A collection of today’s economic, market, political, geo-political, and human-interest news, thoughts, and analysis.
In This Month’s edition:
- Mental Detox
- An Economic View from the Cheap Seats
- A Market View from the Cheap Seats
- Being Prepared
- Random Thoughts
I have not written in a while as I found myself in somewhat of a rut in recent months. The markets are schizophrenic and irrational. The political backdrop has become very tiresome. Geo-political worries remain heightened. Global economies teeter on the precipice. Cats are living with dogs, and the rats go unmolested.
What began as an entertaining departure from the normal election cycle completely wore me out. The process became dysfunctional and downright weird. The dialogue seemed focused on superficial subject matter while ignoring the critical issues confronting us today. We worry more about how someone says something instead of what it is he/she is really saying. Everyone seems caught up in the emotional hyperbole while failing to view matters through a common sense prism.
The markets ignore weakening worldwide economies, and we have a record number of adults not working or under-employed in this country. With this as the backdrop, many politicians and financial gurus keep trying to tell us how much better things are for the average American. The others keep trying to convince us that Americans are worse off than ever. In the meantime, nothing gets accomplished.
As a result, I needed to cleanse. At least that was my goal. I had hoped to flush all the accumulated political and economic toxins clogging my brain. Unfortunately, the view still looks much the same. No surprise I guess.Unlike the expected result from a dietary detox, the weighty issues facing this nation and the world have not lost any of their body mass and instead have become more economically and politically obese. At home, we had a socialist give a criminally-at-risk presidential front-runner all she could handle. On the other side of the aisle, the presumptive winner is about as polarizing an individual as I have seen in my lifetime. Clintons, and Trumps, and Sanders…oh my. I guess this is what the face of change looks like when the American people have finally had enough of ‘hope’ and rise up willing to accept anything out of the ordinary as long as it represents real ‘change’. Maybe, just maybe, the mice are tired of electing cats to represent their best interests.
While the media focuses on what bathrooms are appropriate for gender challenged individuals and New York’s mayor urges a boycott of a fast food chain based on the owner’s personal beliefs, the rest of the world struggles with the ‘new normal’ of terror and slow/no economic growth coupled with stagnant wages. Global debt has continued to spiral up since 2008 when only a small part of the total debt burden brought our financial infrastructure to a screeching halt. Layers and layers of new tax and regulatory burdens continue to strangle growth. Reality makes me want to plant my head back into the sand a little while longer.
An Economic View from the Cheap Seats
Following tepid job growth in April, the May jobs report was the worst in several years showing the economy added a meager 38,000 new jobs, and the prior two-month’s numbers were revised down by 59,000 making it four consecutive months of job contraction. Yet the unemployment rate has miraculously fallen to 4.7%. There must be an election soon. Gluskin Sheff’s David Rosenberg observed that the last five times we saw a four-month job contraction (November 1969, April 1974, October 1989, November 2000, and May 2007), a recession followed on average five months later.
An unemployment rate of 4.7% suggests full employment by historical standards…sure doesn’t feel like it. At full employment, one would normally expect wage inflation to be taking off…it is not. What gives? As I have frequently reported, the more important number is the Labor Participation Rate that finds itself at almost 40-year lows. A reported 664,000 left the workforce in May. This is why the unemployment rate fell to 4.7% from 5%…not because we have such great job growth or a robust economy.
Millions of potential workers have given up and instead have gone on the public dole. A record 94.7 million adult Americans (Source: Bureau of Labor Statistics) are no longer counted in the workforce. While this number includes retired Americans, the majority of these people would still like to work if they could get a job…especially one that pays more than the government pays them not to work.
Reports suggest that slack in the workforce is impeding wage growth. There is a ready supply of labor leaving wages to lag due to the laws of supply and demand. Most of the eligible people who have left the workforce will come back if the right kind of jobs were available. Instead they are incented to live off government (taxpayer funded) entitlement programs where they can make more than if they went to work. Talk about a negative feedback loop. Wages will not go up in meaningful ways until the worker surplus is absorbed.
The limited supply of skilled workers also continues to limit employment. Our educational system is mired in mediocrity, unproductive union roadblocks, and overreaching government controls. Students are not prepared for the technologically advanced workforce today’s business requires. The highest percentage of unemployed are among the inadequately prepared younger segments. Those jobs go elsewhere.
