chart shows the same analysis as compared to the S&P 500 index. The dashed vertical lines denote peaks in the consumer composite index.

 

Other recent examples of records to note: 

And the  following from Realinvestmentadvice:

The ECRI Weekly Leading Index (WLI) just spiked to a peak not seen since 2007.

There is a very close correlation between the ECRI WLI and GDP as shown in the chart below. It also includes the Chicago Fed National Activity Index (CFNAI) which is a very broad measure of economic activity consisting of roughly 85 subcomponents.

Importantly, there is currently a rather significant divergence between the WLI and CFNAI measures. Historically, such divergences tend to correct themselves over the next several months with the WLI correcting back towards the CFNAI.

Furthermore, there is also a significant divergence in the ECRI leading and lagging data sets. These two data sets were very closely correlated until the turn of the century where they have become increasingly more detached. This is one reason, I suspect, the ECRI has struggled in recent years with its economic forecasts to some degree.

We can take these two indices and create an effective “book-to-bill” ratio by subtracting the lagging index (what actually happened) from the leading index (what we expect to happen). What we find is very interesting. The current level of the leading-lagging index has plummeted to the lowest levels on record with historical spikes lower associated with recessionary economic periods

 

On the surface 2016 was pretty straightforward party hardy from an investment perspective: After the worst start to any year stocks recovered quickly and any further downside experienced during the year had a lifecycle of a few hours at best and stocks finished the year near record highs with big gains for the year on the main indices.

Yet as positive as the index performance appears to be the majority of hedge funds were underperforming and so were individual investors if they have adopted any sort of balanced and/or diversified portfolio approach as the real gains were in the few and not the many while 2016 offered plenty of opportunities for investors to get hurt somewhere.

During the November election night, S&P500 futures dropped not only negative on the year, but below November 2014 highs. Yet it was all operating in the green by market open. The main culprit: More stimulus was coming with a surprise Republican majority in Congress in essence throwing fire on an already liquidity drenched market.

In 2009 president Obama came into office and immediately authorized a giant stimulus package. It was labeled the American Recovery and Reinvestment Act of 2009 and ended up costing over $800B. Fast forward 8 years later and $10 trillion in additional debt and over $4 trillion in FOMC balance sheet expansion and here is president elect Donald Trump proposing tax cut and spending measures that would even exceed the 2009 program in form of a promised $1 trillion infrastructure program and broad based tax cuts. For good measure of comparison: That 2009 stimulus package was larger than the 50 year running budget of NASA.

In this context so what if EPS expectations for Q4 have fallen by 2.2% since September 30, or by 3.7% over past 26 weeks

 

And markets have reacted consistent which is to embrace free money. For years we have seen trillions of dollars of artificial liquidity slugging through these markets. It needs to be pointed out that no year has ever seen greater central bank intervention than 2016. Over $2.2 trillion in added QE and dozens upon dozens of rate cuts, indeed the acceleration in central banks asset growth has been quite the show:

But while this helped propel markets to new highs, they did not accelerate at the same speed, as some are still beneath their highs, and even in the US we are talking about lower total returns than the period of 2009-2014. And we all know many central banks buy stocks directly. The BOJ and the SNB are buying stocks outright with the BOJ not only being the largest buyers of Japanese stocks but also becoming the largest shareholders go Nikkei listed companies in many cases. And the ECB is buying corporate bonds like there is no tomorrow with their program even putting the US Fed to shame:

 

If you don’t think intervention of such grand scale has an impact on price levels think again(albeit to a lesser and lesser effect over time as I have pointed out - think drug addict). To put all this in perspective: Central banks adding over $2.2 trillion in artificial liquidity a year exceeds the $1.7 trillion it costs to run all the militaries in the world by over $500B per year.

We also know from Mario Draghi that the ECB was prepared to intervene with additional liquidity in case of a Brexit vote. He said so himself.

The Bank of Japan’s contribution:

And despite a couple of puny rate hikes the US FOMC remains fully engaged with awesome power:

By constantly intervening in everything central banks continue to distort market conditions. Why? Because they have to to keep the illusion alive. There is zero evidence to support the notion that markets can maintain current price levels without trillions of dollars in ongoing intervention.

I am firmly convinced all this intervention has impacted the psychology of the entire global marketplace in major and very dangerous ways. Risk has been removed as a factor in markets setting up an illusory complacency. Buy the dip as quickly as possible, Don’t even give it more than a few minutes to make its presence felt. This has been the Pavlovian effect cultivated for years and brought to a new accelerated level in 2016. My view is that the perception that risk no longer exists is the greatest illusion, one that investors will pay dearly for at some point.

The reason I point all this out again is that price, as it is presented to us now, is not the result of a booming organically growing economy with a broadening earnings picture.

Earnings growth on the S&P was 0.1% in 2016:

If you exclude the worst performing sector - energy, then things look a bit brighter with earnings growth at 3.4%. Before you get too excited recognize that the $SPX gained 9.5% in 2016. The obvious disconnect being valuations as no matter how you look at it stocks are historically expensive with most gains coming from pure multiple expansion:

And this multiple expansion is the result of a fundamental backdrop not keeping up with price as struggling GAAP earnings remain masked by pro forma reporting, a multi year trend now:

Indeed revenue growth, while positive excluding energy, shows precious little signs of an organically expanding economy. And seriously, is this all we get with record central bank intervention?

No, global market performance still remains a function of massive liquidity and promises of stimulus and tax cuts. A plain fact: We’ve never had such distortions operating freely and unchecked in capital markets. One of the big question marks was always whether all this artificial liquidity would ultimately result in a "blow-off" top, and it appears we are getting an affirmative response:

The main premise for the year end rally: Tax cuts, deregulation and a coming administration extremely friendly to big banks and corporate business in general. After all Donald Trump’s new administration is filled with Goldman Sachs alumnus. 

On this basis is it then a surprise that banks are celebrating? As outlined earlier during the night of the US election $ES futures fell below November 2014 highs. In the weeks since we have not only seen it transverse 2015 and 2016 highs, we have witnessed a vertical "upward crash" in financials rarely seen before. 

$XLF:

And it is this vast outperformance that has skewed much of the latter part of the year. Indeed just three $DJIA stocks account for 40% of the $DJIA’s gain this year. Call it whatever you want, but don’t call it broad based. Indeed going back to the 2015 highs the outsized performance of the financial sector cannot be overstated impacting the $DJIA and the $RUT as well while other indices lagged:

 

And so nothing, absolutely nothing, suggests any change coming in the long standing trends of wealth expansion toward the few with all data points suggesting that the vast debt expansion and market party has left the middle class and workers in the dust:

 

So here we are after 8 years of intervention with just 8% of people controlling virtually all wealth on the planet and just 0.7% holding almost half:

Yet it is precisely now that we are at the cusp of this grand central bank experiment nearing the end of its lifecycle. While we still see immediate intervention on any bad news item there is a notable shift taking place in the central bank narrative. They all want governments to step up and provide fiscal stimulus, in other words more debt. Why? Because they are at the end of the line here. The ECB is running out of bonds to buy and will start reducing QE next year, the Fed will continue to raise rates, albeit slowly, and the BOJ will become majority shareholder of many Japanese companies. It’s absurd, but they have done all they can do and this is what it took: Since the financial crisis there have been 690 rate cuts across the globe. That jig is up.

It is then a fair question what this has all produced light of business cycle theory demanding that eventually a recession will hit the world again, in all likelihood by the end of this decade. How well is the world prepared? Shockingly not at all. In fact it may be said it is in worst shape ever to handle a future recession.

Consider:

Global debt has exploded higher and has been the primary vehicle to finance the 8 year bull run.

Money quote:

“At $152 trillion, global debt was 225% of world GDP in 2015. 2/3 of debt or $100T consists of liabilities of the private sector”.

It is higher now and is getting higher every day. While people's eyes tend to glaze over at mention of data points like this not realizing that the seeds for a massive reset are in the works.

Also consider it’s not only government debt.

