One Year To Nowhere

[OriZ 3,157]

While I do not necessarily agree with all of the technical tools that were used or the ways in which some were used, I find this to be an interesting take.

https://northmantrader.com/2016/09/12/time-to-get-real-part-iii/

[OriZ 3,157]

The negative interest rate strategy that Japan and Europe’s central banks have embraced may do more harm than good, according to John Taylor, the creator of an eponymous rule for guiding monetary policy.

“What we are learning is that, in my view, negative rates may not have helped and may have hurt,” Taylor, a professor at Stanford University in California, said in a telephone interview this week. “It could be counterproductive, no question.”

John Taylor

Photographer: Andrew Harrer/Bloomberg

A potential problem is that the strategy of charging banks for a portion of their reserves squeezes the availability of credit.

Bank of Japan Governor Haruhiko Kuroda last week rejected the idea that the negative-rate policy adopted in January had hurt banks’ “intermediary functions” -- their ability to channel savings to lending. Even so, he acknowledged that the move had spurred a powerful drop in long-term yields. That, in turn, hurt earnings on savings including pensions, generating some risk for the “sustainability of the financial function in a broad sense.”

To see what the Taylor rule recommends for benchmark rates around the world, click here.

“The macro models we have don’t really incorporate that financial-sector behavior, so it’s hard to give a magnitude to it,” Taylor said. While some companies may boost investment, others could pare it back, and saving rates could be affected, said Taylor, who served as the U.S. Treasury’s top international official from 2001 to 2005.

More broadly, developed nations aren’t suffering so much from a dearth in demand as a challenge in productivity, especially in the U.S., the economist said. Taylor underscored the importance of shifting focus to government actions, as called for by many and codified in Group of 20 statements. “Other policies have to play a greater role than they have had,” whether in Japan, Europe or the U.S., he said, emphasizing regulatory reforms.

Negative rates have had a big effect on long-term yields, Taylor said, agreeing with Kuroda’s thinking on the dynamic by which they were brought down. “I don’t know how long that will continue,” he said. “It has not had a big impact on inflation and the economy,” he also said.

Fed View

Taylor reiterated his thinking that, in the U.S., the Federal Reserve is behind the curve in raising rates. “The evidence is very weak” for the view shared by some at the Fed that the neutral level for the benchmark rate is now lower than it once was, he said.

“I don’t think we have lots of evidence that it’s lower” than the 4 percent level calculated many years ago, Taylor said. Even if the level is 3 percent, that still leaves the Fed -- at a 0.5 percent upper-bound target -- “a ways to go” to normalize, he said.

The economist, known for an equation that measures where a central bank should set its benchmark rate based on inflation and growth, criticized global policy makers for an excess focus on reaching 2 percent goals for consumer-price gains.

While inflation targets “are useful,” central banks ought not to judge that “below 2 percent we have to have the foot all the way on the floor, and accelerate as much as we can” with stimulus, he said. “That’s what I worry about.”

http://www.bloomberg.com/news/articles/2016-09-13/negative-rates-may-hurt-more-than-help-taylor-rule-creator-says

[OriZ 3,157]

I see Obama tried to take credit for himself for the price of gas again...How pathetic can one be, and how sad is it that some actually buy into that.

[OriZ 3,157]

Interesting day today, looks like we're going to test the pre-brexit highs as support now on the S&P500, they are not much lower from today's close. If they hold the market could continue higher through election day but if they don't we could end up seeing 2,000 and if we see 2,000 that would mean around 10% decline from the top which I said would turn the elections back into a tossup. Below 2,000 favors Trump. Current levels still favor Clinton. All based on this:

http://www.visajourney.com/forums/topic/577938-one-year-to-nowhere/?p=8262915

Another interesting day today. Market opened lower to test the pre-brexit highs(While the cash index didn't go low enough to quite "touch" the line in the chart, the overnight futures were a little lower and did a full test before bouncing) and then finished 1.5% higher. Second thing that happened is that as I've explained in the past here, here, here and here, once the bands start to narrow a sharp move usually follows. We saw a very tight range within the bollinger bands for several weeks with price barely moving(the bands are in dark green), and finally, a break beneath them and a 2.5% sharp down day. However another thing I have said in those 4 links and showed live examples of is that if price breaks out of the bands too violently, and not gradually, we tend to see it snap right back to the "scene of the crime" i.e. the price point where it exited. I'm showing this in today's chart using a little horizontal line and a little circle, that is where price exited yesterday, around 2150. So between knowing we're supposed to at the very least get back there, as well as being at pre brexit highs support, today morning was definitely a good opportunity for a nice swing long, and that is exactly what happened. Now, that doesn't mean support will hold forever but for now the market has a chance to continue higher and Clinton is safe. However as I have said before going beneath the pre-brexit highs may take us down to ~2,000 and there or under life will start getting really difficult for her.

The importance of technical support/resistance levels

[OriZ 3,157]

Well, whadda shock! Bill Gross might be surprised but anyone reading this thread wasn't.

http://www.cnbc.com/2016/09/21/bill-gross-im-hardly-able-to-speak-after-fed-decision.html

I'll say it again T-Bills T-Bills T-Bills

[X Factor 1,112]

Well, whadda shock! Bill Gross might be surprised but anyone reading this thread wasn't.

http://www.cnbc.com/2016/09/21/bill-gross-im-hardly-able-to-speak-after-fed-decision.html

I'll say it again T-Bills T-Bills T-Bills

I don't think the Fed will raise rates in November right before the election. That leaves a possible rate hike in December on the table.