At the same time, policy and regulatory pressures keep businesses from hiring. Instead of hiring for the long term, businesses are adding lower wage, part-time, or temporary workers. Even Yellen acknowledges, “The number of individuals who are working part-time, who would like to have full time jobs is unusually high, and we’ve really not seen much improvement in wage growth, which is suggestive of some slack in the market.” This confirms that we are far from full employment.
Clinton and Sanders bemoan the president’s slow economic recovery, yet President Obama recently traveled to Elkhart, Indiana to tell the nation how his economic policies have brought the economy back. Does anyone else out there see that the emperor has no clothes? He offered Elkhart’s 4% unemployment rate as proof. The sad reality is that the area still has fewer jobs than it did in 2007 and more of the jobs that now exist pay less or are of the part-time variety. This little sample set is quite representative of the rest of the nation….fewer jobs, lower wages, less hours.
We need new, permanent, higher paying jobs, but business is sitting on its hands because it is so hard to add new employees today. Businesses add employees if doing so will grow revenues and profits. Today, businesses are effectively penalized for adding workers, so they don’t. Regulatory creep in other areas serves as system of startup prevention policies. The regulatory elephant in every room is The Affordable Care Act. Using that common sense prism I mentioned earlier, ask yourself what is most likely to create more jobs:
- Lower taxes, reduced regulation?
- Higher taxes, increased regulation?
Throughout our nation’s history, creative destruction has defined an evolution where old, outdated businesses fade away leaving room for more dynamic and productive businesses resulting in GDP expansion. Unfortunately, we have seen steady declines in business formation over the last 30 years as the rate of closures has remained relatively constant.
Today we are witnessing more businesses close than start for the first time ever with fewer companies in America today than there were in 2004. The “new normal” of 2% economic growth, high taxes, and regulatory burdens does little to inspire the entrepreneurial spirit to assume the risk associated with starting a business and hiring people. Big banks have over-tightened lending criteria and community banks have disappeared thanks to Dodd-Frank (23 times longer than Glass-Steagall…passed following the Great Depression.)
From a political perspective, Trump’s candidacy would seem to benefit from dreadful jobs data going into the election while Clinton’s campaign loses on this point. In addition, pension funds are also losers. The data diminishes any chance of the Fed continuing towards interest rate normalization anytime soon which pension plans desperately need to have any hope at all of achieving the kind of investment growth they need to meet their current and future payout obligations.
Donald Trump sounds like his opposition when blaming job losses on international trade. The non-political reality is that international trade has almost nothing to do with it. Every year about 5 million jobs are created and an almost equal number are destroyed. International trade accounts for a very small part of the churn. Almost all is due to competition and technical change.
Trade is about economic efficiencies…not jobs. However, wages tremendously influence trade. For instance, most of us do not make our own clothes. The making of clothes is mostly about using labor most efficiently which creates foreign trade where labor is less expensive. Logically, all the influences that force wages higher in the United States (e.g. taxes, regulatory burdens, union demands, minimum wage creep, etc) end up forcing more international trade. If you want to reverse the flow of trade back to the U.S., find a way to make it easier and less costly to employ people at home. Until we do, the whole ‘bring jobs back’ rhetoric that campaigns spew is virtually impossible to achieve.
The average American could not afford to pay for much of the stuff we consume in the course of our daily lives if it was valued to reflect U.S wages. As long as something can be produced here in a cost efficient manner, it generally is. However, once wage or regulatory pressures make it inefficient, business looks elsewhere. The void created by inefficiency will often find a solution in foreign trade.
By itself, a trade imbalance is essentially meaningless, uninteresting, and to be expected. For example, each of us runs a huge trade imbalance with the local gas station. We buy lots of gas from them, but they buy nothing from each of us. Countries have the same relationships. Some may need more of our stuff than we need of theirs and vice versa. Those imbalances have very little to do with jobs. Jobs are simply a side effect of inefficiencies created often in the form of unintended consequences of government trying to engineer some sort of outcome that stands to benefit them politically. Trump has this one wrong.
The fact that we run a trade imbalance with the rest of the world (we import more than the world exports from us) does not mean we are losing. The world is a big place. We have the ability and resources to get a lot of stuff in other parts of the world. The collective ability, need, or resources of other countries are not the same as ours. As a result, most countries tend to trade with neighbors close by and do without much of the stuff we desire and demand. Historically, we were often at the leading edge of new products and services. The need or market for ‘new’ continually lags in many other parts of the world because we were generally so far ahead of the curve in that respect. However, this too is changing as it is becoming economically inefficient for the entrepreneurial spirit that has driven this country’s economic engine of success to continue to evolve.