Household debt has ballooned to record levels as incomes have not kept pace with expenditures:

Consumers are loading up on debt they can’t repay:

“In the past few weeks, some auto lenders have warned that default rates are creeping up. Used-car prices are also falling faster than many anticipated, leading to lower recovery amounts when borrowers do default.

The latest stress signal comes from auto research firm Edmunds.com, which said in a recent report that record numbers of shoppers are trading in old cars for new ones when they still have substantial amounts due on their existing car loans.

 In the first three quarters of 2016, the number of these new-car purchases with negative equity on previous loans reached a record 32% of all trade-ins, according to Edmunds data. That is up from 30% in the same period a year earlier and just 22% five years ago. The average amount of negative equity also reached a record, at $4,832.

 That is significant when one considers that the average selling price for a new car is around $33,000, says Edmunds analyst Ivan Drury.

As a result, many borrowers are rolling over their balances into new loans, pushing loan-to-value ratios above 100%.They have to pay that back over time, either through higher monthly payments or a longer payback period. Already, payback periods have risen to an average of 69 months, from 63 months five years ago, according to Edmunds.”.

And just before the cost of carry will increase as a result of rising rates, households have loaded back up on debt in full exceeding even the 2007/2008 peak:

On the corporate side we see the same trend as 2016 was a bonanza in new debt issuance: Corporates lead surge to record $6.6tn debt issuance

Money quote:

“Companies accounted for more than half of the $6.62tn of debt issued, underlining the extent to which negative interest-rate policies adopted by the European Central Bank and the Bank of Japan, as well as a cautious Federal Reserve, encouraged the corporate world to increase its leverage.”

Barron’s:

“Net debt-to-Ebitda (earnings before taxes, interest, depreciation, and amortization) among S&P 500 companies is pushing a high near 1.6 times, so some of the cash might be quietly steered to pare debt. And companies are using just 75% of their capacity, still below the long-term average of 80%.”

Deficit spending is already flying higher again exacerbating the increasing amounts of debt that being added to keep the game afloat. And this is before additional spending/tax cuts promised by Donald Trump:

So are $1T+ deficits on the way again? We won’t know until we see an actual budget proposal from the new administration with actual spending line items. What we do know is that with higher rates the biggest growth line item in the budget is likely to be interest on debt payments:

In this context the current trend on Federal Tax collections is not encouraging:

The summary picture:

The larger message: The system requires ever more debt to sustain itself, and sustainability will become a major obstacle as rates rise. We are firmly in a make believe phase of the market. People embracing narratives on face value and with it high valuations based on premises of a better future. Excessive optimism, a key ingredient to any bubble, can now be observed everywhere including asset allocations:

Big time pig time and investors have decided to finally throw in cash at the top of the market:

“TrimTabs said that U.S. stock ETFs saw $97.6 billion in inflows between Nov. 8 and Dec. 15—around 150% of the $61.5 billion that flowed into the category over all of 2015.“

In short: Going long at a time when markets are the most expensive in years.

Look, I can’t dissuade anyone from these narratives and neither can I influence people’s willingness to pay high prices for equities. But I can do my dearest to stick to process and analysis and both keep telling me this market has an appointment with pain. How severe this pain will ultimately be remains to be seen, but reality has a way of catching up.

In my humble view risk is not dead. In fact it’s the next big one way ticket.

Why? Because, I for one, still believe in math:

“Stanford University’s pension tracker database pegs the market value of California’s total pension debt at $1 trillion or $93,000 per California household in 2015. 

In 2014, California’s total pension debt was calculated at $77,700 per household, but has increased dramatically in response to abysmal investment returns at California’s public pension funds that hover at or below zero percent annual returns.

Pension Tracker recently added the 2015 data, and plans to also add data for 2016 and 2017 when it becomes available.  The market value of California pension debt is expected to likely exceed $100,000 per household in 2016, based on recent market calculations. 
 
Nation says Pension Tracker is also slated to include data on unfunded liabilities for “other post employment benefit” obligations, which is mostly retiree health care costs.”

The total picture:

Hey what’s $5.6 trillion in pension debt among friends? I guess in a country $20 trillion in debt and heading toward $30 trillion it matters not. That’s at least what every Wall Street analysts is telling retail.

Here’s the trend:

So either pension funds are defaulting or they need to be financed somehow and currently the answer is they are being funded with more debt and allocate ever more risk exposure into equities.

Investors are bidding up equity prices along with entities that face no personal consequences for overpaying: Central banks and corporate buybacks. And buying they will continue to do:

Norway’s Wealth Fund Wants to Add $129 Billion in Stocks

“Norway’s $860 billion wealth fund recommended it add about $130 billion in stocks and sell off bonds as it presented a bleak view on the returns from its investments across the globe in the decades to come.

The central bank’s board, which oversees the fund, on Thursday recommended an increase in the equity share to 75 percent from 60 percent. That will raise the expected average annual real return to 2.5 percent over 10 years and to 3.5 percent over 30 years, compared with 2.1 percent and 2.6 percent, respectively, under the current setup.”

And one can argue we are already seeing some of this happening now:

Yup, it’s a perfect storm alright. A financial system where everyone owns the same stocks and ever more debt and ever higher valuations are required to sustain itself. And while investors are riding the wave higher at the moment I remain highly skeptical that this the wave they want to ride.

Nobody sees any downside, recession risk or any doubt that markets will simply continue on a bull run:

Well everyone except for the US’ largest pension fund that is not all that optimistic it seems as it is considering reducing its expected growth forecast. One of the key issues I keep harping on about:

“Compounding the problem is that CalPERS is 68% funded and cash-flow negative, meaning each year CalPERS is paying out more in benefits than it receives in contributions, Mr. Junkin said. CalPERS statistics show that the retirement system received $14 billion in contributions in the fiscal year ended June 30 but paid out $19 billion in benefits. To fill that $5 billion gap, the system was forced to sell investments. 

CalPERS has an unfunded liability of $111 billion and critics have said unrealistic investment assumptions and inadequate contributions from employers and employees have led to the large gap.”

But markets are ignoring it all for the moment despite all warning signs. Examples:

Libor rates have been starting to rise again as well. While they are currently still nowhere near the levels of 2008, considering how low the Federal Reserve has been keeping interest rates and for how long, this is an alarming trend as it means banks are becoming more reluctant to lend to each other:

 

 

Considering the 3 month T-Bill is only half the rate the 3 month Libor, this should raise concern. The other two times we have seen a spike in the libor rates in 2010 and 2011 the market experienced large corrections. This time the rate has already surpassed the former rates. 

 

 

House flipping is also back and in a big way. Here’s a unicorn with a $1 billon valuation, a company’s whose primary business model is house flipping. You can’t make it up:

“Silicon Valley’s club of unicorn startups hasn’t been growing as fast as it once was, and its newest member is unlike most of is venture-backed peers. Opendoor Labs Inc., a San Francisco startup that buys houses and then resells them, received a valuation of at least $1 billion after its latest funding round, said people familiar with the matter.

Opendoor said it raised $210 million, which it will use to fund expansion to 10 cities next year.”

Maybe it’s a trade nuns are interested in. No really, nuns are now running portfolios:

Low Rates Turn Nuns Into Traders

“On a recent morning, Sister Lioba Zahn read the Bible, attended prayer, did the laundry and then prayed again.

In the afternoon, she called her bank and started trading.

Ultralow and negative interest rates have hit savings and investments around the developed world, crushing the income that many mom and pop investors rely on. Mom, pop and Sister Lioba.

For over a century, Mariendonk financed itself by selling milk and candles, and through income on its bank deposits. After the European Central Bank began cutting rates, eventually going all the way below zero to their current -0.4%, Sister Lioba realized her convent needed extra income to survive.”

Yes it’s quite the world we live in and these are mere symptoms, but I am using them to illustrate a larger point: Exuberance and leverage is in the system, yet it is based not on organic growth, but a false complacency that has been created by artificial liquidity while the underlying risk factors have been masked. For now markets have pretty much decided to view everything through the prism of rose colored glasses. The concept of risk has been neutered and nobody sees any downside for the next year.