So, just how do we go about reversing the forces that are constricting economic growth in this country? Annual GDP growth in the first quarter was only 0.5%. While not recessionary, it’s damn close. How devastating can the new normal be in the future? To understand the potential impact, we need to look back.
John Cochrane offered some analysis and thoughts about how to end America’s slow growth tailspin in a recent Wall Street Journal contribution. Cochrane is a senior fellow at Stanford’s Hoover Institute. He noted that in the 50 years between 1950 and 2000, GDP growth averaged 3.5% per year. Since 2000, the average has been about 1.8%. Since the Great Recession (2009), the growth rate has averaged 2% at a time when recoveries are typically robust.
According to Cochrane, the average American was three times better off in 2008 than they were in 1952. In 2000, the average GDP per person was $50,000 up from $16,000 in 1950. If GDP growth had only averaged 2% over the same 50 years, the average would have only been $23,000. We would be a vastly different country and society under that scenario. History, on so many levels, would have evolved in a radically different manner.
The message is clear. Solving most of America’s problems hinges on growth. While it may not solve the bathroom dilemma we seem to have, it could supply the necessary funding for Social Security, Medicare, defense, environmental concerns, and help deal with our debt problem.
Have we run out of ideas? No…most likely, as Cochrane states, we are the victim of an out of control and increasingly politicized regulatory state. His solutions are:
- Complete tax reform…a complexity detox.
- Reform entitlement spending…eliminate duplication, waste, and properly align motivations.
- Refocus on educating a modern labor force by increasing choice and competition.
- Dramatic legal and regulatory simplification.
As economist Brian Wesbury recently wrote, “The only way to get faster growth in any country is to use fiscal policy levers – tax cuts, spending cuts, and regulatory relief.” These structural reforms have and will work. Monetary policy (interest rate manipulation and Quantitative Easing) has never proven very effective. It can and has artificially buoyed stock market values creating bubbles that eventually burst, but monetary policy does not create sustainable growth. It generally masks the underlying problem.
A Market View from the Cheap Seats
Four months of poor job growth has essentially assured that the Fed will not raise rates anytime soon thus buying more time for the stock market. Weak employment growth following years of weak economic growth creates uncertainty and induces fears of a potential recession. However, Fed inaction will reassure the markets that the free money risk rally may continue…for now.
So what’s next? The recent Barron’s Big Money Poll found financial experts far from optimistic. The consensus seems to be suggesting a time for caution. Only 38% of money managers are bullish down from 55% in the fall. Fully 62% believe the market is fully valued while only 12% see it as undervalued. This is the least bullish sentiment in the poll’s 20-year history making the contrarian in me oddly bullish. While only 16% are outright bearish, two thirds are expecting the markets to pull back 10% or more in the next 12 months largely due to expected disappointing corporate earnings. The bears are very bearish expecting the markets to be down 8% over the next 12 months after having recovered from a far more serious drawdown.
The group does not see an imminent recession…by the way, they never do. Recessions always catch most of the so-called experts by surprise. As a whole, they expect value to outperform growth and that Apple was ‘crazy cheap’ at $106. They must have really loved it when it subsequently traded down to $90. The biggest problems cited were:
- Subpar earnings.
- Economic slowdown and the increasing risk of recession caused by weaker corporate profits.
- Worsening economic turmoil in China.
- Stretched valuations.
- Structural economic headwinds…debt, taxes, regulations.
- …and their biggest fear…THE FED.
The silver lining for investors is when the sentiment has been this bearish in the past it has generally proven to be a bullish sign for the markets. However, we are 84 months into this pathetic recovery. The longest recovery on record lasted for 100 months…not liking our chances in 2017.
Barron’s Mid-Year Roundtable didn’t offer much in the way of inspiring messages either. Most of the experts remained non-committal and noticeably lacked enthusiasm. These pros see continued slow economic growth and modest gains for stocks through the end of the year. The negative comments stood out to me…maybe I’m just biased that way. What follows are a couple of the more notable thoughts worth mentioning:
- Mario Gabelli: U.S. economy continues to grow at a slow but steady pace. The consumer and housing market looks good. The only troublesome spots are student loans and subprime auto debt. He likes the outlook for northern Europe. The market will not finish the year much higher than where it is today.
- Jeffrey Gundlach: The Fed wants to raise rates only to have the ability to ease when the next downturn occurs. He predicts Trump will win in a continuation of the wave of anti-establishment sentiment, the weak economy, slowing corporate earnings, poor jobs data, etc. Trump has not even begun to focus on Clinton’s deficiencies, inconsistencies, and legal problems.