But here is all that has been happening, in reality - The FTSE world index that I have shown before as well, which represents about 95% of tradeable global equity market capitalization.

 

And biotech?

NYSE composite index, broadest measure of market action in the US:

  

Transports:

       

The ratio of bear/bull funds has also reached the lowest levels since 2000. This basically means there are almost twice as many bull funds as there are bear funds, in another sign of top area optimism.

 

 

As you can see prior instances of the ratio being so low led to sharp declines. And in the next set of charts we see data for the manufacturing sector:real output and real output per person, the industrial production index and real output per hours of all persons. As you can tell just by looking at these, the current levels and trends have been associated with or near recessions many times in the past.

 

 

What’s the main technical message? Price continues to operate within the confines of potentially devastating bearish chart patterns showing new highs came on large negative divergences masking underlying weakness.

And so Trump has two main options; One option is to wait for the crisis to hit and then respond as the two previous administrations - i.e. cutting interest (as much as possible anyway, since the interest rate probably won't exceed 1% by much), encourage another round of printing by the central bank, and we may even add to this dubious basket of solutions fiscal stimuli. Such a solution has three vulnerabilities. The first weak point is it is not clear when exactly the crisis will strike so it is unclear whether the positive effects - temporary as they may be -  will affect the US economy fast enough to bring Trump the second term.

A second weak point is that this is exactly the policy that cost the Democrats the White House. The middle class did not benefit from zero interest rates that cut into the savings and have not benefited from the stimulus that went mainly into the pockets of the rich. The third weak point is that this time, it is possible that even these traditional measures will not succeed in stopping the deterioration of the economy, even temporarily. As mentioned above, 8 years of zero interest rates is an unprecedented phenomenon, perhaps the crisis that follows would be unprecedented as well.

But Trump is facing a second option; This option is dangerous, difficult, almost impossible to the average politician, but one that can make him a great president. Trump can embrace the recession. The recovery anyhow during Obama's term was focused in financial assets, created bubbles, failed to create high quality jobs for the middle class and failed in creating healthy and sustainable growth. Trump can take the opportunity to use the recession to erase the legacy of Bush/Obama and reboot an economy in serious need of a reset.

With the first signs of the crisis or even before that, Trump should push the Fed (Trump will be able to appoint the next Fed Chair in February 2018) to allow interest rates to rise to a normal level(according to Greenspan normal level is around 5%) and let all asset bubbles burst, with all the pain it would cause to the financial sector. Rates should never again be taken beneath 2% even during a crisis. At the same time, he must engage in deregulation, cut taxes where possible especially for the middle class, cut spending and control the budget. That is, Trump should take advantage of the crisis to begin restoring the US route of a free economy.

If the crisis hits soon enough, considering the underlying flexibility of the US and its advantages in many areas, there is a reasonable chance that by 2020 Trump will lead a recovering economy that is healthy and viable and prove to the voters that he was the first president in decades who is not a prisoner of Wall Street.

And if the crisis will strike too late, and recovery will not arrive in time, Trump really could lose the election. Indeed, the sad truth is this - without the courage to act in an original way, the business cycle likely will make Trump a one term president. So if anything, why not do the right thing?

 

“Let us not, in the pride of our superior knowledge, turn with contempt from the follies of our predecessors. The study of errors into which great minds have fallen in the pursuit of truth can never be uninstructive... Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one... Truth, when discovered, comes upon most of us like an intruder, and meets the intruder’s welcome... Nations, like individuals, cannot become desperate gamblers with impunity. Punishment is sure to overtake them sooner or later.”

Charles MacKay, Extraordinary Popular Delusions and The Madness of Crowds, 1841
 

Edited January 10, 2017 by OriZ

[OriZ 3,157]

 

Blinding Flash of the Obvious

January 25, 2017

Dear President Trump,

It’s conceivable you are not a regular reader of these newsletters. In deference to how busy you’ve been since last Friday, I’ll resist directing you to the full archive for the moment. Suffice it to say these missives usually begin with a catchy or sometimes kitschy cultural hook to draw readers in to such spicy subjects as bond market valuation, the prospects for monetary policymaking and one that’s near and dear for you — the state of the commercial real estate market.

But this week, in an open letter to you written in all humility, on behalf of myself and every patriotic American, I’d like to share with you the wisdom of one of our nation’s best and brightest military minds in the hopes you might adapt it to the economic issues you will be tackling during your time in office.

Lieutenant General John W. ‘Jack’ Woodmansee, Jr. served 33 years in the United States Army before retiring with the highest honors. Today, Lt. Gen. Woodmansee is the CEO of Tactical and Rescue Gear, Ltd., an 18-year old company that manufactures and sells goods to the Department of Defense, Department of Homeland Security and law enforcement markets. He’s a huge patriot if there ever was one and I’m sure you will agree we can all stand to benefit from his experience.

It is not uncommon to have mantras by which we live on our desks. When I was on Wall Street, I read and re-read mine every day, “Pigs get fat, Hogs get slaughtered.” That’s a good one, but perhaps better suited to your former day job. In your new role, which includes that of Commander in Chief of the Armed Forces, you would be better served to adopt the quotation Lt. Gen. Woodmansee uses as his guidepost to resolve “complex future requirements,” to borrow his words. (Get with me privately if you’d like to see Lt. Gen. Woodmansee’s Top Four Foreign Policy Priorities for National Security.) Without further ado, you may recognize these words as those of George Orwell:

“Sometimes the first duty of intelligent men is the restatement of the obvious.”

Let’s simplify that, military-style, in case you’re inclined to tweet this in the night. Call them Blinding Flashes of the Obvious that guide you — Bravo-Foxtrot-Oscar — to help sear the words into your memory bank. With that, what exactly are the obvious issues facing our economy? The Lt. Gen. narrowed his list to four, so I shall follow suit.

1. The biggest challenge is what got you elected, that is the sense among millions of Americans that they’ve been on the outside looking in on the so-called economic recovery which technically started in 2009.

 

2. Time is the second obvious element that is not on your side. Next Thursday marks the beginning of the third longest expansion in the post-World War II era. Recession will be a reality on your watch, and perhaps sooner than later.

 

3. As you’ve recognized yourself, the financial markets are wrapped in bubble. You name it, they’re overvalued, some more than others.

 

4. And finally, your central bank is, as my former boss Richard Fisher said, “a giant weapon that has no ammunition left.”

 

If only the solutions to what ails the economy were as glaringly obvious as what ails it. Patience and fortitude will see you through but you must prepare yourself for what’s to come. And though your initial actions do make it appear as if you believe economic prosperity can be signed into being with the whisk of an executive order, take it on faith that the country needs a lot longer than 100 days to get this economic party started.

That isn’t to say your energy industry actions aren’t to be lauded. Here’s for hoping exports are next. That natural foray accomplishes a national security aim as well. Foreign policy will be greatly strengthened if a certain egomaniac who lives east of Western Europe can no longer hold our allies hostage with the threat of their natural gas supplies being cut off in the depth of winter. Energy exporting and building those pipelines will also take us one step closer to energy independence, which is a foreign-policy and economic positive.

Then there’s the red tape that’s increasingly strangled our proud history of entrepreneurship. Please proceed to dump them at the nearest exit as you’ve promised to do. Let’s start-up and grow small businesses.

Afraid that sums up the low hanging economic fruit you can pick right away. Bringing bigly job growth back requires long term investment in educating our children in science, technology, engineering and math. Do you want to build the factories of tomorrow on American soil? Fine. Rip up the game plan and rebuild our education system, one community at a time.

If you won’t take my word for how critical this is, have a quick look at our literacy stats vis-à-vis other developed nations. As for the desire and wherewithal, Google that photo of single African-American mothers marching across the Brooklyn Bridge to retain charter school funding. Easier yet, pull up footage of this past Tuesday’s protest on the south steps of the Texas state capitol building – thousands of parents demanding tax dollars to help fund optionality in where they educate their kids. It IS broken and you’re not beholden to any special interests. Let’s fix education!

Fair warning: the recession inevitability thing won’t be easy on you. So why not bet on the come? Starting points do matter and, hate to break it to you Dorothy, but we are not back in Kansas circa 1980 anymore. Resisting radical central bank intervention will be a difficult test of your mettle. Helicopter money, negative interest rates, more bond purchases to grow the Fed’s balance sheet further, the abolition of cash. Just say no, which you can do via proxy, which we’ll get to shortly.

When it comes to recessions, we all know that discretionary spending is hit the hardest. That’s where those tax cuts and infrastructure spending you’ve committed to come in. They’re not perfect, but why not anticipate a crisis and simplify the tax code now – like tear it up and start from scratch? That’s called an uphill battle as your own party might not cotton to radical change. But you say you’re an artful master in the deal-making department. Go make one while the sun is still shining and what little time you have left remains on your side.

You’ll note that a purist’s approach to tax reform slaughters many sacred cows in the process. In the event this is intimidating, recall that thing about owing no one anything. Ask yourself a few questions. Will hedge funds, private equity firms and venture capitalists be destitute if you close the carried interest loophole? Do occupants of mansions really need the extra tax break afforded mortgage interest deductibility? And would it be better to bring a big chunk of those overseas profits back home? If you answered yes to that last question, ask around — there are ways to ensure those firms don’t simply plunk what’s repatriated back into share buybacks. We’ve seen how that stagnates economic growth, so why go there?

Tax reform will, by the way, go a long way toward dispensing with the searing criticism you face as you approach the desperate, and bonus, obvious, need to upgrade the country’s crumbling infrastructure. While you might like to have this be a purely privately funded scheme, it’s reasonable to assume that some public funding will come into play – think they call it ‘hybrid’ funding (call up your Australian counterpart for the specifics). The good news is that unlike tax cuts, which can be saved or diverted here or there, investment in bridges, tunnels, roads, schools, hospitals and the like is here to stay and keeps paying economic dividends in the form of the other business spending it induces around it. So, direct and indirect lasting economic benefits.

As for those bubblicious markets, they’re sure to be upset once they get the first whiff of that recession we just discussed. We can agree that letting the air out of the markets will be disruptive, and not in a good Uber way. There are no easy answers on this count. You might be faced with so few options that you’re forced to focus on the really heavy, preemptive, legislative lifting discussed above to mitigate the collateral damage. The best news that can be offered is that reasonably valued assets forge a natural pathway to future economic growth.

Finally, there’s the thorniest issue of all, the Fed. You may note the long road ahead is fraught with legislative barriers. To the extent financing is required, it’s always beneficial to contain borrowing costs. It would be nice to think you could rush into the Treasury market and issue a boatload of 50-year and 100-year bonds. But there are more than even odds that opportunity has been squandered by an epidemic of short-sightedness on the part of your predecessors. Let’s be magnanimous and say they didn’t appreciate the immense fiscal defenses that could have been built up against the backdrop of the lowest interest rates in 5,000 years. Deficit smoke-and-mirrors surely never came into play.

For the here and now, Fed officials seem intent on doubly tightening financial conditions by shrinking the $4.5 trillion balance sheet while raising interest rates. Knowing recessions are an inevitability should give you the resolve to offer the politically-driven doves-turned-hawks two words: “Try me.”

This done, back legislation to reduce the Fed’s mandate to minimize inflation. This will prevent future bouts of mission creep. Next, beef up bank supervision (note, never used word “regulation”) to stay one step ahead of nefariousness. And finally, fill those two open vacancies on the Board, and fast, with individuals who don’t think “no” is a four-letter word. Bring dissent back to the Fed by installing the best and brightest, who also happen to have uncompromising constitutions. Let the new kids on the block carry out your leadership of the Fed by proxy.

Tall orders, one and all? Without a doubt. But at least you’ve got hope, ebullience and inspiration on your side. Surveys of businesses and households suggest you’ve even got the fillip of an economic acceleration in the cards. So seize the moment and embrace the fact that you don’t require a lot of sleep to effectively lead. The hardest deals of your lifetime lie ahead. Don’t back down for all our sakes. And keep Orwell’s words in mind if wily politicians try to bog you down in the weeds. Bravo-Foxtrot-Oscar. An added bonus: it makes a great Tweet.

Sincerely,

We the People

http://dimartinobooth.com/blinding-flash-obvious/

 

Not quite what I said in the post above but interesting nonetheless.

[OriZ 3,157]

Reprinting the latest piece by Hussman in its entirety. Do not agree with everything in it, but nonetheless a very interesting piece by a very smart man.

 

Those who aspire to “right speech” often measure their words with four questions: Is it true? Is it kind? Is it necessary? Is it the right time? Right speech should not escalate conflict, but it doesn’t retreat from necessary truth, and criticisms don’t always seem kind. The question of right speech is the question of how one might best serve others. Criticism with the intent to offend is not constructive, but silence is equally detrimental when it quietly endorses a pattern of offense, or encourages the silence of others.

 

Those of you who have followed my work over the decades know that I look at the world holistically in terms of the interconnection and responsibility we have toward others, and I’ve never been much for separating “business” from those larger values. After all, most of my income regularly goes to charity, and nearly everything that remains follows our own investment discipline. Whether my comments on matters like peace, civility, economic policy or governance are well-received or not (and I'm grateful that they have been over the years), there are moments when one has the responsibility to speak if one has a voice.

 

Our country faces many legitimate political disagreements. There are segments of America that view government as too bureaucratic, see foreign trade as a source of job insecurity, value national security as a priority, believe that each country has the right to a national identity, and feel that even a nation of immigrants has limits on the pace at which it can assimilate new citizens. They feel that their interests have been subordinated to an elitist philosophy that presumes that regulation is always beneficial, and that government always knows best. We can engage honestly and in good faith about those concerns, even where we disagree. Political issues like that are best settled not by insulting each other, but by openly expressing and listening to the values and concerns of each, and constructing solutions where each side might concede or trade various lower priorities, so that both can achieve their higher ones.

 

From my perspective, the problem isn’t politics. A civil society can work out those differences. The immediate problem, and the danger, is the mode of leadership itself. A leader can call forth either the “better angels of our nature” or the worst ones. I am troubled for our nation and for the world because of the example of coarse incivility, mean-spirited treatment of others, disingenuous speech, thin temperament, self-aggrandizing vanity, puerile character, overbearing arrogance, habitual provocation, and broad disrespect toward other nations, races, and religions that is now on display as our country’s model of leadership. I am equally troubled by emerging risk, discussed below, to the Constitutional separation of powers.

 

My intent is not to insult, but rather to name the elements of this pattern. Even in the face of our differences, it’s important that we refuse to resign ourselves to passively accepting or normalizing this model. A dismissive regard for truth, civility, transparency, ethics, and process is dangerous because it lays groundwork and creates potential for unaccountable, corrupt and arbitrary government. I believe that the people of our nation are both decent and vigilant enough to openly and loudly reject this behavior even where they might agree with various policy directions.

 

There is no changing the outcome of what was already a dismal choice for many Americans, but we can insist on rejecting a model of uncivil behavior. It is unworthy of emulating for ourselves, much less for our children. To minimize detestable behavior is essentially to condone it. It is the refuge of cowards to defend obvious offenses by deconstructing them (“He wasn’t belittling a disabled person. See? He’s waving his hands while belittling this person too”), or to condone predatory behavior toward women by diffusing responsibility (“Yeah, but that other guy was also a predator”). Our intolerance for such a tireless pattern of offense shouldn’t depend on our race, or gender, or ability, or political views, even among those who view the man as a means to achieve political ends.

 

With regard to international relations, the intentional provocation of both allies and trading partners is of deep concern. One might allow a generous interpretation that these provocations are intended to create new bargaining chips for use in trade negotiations (e.g. insulting Mexico, taunting China about Taiwan and the South China Sea). Yet even setting offenses aside, the associated protectionism is misguided economics, particularly at this point in the economic cycle. Given U.S. labor demographics, even a 4% unemployment rate in 2024 would bring average annual civilian employment growth to just 0.4% annually in the coming 8 years, while a 6% unemployment rate would place intervening job growth at just 0.2% annually. All other economic growth will rely on productivity growth (output per worker). The primary determinant on that front will be growth in U.S. gross domestic investment (GDI). Because of savings-investment dynamics, steep reductions in the trade deficit have always been associated with a collapse in U.S. GDI growth. Put simply, this new trade strategy courts recession or worse. That’s particularly true given a speculative financial bubble resulting from Federal Reserve’s misguided dogma that zero interest rates would bring prosperity without consequence. We now face the third financial collapse since 2000 (more data on that below).