- Brian Rogers: Growth is challenged all over the world, and he expects more of the same. The market may be buoyed because there isn’t any place else to go.
- Scott Black: The market is expensive and there is no earnings momentum to carry it higher. He is not bullish on stocks and concerned about the economy. The political candidates offer platitudes but have no real plan to turn the economy around. Does not expect rate increases. He notes that if the interest rate went up 2% from current levels, it will stress the federal budget by an additional $380 billion per year. Something it cannot afford.
- Felix Zulauf: The equity markets have not done much in the last 24 months other than behaving like a yo-yo. Business fundamentals are weak. We are moving towards a recession and almost all asset prices are near historical highs. Government manipulations have distorted the business cycle. The risk is high and rising that something is going to go wrong in the world economy. He is bearish on stocks, likes high-quality debt, and gold.
I know…not much substance from the Roundtable this time around. That alone might tell you something.
Each year I attend Pershing’s annual INSITE Conference. This year’s was in Orlando the first week of June. One of the speakers I look most forward to hearing is Federated’s Chief Equity Strategist Phil Orlando. We are kindred spirits of sorts in our desire to marry economic cause and effect with the political landscape…only he does it far better. Marshalling Federated’s massive resources and a large staff, he can connect the dots in a way I can only sit back and admire.
I found this year’s presentation compelling and would like to share the high points with each of you. You’ll find his statistical analysis and conclusions fascinating.
In general, Orlando believes that the risk of a near term bear market (20% decline or more) is off the table, but there is a very high probability that the market has gotten ahead of itself and we could see an 8% to 10% retracement over the summer months. His support for this argument is as follows:
- GDP growth is awful. The first quarter is historically not strong. The last two years has seen a strong Q2 bounce following harsh winters. Won’t happen this year and not expecting GDP to be materially better for the balance of the year.
- We’re are in an earnings recession and management has skillfully guided down expectations and is now exceeding the reduced numbers keeping stock prices stable.
- The labor market stalled in April/May.
- Energy bottomed at $26 and then rallied 90% in 4 months…probably ahead of itself. Supply problems have corrected themselves and will come back online (Canadian fires, Libya, Nigeria, Venezuela). Prices will probably retrace to the high $30s. Eventually prices will settle in the $40 – $60 range…high enough to warrant turning fracking back on.
- U.S. Dollar rally is probably over as the economy softens and the Fed backs off.
- The manufacturing recession was about too much inventory, weak trade, and a strong dollar…should be about over.
- The FED will not tighten in front of Britain’s BREXIT decision, the conventions, or the election. Will not risk a market overreaction leaving the December meeting as the most likely next rate hike unless economic numbers strengthen sooner…not very likely.
- The markets are focused on fundamentals right now but will soon focus on the November election…very scary.
- Valuations are stretched at 18x 2016 earnings.
- Seasonal influence: sell in May and go away.
He sees the upcoming presidential election as the most significant one of our lifetime. Who doesn’t? He accurately points out that the following are in play:
- Executive Branch (obviously)
- The Senate – will probably go to whichever side wins the Presidency. Five seats are up for grabs and four of them are currently Republican seats. If they lose a net five, they lose control of the Senate.
- The House of Representatives – a Democratic landslide could bring control of the House with it.
- The Supreme Court – with one vacancy and three justices in their 70s/80s, the next president could appoint four justices potentially changing or securing the balance of power for a generation or more. The four positions are:
- Breyer (age 77 – Liberal)
- Kennedy (age 79 – Swing)
- Ginsberg (age 83 – Liberal)
- Scalia (open/deceased – Conservative)
He sees ‘Anger’ as the new ‘Hope’ this time around. Americans are unhappy by a ratio of 3:1 and 70% believe the country is moving in the wrong direction. National security and terrorism have become the issue of the day with 40% of voters listing it as the most important followed by the economy and jobs. Only 27% list other issues as the most important. Voters are asking two questions:
- Am I safe?
- Is the economy growing?
This sentiment bodes well for the Republican candidate. People are feeling less safe as we continue to gut our defense, and the economy continues to go nowhere. On the other hand, the electoral map favors the Democrats. Of the 270 electoral votes necessary to win, 217 appear safely in the Democrat’s corner. Only 191 seem to be safely Republican with 130 swing votes in play. Seven states will determine the next president.