 

Meanwhile, we should recognize that foreign provocation has also been used around the world, and throughout history, as a strategy to expand domestic control. This often takes the form of “emergency powers.” Given the man’s clear aspiration to accrue and exercise authority, we shouldn’t naively ignore that potential. Recalling James Madison, “If tyranny and oppression come to this land, it will be under the guise of fighting a foreign enemy. The means of defense against a foreign danger historically have become the instruments of tyranny at home.” We have a leader that talks of the benefits of foreign plunder and the virtues of torture, yet we don’t recognize the seeds of despotism? Oh, that’s right, because we’re talking about the “enemy.”

 

The enemy. It’s necessary to prosecute those who commit violence, in order to defend the rights of others, but to entertain notions such as torture, plunder, and the violation of human rights is an insult to the virtues our nation has sacrificed so much to achieve. Hatred does not remove hatred. We have to look into causes and conditions. Prejudice against a whole religion will not bring peace, nor will it contribute to an understanding of what motivates extremism. Whether the roots of violence are about foreign influence, territorial control, fear of losing power, protecting an existing way of life, or perceptions of injustice (whether legitimate or imagined), violence is often clothed in religion, both as a mobilization tactic, and so each side can claim that God is on their side. ISIS is no more about Islam than the Troubles in Ireland were about the religious faith of Catholics or Protestants, or the KKK was about Christianity.

 

We can’t kill and torture our way to peace. We might satisfy pride and the desire for revenge, but the outcome would be a perpetual cycle of hatred, where our children eventually take our place in that cycle. The temptation is for sides both to turn up their high-beams, but as the Reverend Dr. Martin Luther King implored, “Someone must have sense enough to dim the lights.” Again, yes, those who actually commit violence should justly be prosecuted, but it’s madness to make enemies of entire populations. Along with enforcement against violent extremists, it’s essential to seek out and address the legitimate concerns of moderates. The first step toward peace happens when somebody has the courage to look deeply and ask, “How does the person I call my enemy suffer, and what can I do within my power, and consistent with my security, to address that suffering?”

 

We are asked to rally around our new Administration, in the hope that it will be successful. Yet if, even at the outset, “success” asks us to accept the insult to loyal allies; if it asks us to accept daily incivility toward other citizens of our country; if it asks us to accept a demonstrably ill-conceived economic dogma that will do little but provoke trade frictions, weaken domestic investment, and provide tax benefits to the business sector, while indiscriminately shifting the costs and externalities of harmful action onto the public and the environment; if it asks us to accept blind prejudice toward other nationalities and religions; and if it flirts with even the prospect of foreign plunder and torture, then there is little question that we have already lost.

 

A final concern relates to the separation of powers and the relationship between the express will of the People and the actions of the Executive. When the founders of this nation established the separation of powers in the U.S. Constitution, they were serious about it. Over time, through lack of vigilance, the public has allowed this separation to be undermined, to the point where people hardly recognize when violations occur. Here is a reminder. Article I Section I places all legislative powers with Congress. Article I Section 7 provides that all bills for raising revenue originate in the House of Representatives, which are then amended by the Senate. Article I Section 8 provides that only Congress has the power to declare war. Article I Section 9 provides that no money may be spent that is not pursuant to a law enacted by Congress.

 

The Executive branch has the obligation under Article II Section III to “take Care that the Laws be faithfully executed”, and under the Constitution, only after a war is declared by Congress, or the military is called forth by Congress, does the President have the authority to direct military actions. In order to carry out the obligation of Article II Section III, the President may very well issue executive orders, but those orders are not laws in themselves. They are directives that apply only to members of the executive branch, for the purpose of upholding and faithfully executing existing laws previously passed by Congress. If an existing law infringes on the rights of the people, or overreaches the powers enumerated in the Constitution, the role of the Supreme Court is to adjudicate those disputes. If an executive order or an agency’s interpretation of an existing law is challenged, the Court has previously articulated a two-part test: if the intent of Congress is clear, the Court should “give effect to the unambiguously expressed intent of Congress.” If the intent of the law is ambiguous, the Court should examine whether the interpretation is a permissible construction.

 

What I find alarming is that recent executive orders have been announced as new proclamations, instead of faithfully executing the provisions of existing laws duly enacted and funded by Congress under Article I of the Constitution. While the formal language of the orders themselves might reference existing laws, or give lip-service with the phrase “to the extent permitted by law,” the orders then self-contradict by directing the circumvention of those laws (for example, “to the extent permitted by law,” agencies are directed to “waive, grant exceptions from, or delay” the execution of the law, or to identify sources of funding for a project that is nowhere specified in the law).

 

Even the media fail to discuss the fact that the Executive is both obligated to, and constrained by, the express will of the People, not the other way around. Only when Congress passes a law does it become the law of the land, provided it is otherwise Constitutional. To allow a weakening of these separate and enumerated powers is to invite the arbitrary exercise of authority, and even the risk of tyranny, rather than limited, representative government of the people that honors the Bill of Rights, equal protection, and the rule-of-law.

 

I understand that facts are facts, and that this is the election result that our system produced. So what is the point, or the desired outcome, of protest? The fundamental outcome is to raise our vigilance; to preserve our character; to defend the rule of law and the separation of powers; to refuse to normalize or quietly endorse incivility; to promote diplomacy even as we pursue security; to demand more than the example set before us; to call us again and again to the better angels of our nature.

 

We should voice our full expectation that Congress defend those enumerated powers, unmoved by speeches that assert the right of the executive to bind our nation to some “new decree” (who uses the word “decree” in an inauguration speech?) We should also ask that regardless of party, our representatives exercise those powers with dignity that befits our nation. As for individual issues, remember that the laws of our country are not established by tweets in the middle of the night. They are established by Congress. Citizens lose their voice when they fail to use it. All of us, left, right, or moderate, should protect that freedom. The U.S. Senate switchboard is (202) 224-3121. The U.S. House switchboard is (202) 225-3121. An actual person will answer, and can direct you to your state representative. Feel free, also, to forward or reprint these comments as you wish.

 

Foreign trade, real investment, and corporate taxes

While references for many of the foregoing observations are easily available, the basis for a few of the economic and financial comments is provided below. For data and evidence regarding labor market demographics and the components of GDP growth, see my December 12, 2016 comment Economic Fancies and Basic Arithmetic.

 

On the relationship between the trade deficit and U.S. gross domestic investment, the following chart shows data since 1947, and captures the inverse relationship. Think of it this way: Whenever we import a dollar of goods and services, we export a dollar of “stuff” in return. That “stuff” can either be goods and services, or securities. So by definition, when the U.S. is a net exporter of securities to foreign investors, it must also be running a trade deficit in goods and services. That’s just an accounting identity.

 

Investment and savings must be equal in equilibrium (this is also an accounting identity). From a financial perspective, an export of U.S. securities is an import of foreign savings. Putting this all together, booms in U.S. gross domestic investment (factories, capital goods, equipment, housing) are typically financed by an import of foreign savings and corresponding “deterioration” in the trade deficit. Conversely, “improvement” in the trade deficit is systematically related to deterioration in U.S. gross domestic investment.

 

 

The result of all this is that U.S. investment booms are typically associated with a widening, not a narrowing, of the U.S. trade deficit. If you really want a collapse in U.S. gross domestic investment, cannibalize national savings by expanding the U.S. budget deficit through massive spending projects and lower taxes, and simultaneously limit the import of foreign saving by provoking a trade war aimed at “improving” the U.S. trade deficit. That’s precisely the direction this administration is heading. It seems we’ve forgotten the consequences of the Smoot-Hawley Tariff, which was passed in June 1930.

When we look across history at periods of sustained economic growth like those that began in 1982 and 1990, we find that they began from points of significant slack, including high unemployment and a surplus on the trade balance (reflecting prior weakness in gross investment and the general economy). Neither condition is true today.

 

With regard to tax policy, we already know from the 2004 tax holiday that reductions aimed at repatriation of foreign profits don’t result in more investment or jobs, but in stock buybacks and bonuses. I’ve always been a strong advocate of reduced monetary activism, of productive investment, of infrastructure that durably relieves capacity constraints (renewable energy would be one such area), and of expenditures and tax incentives toward those ends, particularly when they are tied to job creation or workforce training. Those approaches deserve bi-partisan support. But the effect of those shifts will emerge over decades, and will not materially alter the course of the real economy over a small number of years.

 

As for current tax policy, the chart below shows effective U.S. corporate taxes as a percentage of pre-tax profits (the negative figures represent recessionary periods when corporations accrued a net tax benefit as a result of loss write-offs - click for a larger image). It’s quite possible that a change in corporate tax policy will change the way that corporations shelter their income, but given that the effective corporate tax rate is already lower than at any time except recessions and the recent recovery, my impression is that investors are vastly overestimating the increment to profits that would result from corporate tax reform.

 

 

Presently, U.S. corporate taxes represent just over 4% of corporate revenues. Historically, the lowest level outside of recession (and the recent recovery) has been about 3%. From here, even moving to the lowest effective U.S. corporate tax rates in history would boost corporate profit margins by scarcely 1%.

 

A massive speculative bubble meets an errant pin

Given limited prospects for a material expansion in already-record profit margins, investors continue to face steep downside risk as the result of obscene market valuations. The consequences of years of yield-seeking speculation are still baked in the cake.

 

Recall that the housing bubble and subsequent global financial crisis had two sources. On the demand side, the Federal Reserve’s decision to hold short-term interest rates at just 1% after the 2000-2002 market collapse created yield-seeking demand among investors for relatively safe but higher yielding alternatives to Treasury bills. They found that alternative in mortgage securities. On the supply side, a poorly regulated Wall Street was more than happy to create new “product” by churning out new mortgage securities. To create mortgage securities, you have to make mortgage loans, so Wall Street lowered credit standards and eventually lent to anyone with a pulse. A combination of "financial engineering" and lax oversight of ratings agencies and GSEs then ensured that much of this odious debt was inadvertently backed by the good faith and credit of Uncle Sam.

 

The resulting bubble and collapse taught us nothing. That same misguided codependence between Federal Reserve and Wall Street has now produced yet another speculative episode. Years of zero-interest rate policy have produced a mature first half of a yield-seeking bubble-crash cycle, but the objects of speculation have now extended to both the stock market and the debt market (particularly the higher-yielding but junkier “covenant lite” variety that provides little protection in the event of bankruptcy). The unpleasant second half of this cycle remains ahead.

 

To offer a sense of what’s likely to unfold, the following chart shows the ratio of nonfinancial market capitalization to corporate gross value added (MarketCap/GVA), which is more strongly correlated with actual subsequent S&P 500 total returns than any alternative measure we’ve studied over time. In the chart below, MarketCap/GVA is shown on an inverted log scale in blue. The red line is the actual subsequent S&P 500 nominal total return over the following 12-year period. At present, we project a likely market loss over the coming decade, with S&P 500 total returns averaging just 1% annually over the coming 12 years. Those aren't much different than the awful market outcomes I projected in real-time at the 2000 market peak. In that instance, the S&P 500 lost half of its value over the completion of the market cycle, with negative total returns for a buy-and-hold approach from March 2000 all the way out to November 2011. Every investment strategy has its season. My sense is that passive, value-insensitive investors are now facing another long, hard winter. Meanwhile, flexible, value-conscious investors are approaching the first day of spring.

 

 

[Note: For a relative ranking of useful valuation measures, see Rarefied Air: Valuations and Subsequent Market Returns; for more detail on the link between these measures and subsequent returns, see Two Point Three Sigmas Above The Norm; and to understand why earnings-based measures should always be adjusted for the position of profit margins in the economic cycle, Margins, Multiples, and the Iron Law of Valuation].

 

The following chart shows some of the most reliable valuation measures we identify in terms of their percentage deviations from historical norms. These measures are currently 125% to 150% above (2.25 to 2.50 times) norms that have regularly been approached or breached over the completion of market cycles across history. At the 2000 and 2007 peaks, we correctly projected the probable extent of the losses that passive investors faced over the completion of the market cycle. Presently, we estimate that this speculative cycle will be completed by market loss in the S&P 500 in the range of 50-60%.

 

 

On the basis of capitalization-weighted indices, historically-reliable valuation measures now approach those observed at the 2000 bubble peak. Yet even this comparison overlooks the fact that in 2000, the overvaluation featured a subset of very large-capitalization stocks that were breathtakingly overvalued, while most stocks were more reasonably valued (see Sizing Up the Bubble for details). In many ways, the current speculative episode is worse, because it has extended to virtually all risk-assets. To offer some idea of the precipice the market has reached, the chart below shows the median price/revenue ratio of individual S&P 500 component stocks. This median now stands just over 2.45, easily the highest level in history. The chart presents data since 1986. The longer-term norm for the S&P 500 price/revenue ratio is less than 1.0. Even a retreat to 1.3, which we’ve observed at many points even in recent cycles, would take the stock market to nearly half of present levels.

 

 

A final comment. With the notable exception of the half-cycle since 2009, we’ve always come out admirably, and with quite a good reputation, over complete market cycles. In the early 1990’s, our historically-informed, value-conscious discipline encouraged a leveraged investment stance for years. We later anticipated both the 2000-2002 tech collapse (and its extent), and shifted to a constructive outlook in early 2003. We anticipated the 2007-2009 global financial crisis (and its extent), and encouraged a constructive outlook in late-2008 once the market was down by more than -40%, as we viewed stocks as undervalued.

 

We also have our faults. We don't shine in the late-stages of a bubble, but that frustration quickly vanishes over the completion of the market cycle. Our real frustration in the half-cycle since 2009 began when I insisted on stress-testing our methods against Depression-era data, observing that valuations similar to those of early-2009 were followed by a further two-thirds loss in the market. We inadvertently stumbled in subsequent half-cycle as a result, because we relied too much on regularities of prior market cycles that were at least temporarily disrupted by zero-interest rate policy (see the “Box” in The Next Big Short for the full narrative).

 

I saw a kind compliment from a reader last week, saying “he’s two steps ahead of all.” Unfortunately, the markets provide better rewards for being only one step ahead. In recent years, deranged Federal Reserve policy added several extra steps to extend the peak of an already dizzying precipice. We’ve made adaptations to address that, but those adaptations don’t encourage us to speculate during the peaking segment of a hypervalued market cycle where the Fed is already tightening and market internals (particularly among interest-sensitive securities) are already deteriorating. As always, our focus remains on the complete market cycle, and our outlook will change as the evidence does.

 

The problem our nation faces is a serious one. We have now paired a massive speculative bubble with an errant pin that has every prospect of creating disruption. A steep financial retreat was already baked in the cake prior to the election. My concern is that having reached this precipice, there are few policies that have the capacity to make the consequences substantially better, but many that could make the outcomes substantially worse.

 

https://www.hussmanfunds.com/wmc/wmc170130.htm

Edited January 29, 2017 by OriZ

[OriZ 3,157]

Good job by Mark Cook.

 

The U.S. stock market at this level reflects a combination of great demand, great complacency, and great greed. Stocks are clearly in a bubble, and like all bubbles, this one is about to burst.

What do previous financial bubbles have in common with this one? There are many similarities, but one in particular is the real estate bubble of the mid-2000s that led to the 2008 global financial crisis. Then, extensive real estate buying overwhelmed supply. People were borrowing even more than 100% of the cost of the real estate, using creative means of financing never seen before in U. S. credit markets.

But debt is debt, which means it is a liability that someone is responsible to repay. That obligation was totally absent in the minds of borrowers and lenders alike — until demand dried up and reality hit.