If your primary concern is the stock market, I found the next data set he offered fascinating. It shows which combination of political party control of the executive and legislative branches is best for the markets:
President Senate House S&P 500 Annual Return
GOP GOP GOP +15.1%
DEM DEM GOP +13.6%
DEM GOP GOP +13.3%
GOP GOP DEM +10.8%
DEM DEM DEM +9.3%
GOP DEM DEM +4.9%
Source: Strategas Research Partners Feb 2016 (1933-2015, excluding 2001-02 when Senate was 50/50)
It doesn’t appear to matter which party controls the White House. The obvious conclusion is that you would always want the Republicans in control of the House of Representatives if your only consideration were the success of the stock market. This was closely followed by GOP control of the Senate. The worst case for the stock market is when the Democrats control both chambers of Congress while the ideal combination for the market is to have Republicans in control of everything.
The stock market has been down only three times during a presidential election year, however…
- All three times occurred when it was an open election year as this one is.
- Over the last 75 years, five presidents serve an 8th year in office. In 4 out of 5 of those years, the market was down an average of 11%.
Interestingly enough, the market picks the next president with 86% accuracy. If the S&P 500 is positive over the three months leading up to the election (Aug – Oct), the incumbent party usually holds the White House. Conversely, if the S&P 500 is down during the same period, the opposing party usually wins.
We have had 11 post-war recessions. Three occurred in the fourth year of a presidential term and seven in the first year. With the current recovery getting very long in the tooth, the next 18 months could be a little dicey.
Orlando went on to compare our lackluster economic recovery to the “Zarnowitz Rule” which has found that economic recoveries are typically inverse to the depth of the recession that occurred. Uncharacteristically, this recovery has shattered the rule producing approximately half of the expected growth rate. He attributes the miss to poor fiscal policy that reduced GDP growth by an estimated 175 bps (1.75%) per year. Re-read Cochrane’s analysis on page 4 for the tragic significance of this outcome.
He addressed Senator Sanders’ fiscal policy platform’s debt risk. When Obama came into office, the national debt was approximately $11 Trillion. It will be a stunning $20 Trillion when he leaves. Estimates suggest that eight years of Sanders would take our debt to an inconceivable $39 Trillion. An analysis of Clinton’s platform would get her pretty close to that number. Unfortunately for fiscal conservatives, I would expect Trump’s policies to settle in with a national debt much closer to Sanders’ projected number than to Obama’s ending debt level.
Another interesting statistic shows how the number of people self-identifying as Independents has increased from 26% in 2008 to 40% in 2015 (source: Gallup/Wall Street Journal):
Republicans 25% 27%
Democrats 49% 30%
Independents 26% 40%
Other 0% 3%
As usual, Independents will determine the election. With Independents currently leaning toward Trump, Democrats hope Gary Johnson (Libertarian Party) pulls many votes away from the Republican ticket. In his opinion, this is the Republican’s race to lose and they are doing a damn good job of doing exactly that.
The world is a crazy place right now. Uncertainties abound on all levels. The lines between market, economic, political, and geo-political worries and risks are blurred. For those willing or able to see, the dynamics driving each of these spaces are changing right before our eyes. What follows is a somewhat edited/abridged version of a piece my partner (Mike McAlister) put out recently. I thought it was particularly well thought out.
Ultimately, how we view the world comes back to the advice we give our clients on how they should invest their assets for the future based on what we know today. Armed with the knowledge that it is impossible to predict where markets will head with absolute certainty, the best solutions involve establishing probabilities of outcome, being more broadly diversified than ever, and sizing one’s allocations appropriately.
We constantly ask ourselves what advice we would give someone today in order to prepare for the next 3-5 years. Since we ultimately do not know how the markets and economy will reconcile the uncertainties, we must prepare for multiple scenarios. That preparation includes having a game plan for how portfolios will behave no matter what unfolds.
Too many investors focus only on today and results from the last 12-24 months. This leads them to lose sight of the obvious. The right thought process today is to think about the future. The past is the past and none of us can change it. Almost everyone is frustrated today. No matter what type of investor you are or who is advising you, your strategies probably have not worked over the last 18 – 24 months. No matter where you are or from what levels you came from, all that is important right now is the future. Where are we likely to be 3-5 years from now? Thinking this way will allow you to make better decisions in the present.
Zooming out, there are only three possible scenarios for which to prepare. For this argument, we will use equities as a proxy for the markets in general:
- Equities will move higher.
- Equities will continue to chop sideways.
- Equities will move lower…perhaps massively so.