How is this similar to the market now? The Federal Reserve has created an environment of low- to almost non-existent returns on bank saving accounts, and in the process it ruptured the savings mentality that had been a foundation of American society. People once could live within their means and make a habit of saving some of their income for retirement. They expected banks to pay a rate of interest to savers that was fair and consistent.

When this was no longer the case, people with savings chased returns in riskier areas including stocks, as well as not saving as much. Indeed, the saving generation has been forced into stocks, in which they do not have deep-seated faith. They will take the first opportunity to return to their savings ways again.

Three factors substantiate the view that this market is in a bubble. Each factor warns that stocks are in extremely overbought territory.

The first factor is the CCT indicator. This indicator is a proprietary internal measurement of the general volume of the New York Stock Exchange. The measurements take into account the institutional participation as a ratio of the overall volume. Also measured is the duration of heavy block buying in rallies.

The sum total of all the measurements now shows the lowest bullish energy ever — even lower than in 2008, just before the market crash.

The second factor is the sluggish VIX VIX, -4.98%   and the persistence of readings just above 10. These overbought readings indicate a pressure to return to higher levels, thus requiring downside volatility to neutralize the pressure. The longer this persists, the greater the downside pressure.

The third factor is a short-term daily indicator called the 1.5% one-day decline, which signals a pending environment change in chart patterns. The U.S. market has now gone three months without a 1.5% one-day decline. This is the longest period in the record-keeping history of this indicator — and a sign of imminent danger. Bubbles burst.

http://www.marketwatch.com/story/this-money-making-market-bubble-is-about-to-burst-2017-02-08

[OriZ 3,157]

The bears are dead. Long live the bears. And that, in a nutshell, describes every bubble and emerging bear market there ever was. There is no doubt that the recent market environment has been unrelenting in terms of its unidirectional focus. Yet it is precisely the very market environment bears wanted: Exuberant markets, markets highly stretched above historic moving averages, complacency everywhere and capitulation toward the upside at a time when stocks are the most expensive in many years.

Consider: Not only is the $NDX on its 9th year of consecutive up, but also on its 7th consecutive up week in 2017 (in fact it hasn’t had a single down week in 2017 as of this writing) and on it’s 9th consecutive day up in February.

Yet I’m calling for a coming bear market here at $SPX 2351. This market, while perhaps still going higher, is setting up not for a correction, but a major bear market. And mind you this can grind around for a while. Tops are processes and not events.

And let’s be upfront: I’ve not liked the structural backdrop of markets for quite some time, but have been cognizant of its technical apex potential. The blow-off top scenario if you will (see Media). The reason why is plain: The entire global financial system is 100% dependent on central bank intervention and debt expansion and low rates. There is zero evidence that markets can organically support current assets prices anywhere in the world without any of these things. I’ve outlined my structural concerns in detail in the Market Analysis section in the past and you can read up on them there.

Case in point: 2016, starting off with a sizable market correction, saw the most central bank intervention ever in a coordinated global central bank panic response. With the additional free money promises of “phenomenal” tax cuts, deregulation and infrastructure spending following the US election the perfect trifecta of price acceleration commenced: A continued easy Fed supported by global central banks adding $200B in artificial liquidity per month, continued massive buybacks and promises of more free money which is certain to increase the ever ballooning global debt balloon that hit over $152 trillion in 2016. With no end in sight.

The intervention game is self evident:

Yet this chart, and others, reveal the very seeds of the next bear market. While bulls are celebrating a temporary jump in earnings let me caution that this jump in earnings came again on massive levering up throughout the economy continuing the trend that has been going for years.

Here’s the reality everyone seems to be in complete denial about: When, not if, the next recession hits the world will have to face it with record government, corporate and consumer debt and pension funds severely underfunded.  As far as markets are concerned it appears we are repeating again the cycles of the past major bubbles. Extreme high valuations, extreme high debt and absolutely no fear or concern of anything ever getting in the way. Indeed the current volatility compression is the most extreme in market history rivaling only the beginning of 2007. Now let’s deregulate the banks and unleash them back on consumers seems to be the political wind that’s blowing.

And so global markets are repeating exactly the same mistakes again. As in past bubbles folks that abandon any notion of risk look like geniuses and those that are cautious look the fool for not playing along or trying to fade the mania until they finally capitulate, usually at the wrong time. It’s a nasty psychology, but so it goes.

Yes we can claim growth if people pile into car loans, or move into record credit card debt or if governments continue to run high deficits. All of this was what was required to record paltry GDP growth in 2016. Indeed, it is record debt expansion and central bank intervention that masks the structural ghosts of technology and demographics which are at the core of the problems. And so now, after 8 years of relentless accommodation Janet Yellen was forced to admit today:

“Economic growth has been quite disappointing”

You think?

Yet markets haven’t cared about any of it so far as they are focused on the next carrot. Free money.

Last week and this week we saw markets again buying every free money promise by the new administration hook, line and sinker. I’ve been on the record stating that the fiscal realities will cause a rude awakening (Empty Promises).

As of this weekend even Goldman Sachs seems to start agreeing with my position:

“a large fiscal stimulus will be difficult to achieve in light of fiscal constraints.”

Right.

I’ve been very clear that I sense all these free money promises are marketing fantasies the reality of which will come back to haunt those that bought into the fantasy.

And I’m not alone in this assessment. Here’s Cowen & Co:

“A warning to investors sending stocks to record highs: President Donald Trump’s “phenomenal tax plan” probably won’t be so great.

That’s according to Chris Krueger, an analyst at Cowen & Co., who wrote Monday that bulls are bound to be disappointed after Trump’s hint last week that he was close to announcing a corporate tax overhaul helped send stocks to a three-day rally. Instead of a “bigly comprehensive tax policy paper,” Krueger said what’s more likely is:

• “A puff piece with a lot of adjectives;” or 
• A vague mention of tax reform during Trump’s address to congress Feb. 28; or 
• An executive order directing the Treasury Department to come up with a plan.

“You should not study his policy statements (or when his staff clarify/clean-up) with Talmudic concentration,” Krueger said in a note. “Trump’s White House is non-linear and non-consistent by design.”

And what is the core of this fantasy? That tax cuts and deregulation will suddenly spur real economic growth that was withheld from the world for the past 30 years? Please. The truth is effective corporate tax rates are at the lowest levels they have ever been:

And they have declined steadily for decades. And this very decline has been accompanied by ever higher debt and ever lower real GDP growth. While lower taxes here will add to the wealth of the top 1% yet again it will not magically change the structural picture because it hasn’t in decades.

Has anyone seen a budget with line items? If we see one I suspect it may come with a revenue growth multiple fudge factor of x, but let’s be clear, the notion of tax cuts being deficit neutral are highly unlikely.

The US government will officially reach the $20 trillion debt mark in the next few weeks. Be sure there will be headlines about it left and right and just in time for the debt ceiling limit to be reached and becoming a front and center policy discussion on March 15 at the latest. And right then and there the folks in power have to reveal what they intend to do. And frankly this is a process that can take months into the summer as all kinds of accounting tricks will be used to keep the government running. But they have to make a decision.

And they know:

“We know we’re going to have to pay for this,” said Sen. John Cornyn of Texas, the No. 2 Senate Republican. “The question is whether we do it now or whether we send it to our kids and grandkids and make them pay for it. So that’s an important point that we need to achieve some consensus on.”

The question is whether Donald Trump knows this as well and inherently there is a conflict between the narrative and the reality:

“Trump’s tax cut, estimated to cost almost $5 trillion over 10 years, looks sure to be pared way back. Top lawmakers like House Ways and Means Committee Chairman Kevin Brady, R-Texas, and No. 3 Senate Republican John Thune of South Dakota say the GOP’s tax plans shouldn’t add to the deficit. That would mean tax rates couldn’t be cut nearly as sharply as Trump wants.”