Now we must assign probabilities to each of these scenarios. This includes trying to understand what might cause each outcome. While the range of potential outcomes is very wide, the probabilities of success are extremely skewed.
When asked which of the above scenarios is most likely, most will select #2 or #3. Unfortunately, in the majority of cases, investor behavior is totally at odds with these beliefs where most investors (not ours) are positioned for #1.
For purposes of full disclosure, we believe that all the technical and fundamental indications are lining up in an extremely bearish manner. It is very difficult to find data points that would cause one to be even mildly bullish. That said we also recognize that we could be wrong. So what are the likely catalysts for each scenario?
For scenario #1 to work, many things would have to go right. History and the current facts suggest that they will not. If equities continue higher from here, the move will most likely be driven by a continuation of accommodative Federal Reserve monetary policy. No other fundamental or technical view can support significantly higher markets based on available economic data. The Fed is attempting to inflate their way out of the mess we are in at this time. If the Fed wins…if they pull it off, stocks might continue higher. If world central banks fail, and we believe they will (history is on our side), equities could fall precipitously.
Scenario #2 has a much higher outcome probability which will continue to frustrate people and have them looking for different solutions in a world where almost everyone does it the same. In a sideways chop, you need to have exposure to non-traditional spaces that offer growth opportunity without significant risk factors. To beat the market, you have to do something different from the market.
Scenario #3 also has a higher outcome probability over the next 12 -24 months. By any measure, equities are expensive. Optimists are drawing comfort from meager economic data that would have caused considerable worry and been viewed as warning signs in the past. We are in a period of declining earnings and reduced expectations. Geo-political risks are stressing every corner of the globe. Debt is a bigger problem than ever. Demographics and generational behavioral shifts suggest contracting economic growth trends. Tax and regulatory pressures continue to be a ball and chain on growth. In this scenario, investors want exposure to investments that have a higher probability to benefit or at least preserve capital if the markets roll over.
Given the above, being prepared for the potential outcomes requires an investor to be far more broadly diversified than ever before. One must think in terms of diversifying their risks not their assets. The difference is considerable and causes investors to think and behave differently. The advice that most people receive revolves around owning some combination of stocks and bonds. The investor wanders through time believing their portfolio is diversified, and they have appropriately managed their risk exposure. The problem is…they are not and they have not.
So much of investing has to do with discerning between real risk and perceived risk. We believe we have clarity in what we are seeing, thinking, and more importantly, where we are currently taking risk. What we think will change. How we think should be consistent over time.
Fundamentals matter over the long run. From a fundamental or an earnings standpoint there is not much of a case to own equities for anything other than a trade. Historically, a 10x multiple has been cheap and has rewarded buyers. A 20x multiple has been expensive and eventually punishes buyers. At current levels…
- Market volatility is changing
- Equities are expensive (the multiple) by any historical measure
- Earnings are declining
- Monetary policy may have reached its limits.
The relationship between these four variables will become clearer in a moment.
The volatility profile of the equity market seemingly began to change in October of 2014. The S&P 500 closed September of 2014 at 1,972. It closed March 31 of 2016 at 2,063…4% higher from eighteen months earlier, but not without some major price swings. Generally, at major turning points, the volatility profile changes. This can be seen by simply looking at a chart. From 2012 through most of 2014, the S&P 500 climbed higher in a relatively defined channel (dotted red lines). However, since October of 2014, price has move sideways, and the market has been marked by much larger swings than we have previously seen (notated with green arrows on the following chart).
The challenge lies in trying to figure out whether this is a correction in an ongoing bull market or if it is indeed a turning point. The answer will very much determine what to do next. In the meantime, we have been carrying very little risk. We hope to be in a position soon where we are willing to add more risk because a new trend has developed…up or down. For now, the prudent path is to trade small, de-risk, and remain patient.
EARNINGS & THE MULTIPLE:
GAAP stands for Generally Accepted Accounting Principles. GAAP earnings are real earnings. They are the only earnings that a company can spend. Pro-forma earnings are GAAP earnings minus “one-time events”. Essentially, they are manipulated earnings. There are always “one-time events” to report.
The S&P 500 ended 2015 62% higher than where it closed in 2011 with no correlating growth in GAAP earnings. Thus, the gains we have experienced since 2011 is multiple expansion to where the S&P 500 now trades at 22 times GAAP earnings…expensive by all historical standards. In addition, we now are facing a period where most experts are projecting a declining trend in earnings. Since the most important determinant of market valuations is earnings, a declining trend not bode well for equity markets over the next few years.