In fact the rift is so large that Fink has prompted to send this warning on Friday:

Trump administration poses risk to global government debt — Fitch

“The ratings company said a less stable US could cause a slew of issues, including “disruptive changes to trade relations” and “exchanges between policymakers that contribute to heightened or prolonged currency and other financial market volatility”. “The materialisation of these risks would provide an unfavorable backdrop for economic growth, putting pressure on public finances that may have rating implications for some sovereigns,” Fitch added…….In Fitch’s view, the present balance of risks points toward a less benign global outcome”. The sovereigns most at risk would be those with “close economic and financial ties with the US that come under scrutiny due to either existing financial imbalances or perceptions of unfair frameworks or practices that govern their bilateral relations”, Fitch said. Among the countries that Fitch pointed to were Canada, China, Germany, Japan and Mexico, but “the list is unlikely to end there”.

So there is no clarity what will happen in terms of actual policies or trade-offs. I’ll leave that for others to discuss, but what I will say is that the charts have produced what one may consider to be upside capitulation while the underlying picture remains horrifically weak.

Indeed troubling signs are popping up everywhere if you look closely:

Tax receipts are not showing signs of a largely expanding economy:

And gross private investment has been lagging severely. Without investment future growth will be tough to come by.

Yes one can use the odd corporate announcement as a marketing tool here and there, but the larger structural realities are what they are.

On the consumer front here’s the issue I see: It’s all debt driven again and pushing people into loans that will hurt them as affordability will become an issue. Retail is being pushed into expensive auto leases at unprecedented levels for example:

Recent real wages data once again disappointed and when you have a spike in inflation it messes with the affordability of things in a big way:

So I’m sorry, but structurally we are again doing the same things that got us into a big mess before: We fly on debt, we let the banks loose and we push retail into bad loans and into things they can ultimately not afford.

Meanwhile we see evidence of banks loan standards being tightened for consumers:

…which is also reflected in stalling loan growth:

So what’s been driving the momentum into stocks here? It’s actually an easily understood trifecta. While we had central banks and buybacks in markets over the past few years the election of Donald Trump with promises of tax cuts, deregulation and infrastructure spending made it a trifecta: Folks piling in long as they are smelling free money. Add to the fact that we are in a seasonal strong period strength and earnings have come in with some growth versus last year strength shouldn’t surprise.

What also shouldn’t surprise is the fact that there is low volume. This has been the cornerstone of every single large rally over the past several years. As organic buyers disappear at higher prices it is algos and the price insensitive buyers, the ones that have no personal stake in the outcome of a long buy at any price, that are dominating the landscape and they are buying till the damn breaks technicals be damned.

Last week on CNBC Fast Money I pointed to one of the charts speaking of the number of stocks above their 50 day moving average deteriorating, a pattern similar to what we saw in the summer of 2015 and in 2007.

Here’s the clip, and that includes the comedy bit at the end when the time delay caused a mix up in communications as we wound the segment up. Hey if you can’t laugh at yourself…..

But the larger technical point is this: While we see complete capitulation to the upside in certain stocks and sectors we see serious weakness beneath.

Indeed most of the new highs coming this week came on negative advance/decliners.

The equal weight chart keeps waving red flags:

Let me highlight several key concerns on the technical front.

The weekly $XIV, the inverse of the $VIX shows historically unprecedented capitulation to the upside. Previous moves of lesser extremes have produced reversions to the lower Bollinger Band:

The $NDX is not only on year 9 of consecutive gains, on 7th consecutive weekly gains in 2017 (every week is up) and on its 9th consecutive day up in February. The consequence of all this? The $NDX is now over 18% above its annual 5 EMA:

Further signs of excess: $NDX 11% above its 200 MA. Daily RSI 79.30 #5266 $AAPL 25% above its 200 MA. Daily RSI 90.43 $136.

And have a look at the structure of $MSFT, not only following a similar path of the 200 bubble days, but also showing a massive disconnect from its quarterly 5 EMA:

Not to mention the upside crashes we just witnessed in the financials led by $GS:

So it remains a rally of the few which are historically extended while the many are showing weakness.

Finally, however, also let’s not forget the larger context: Stocks are PRICEY, indeed the multiple expansion over the past few years has been breath taking on many measures running about 17%-25% above the long term mean.

You get my drift: Just a reversion to the mean and/or technical reconnects imply sizable down moves to come, implying at least 20-30% correction just to reconnect with long term technical averages.

We haven’t had a sizable correction approaching 20% since 2011.

But besides the structural and technical concerns there may be another one to be concerned about.

Consider this sentence:

“By the spring of 2017, production, profits, and wages had regained their 2009 levels.”

That seems about right yes? Except I fudged the numbers. The original sentence:

“By the spring of 1937, production, profits, and wages had regained their 1929 levels.”

8 years after the 1929 crash the economy had recovered and then the economy experienced a downturn amidst a world turning to nationalism (in Europe).

Sound familiar? History may not repeat itself but it can rhyme.

Banks, profits and stock prices have recovered from the 2009 financial crisis. This recovery has come at a steep price however. Record debt, intervention and huge wealth inequality which has seeded the breeding ground for political movements of nationalism.

Now I may be stretching it here comparing 1929 to 2009 and 1937 to 2017, but it’s kind of ironic that we even see the numbers and charts align. Just look at the steady up move in the January and February of that year with one final spike higher in March of that year.

Obviously we are living in a very different world now, and 2017 can play out very differently, but still there are overarching similarities that may be too familiar to ignore completely.

None of us can know when and where this ends, but the notion of perpetual higher prices in a structurally low growth environment is not compatible with a happy ending no matter how much you try to artificially juice it. One may choose to believe recessions will never happen again, and one can choose to believe that ever expanding debt will be consequence free or that somehow we will just muddle through.

However the longer historical view reaches a variant conclusion: The central bank experiment has failed. Janet Yellen will never find a less volatile and calm market environment than now. Still she and her team could not bring themselves to raise rates by one measly quarter point in February. Instead she’s gone back to tinkering about uncertainty. January 2018 can’t come soon enough for her and I actually don’t blame her. Who wants to deal with the aftermath of the next bear market? Certainly not the enablers of its creation.

Folks are very optimistic right now and I can’t blame them as perpetually rising prices are infectious. But we have seen these movies before and sentiment is a fickle thing, it can change on a dime once price moves the other direction. And nobody will be more disappointed than those that were promised the moon and didn’t get it.

No, it does not appear we’ve learned a single thing. Except this time around we’ve indebted future generations with an even higher burden. In fact we doubled global debt in just 8 years. And now we have no choice but to add more or it all falls apart. And that is the core basis of the bear case. The world is trapped in a spiral it has created. And the casino needs consumers to keep spinning the wheel despite their pensions withering away and real wages not keeping up with emerging inflation. But don’t worry, we got phenomenal tax cuts coming. How will we pay for them? Oh trust us growth will be coming. Right.

So we say while this blow-off topping move may eventually extend into 2458 per my technical upside risk target we continue to view strength as a primary selling opportunity in 2017 as the next bear market is already programmed in the market’s excess. And so far it looks like we are getting plenty of selling opportunity in this time period between right here and March as it may prove to be a critical pivot time frame.

Why? Consider the following:

February 2016 was a major bottom, February 2007 was an intermediate top. March 1937 was a major top as was March 2000. And who can forget the major bottom in March of 2009? So there you have it, we are historically stretched toward the upside amidst historic compressed volatility while facing a potential key pivot time frame for markets. And be clear tops don’t happen suddenly, they can stretch out for months with volatility increasing as broad sell-off and counter trend rallies duke it out. I expect volatility to pop “bigly”  in the months to come.

As I said last week on CNBC, while we may squeeze higher, without a corrective move this price advance is getting more bearish by the hour as the energy compression will seek a natural release. The coiled spring scenario if you will.

We shall see. Good luck everyone. It’s going to be a fascinating couple of years.

 

https://northmantrader.com/2017/02/15/the-coming-bear-market/

[OriZ 3,157]

... like watching an amateur high-wire act over the Grand Canyon. It won't end well, but you kind of have to admire the audacity.

 

 

 

--Thanks Hussman

 

 

 

 

[X Factor 1,110]

Yep won't end well. But I will ride this bull until it ends.