The most likely explanation for the expansion in multiples is the Federal Reserve and central banks around the world. Monetary policy has flooded the world economies with capital in a failed attempt to stimulate meaningful economic growth. That increase in money supply has essentially funded the growth in the equity markets in the form of multiple expansion. What has the central banks so worried? Moreover, if everything is as good as they say it is, then why is all this intervention necessary?
Our contention is that central banks are concerned about over indebtedness as well as changing demographics because they know that the result of those two things is deflationary. For those of you curious as to why, recommended reading is The Holy Grail of Macroeconomics by Richard Koo and/or any quarterly missive under ‘Economic Overview’ at www.hoisington.com.
Regardless, the Fed has had a massive impact on asset prices over the last several years. In practical terms, we are trying to figure whether we are in a new Fed induced era of permanently higher multiples or whether we will come crashing back to reality. All of which brings us back to differentiating between real risk and perceived risk.
Two independent Wall Street firms, Stifel Nicholas and GMO, have taken a crack at trying to determine how much of the market rise can be credited to Fed and central banks’ stimulus efforts. They went about it different ways, but both ended with similar conclusions. Stifel and GMO concluded that the valuation of the market is almost 2 times what it would have been without Fed intervention, and that fair value for the S&P 500 minus the Fed impact is somewhere in the 1,100 – 1,300 range. That is very similar to where prices were the last time GAAP earnings were last what they are today.
There are a number of clues indicating that the uptrend in Q4 of 2014 may have been the current bull market’s last hurrah. If we are moving into a bear market cycle, the Fed may find itself without the tools it has historically employed such as massive easing. Today, there is very little that they can do.
On a longer-term time horizon (years), we believe real risk to be much higher than perceived risk. No one rings a bell when a bull market ends or a bear market begins. Instead, there are subtle changes to the underlying behavior of prices, and as time passes, those subtle changes become less and less subtle. From 2009 through 2014, the S&P 500 enjoyed an incredible bull market. Rising earnings and expanding multiples were behind these gains. If we are in the midst of a major turning point as the market transitions from bull to bear – what worked in a bull market will not work in a bear market. As a result, we have been trading small. We have been trading with reduced positions sizes for a year now.
This period will not last forever, and we hope it ends soon. Our view is simple…we believe it is more likely that this resolves bearishly than bullishly. Being prepared now will preserve both physical and emotional capital and allow investors to participate in some positive way no matter which scenario plays out. When the big opportunities present themselves, and they will, we will be ready to seize those opportunities with confidence.
You know how some numbers just jump up and grab your attention? Here are a couple of doozies:
- Approximately one third of young adults between the ages of 18-34 now live with their parents. This is up from 20% in 1960 and speaks to how difficult things really are in today’s economy. I remember as a child most families only had one working spouse. Now that is the exception to the rule. Social and economic changes…not necessarily for the better have forced that transition to occur. The same is true for young people forced to live at home. From a high level, the genesis of this phenomenon is government getting bigger and bigger, the tax burden getting ever more onerous, and the regulatory environment making it more difficult for people to find higher paying jobs or start businesses. Personally, I do not hold out a lot of hope that this trend will reverse itself anytime soon. I suspect that we will see three-generation households rapidly increase as those in retirement live longer and young adults struggle to advance.
- The Wall Street Journal reported that NASA’s chief toxicologist estimates that between 210,000 and 440,000 Americans die each year due to medical error. This includes outpatient treatments, misdiagnosis, and failure to identify medical issues. Approximately 700,000 people are infected while hospitalized…75,000 of which die as a result. The article suggested that many die due to poor access to medical records. I almost understand why our grandparents feared the hospital way back when. Too often, when they went in, they never came out.
- It is estimated that one third of all cash on U.S business balance sheets is held by only five companies…Apple, Microsoft, Alphabet (Google), Cisco, and Oracle. In total, these five companies have chosen to hoard $526 Billion rather than reinvest in an uncertain, overly regulated economy. There is a message in here somewhere. Free market capitalists would like to see a more business friendly environment ensue where the risks and burdens of putting that capital to work are significantly reduced. Progressives eye this pot of gold as a source of capital to be redistributed either by the government confiscating it to bolster entitlement programs or by forcing companies to pay it out through anti-growth regulations such as an increased minimum wage or broader overtime pay rules. The free market path creates growth, jobs, and more tax revenues from the result. The other restricts growth with the opposite effect on jobs and tax revenues. Am I wrong?
- The headline read, “Investors haven’t hoarded cash like this in 15 years.” A recent BOA Merrill Lynch’s fund manager survey found that investors have 5.7% of their holdings in cash. Does that number seem surprisingly small? It did to me. Hoarding? Safer? I think not on both counts.
I still don’t understand why Americans want to entrust the oversight and management of major organizational entities and programs to the federal government. This was not our founder’s intent. Government repeatedly proves its inability to manage programs in an economically prudent manner. In addition, operational inefficiencies are the rule. If the private sector performed in a similar manner, we would have no economy. The private sector is so much better suited to manage programs and enterprises where experienced leadership is held accountable for outcome. The TSA fiasco is only the most recent example of governmental bureaucratic inefficiencies while the VA continues to provide grossly inefficient service to some of the most deserving American citizens, and don’t get me started on healthcare…maybe next month.
President Obama surprised me by appointing the most conservative SCOTUS nominee that a Democratic president has appointed since FDR. Let’s unpack this nomination. It was only made because Obama knows it will never be acted on. If this were a serious nominee, it would have been a young, minority candidate with a very progressive resume. It was done as part of a political chess game so they can hold it over the Republicans head as they are accused of obstructing the process. Republicans seem to be determined to invoke the Biden Rule: no SCOTUS nominee considerations during a presidential election year. The calendar now almost assures no action will be taken before the election. Congress will effectively be in session for only about three weeks between now and then. If Hillary wins, watch the Senate move quickly to confirm. If Trump wins, no new justice until mid-year 2017 at the earliest, and it will not be Garland.
As reported in the Wall street Journal, the late Nobel Prize-winning economist Milton Friedman proposed school vouchers 60 years ago. Now, six decades later, we have some good evidence that they work. Today 26 states and Washington DC have some sort of private school choice program and the concept continues to grow. The University of Arkansas’ Department of Education Reform published a recent study that demonstrates that students using vouchers produce significantly higher test scores in math and reading. The results indicate that students do better if they have access to private school choice and achievement surges the longer a child is in the program.
Much is made of the near $20 Trillion Federal Debt, which has doubled under President Obama. That’s chicken feed! Harvard economist Jeffrey Miron looked out 75 years and calculated that the present value of future U.S. Government expenses based on current expenditures and revenue sources will exceed the value of future government revenues by $117.9 Trillion. Based on this estimate, our debt will increase by over 600% in today’s dollars. It appears more likely that this forecast will never occur because our economy will have imploded long before. There seems to be little chance that we will see the serious reform necessary on many levels that may forestall or even eliminate the risk of a catastrophic outcome. Nothing in either Trump’s or Clinton’s platforms suggest that they will take serious steps towards reform.
The work ethic we inherited growing up has given way to the Welfare System. The Cato Institute released an updated 2014 study showing that welfare benefits pay more than a minimum wage job in 33 states and the District of Columbia. Even worse, welfare pays more than $15 per hour ($31,200) in 13 states. According to the study, welfare benefits have increased faster than minimum wage. It is now more profitable to sit at home and watch TV than it is to earn an honest day’s pay. Hawaii is the biggest offender where welfare recipients earn $29.13 per hour, or a $60,590 yearly salary, for doing nothing. What follows is the list of the states where the pre-tax equivalent “salary” that welfare recipients receive is higher than having a job:
1. HI: $60,590 8. VT: $42,350 15. MN: $29,350 22. SD: $26,610 29. AL: $23,310
2. DC: $50,820 9. NH: $39,750 16. DE: $29,220 23. KS: $26,490 30. IN: $22,900
3. MA: $50,540 10. MD: $38,160 17. WA: $28,840 24. MI: $26,430 31. MO: $22,800
4. CT: $44,370 11. CA: $37,160 18. ND: $28,830 25. AK: $26,400 32. OK: $22,480
5. NY: $43,700 12. OR: $34,300 19. PA: $28,670 26. OH: $26,200 33. LA: $22,250
6. NJ: $43,450 13. WY: $32,620 20. NM: $27,900 27. NC: $25,760 34. SC: $21,910
7. RI: $43,330 14. NV: $29,820 21. MT: $26,930 28. WV: $24,900
The average Middle Class annual income today is $50,000, down from $54,000 at the beginning of the Great Recession. Is it any wonder that people stay home rather than look for a job?
A Little Levity
What follows are some of my favorite cartoons from the last few months. Each one speaks volumes:
Have a great month!