[OriZ 3,157]

I don't think the Fed will raise rates in November right before the election. That leaves a possible rate hike in December on the table.

Them all talk, no action.

[X Factor 1,112]

I expect volatility for the next few weeks all the way to the election. The best trading strategy is to be long volatility via SPY, IWM, QQQ or DIA options. But not via the Vix.

An example: SOLD CUSTOM SPY 20 JAN 17/20 JAN 17/20 JAN 17 212/202/200 PUT/PUT/PUT @-1.10 LMT

Basically initiated for each custom ratio SPREAD in the SPY for the January expiration cycle. One Unit of the JAN spread is comprised of, SELL 1 contract of the 212 puts, BUY 3 contracts of the 202 puts, and SELL 1 contract of the 200 puts close the spreads 1 month prior to expiration to circumnavigate extreme time decay of risk associated with ratio type spreads.

This could get from 100 to 500% gains or more.

[X Factor 1,112]

The above trade is a complex trade but if the market goes up, the loss is very limited and if the market remains at this level the loss is also limited. But it pays off big if the market goes down. Just close the trade 30 days before expiration.

[OriZ 3,157]

The above trade is a complex trade but if the market goes up, the loss is very limited and if the market remains at this level the loss is also limited. But it pays off big if the market goes down. Just close the trade 30 days before expiration.

Got some real good risk/reward there. I think upside is very limited at this point. 2,200-2,250 at best but not more.

Interesting day today, looks like we're going to test the pre-brexit highs as support now on the S&P500, they are not much lower from today's close. If they hold the market could continue higher through election day but if they don't we could end up seeing 2,000 and if we see 2,000 that would mean around 10% decline from the top which I said would turn the elections back into a tossup. Below 2,000 favors Trump. Current levels still favor Clinton. All based on this:

http://www.visajourney.com/forums/topic/577938-one-year-to-nowhere/?p=8262915

Support still holding, for now...

[OriZ 3,157]

Hussman great, yet again. Makes my life easier; Less typing and less thoughts to put into words.

In recent years, the U.S. equity market has scaled the third steepest cliff in history, eclipsed only by the 1929 and 2000 peaks, as investors rest their full confidence and weight on the protrusions of a structurally deteriorating economy, imagining that they are instead the footholds of a robust investment environment.

The first of these is the current environment of low interest rates. While investors take this as quite a positive factor, it’s largely a reflection of a steep downturn in U.S. structural economic growth, magnified by reckless monetary policy. Over the past decade, the average annual nominal growth rate of GDP has dropped to just 2.9%, while real GDP growth has plunged to just 1.3%; both the lowest growth rates in history, outside of the Depression (see the chart below). Indeed, probably the most interesting piece of information from last week’s FOMC meeting was that the Federal Reserve downgraded its estimate for the central tendency of long-run GDP growth to less than 2% annually.

The weakness in real GDP growth is of greatest concern, because it’s largely the consequence of policies that encourage repeated cycles of bubbles and collapses, and chase debt-financed consumption instead of encouraging productive real investment. Indeed, growth in real U.S. gross domestic investment has collapsed since 2000 to justone-fifth of the rate it enjoyed in the preceding half-century, and has averaged zero growth over the past decade. While labor force growth has slowed, it’s really the self-inflicted collapse of U.S. productivity growth, enabled by misguided policy, that’s at the root of the problem.

Ironically, investors have been slow to recognize the implications of declining structural growth precisely because of the opium-like qualities of the Federal Reserve policies that are responsible for it. Fed policy has amplified the feedback loop of weak growth on interest rates, driving short-term rates not only to low single-digits (where historical relationships suggest they ought to be here), but all the way to zero. In turn, the discomfort with zero interest rates has provoked persistent yield-seeking speculation by investors, driving the most historically-reliable equity market valuation measures to offensive extremes. This yield-seeking behavior has also encouraged heavy issuance of low-grade “covenant lite” debt in order to satisfy investor demand for more “product” (just as we observed during the mortgage bubble). Corporate debt has never been higher as a fraction of corporate gross value-added. The result is an enormous volume of overvalued financial securities that rely on the cash flows generated by an increasingly stagnant economy. All of this may feel good, but it’s only a temporary high in a fatal cycle, and the members of the Federal Reserve Board are just dope dealers on speed-dial.

The second outgrowth of a structurally deteriorating economy, which investors have taken as a permanent sign of strength, emerged in the wake of the mortgage collapse and the accompanying global financial crisis. See, it’s an accounting identity that gross domestic savings (household + government + corporate + imported foreign savings) must equal gross domestic investment, and deficits in one sector must show up as surpluses in another. The record profit margins we observed in this cycle were largely an artifact of a profound post-crisis deficit in the government and household sectors, coupled with a QE-induced plunge in the value of the U.S. dollar that prevented the usual deterioration in the current account (the import of “foreign savings”) as gross domestic investment rebounded. These macroeconomic drivers of corporate profits may not be obvious without a bit of arithmetic, but the upshot is that the temporary surge to record profit margins was heavily debt-financed. See the derivation of the “Kalecki equation” in my March 2015 commentEating Our Seed Corn: The Causes of U.S. Economic Stagnation, and The Way Forward for background (and for my views on constructive policies to address our economic situation).

Intuitively, from the standpoint of income and expenses, the spike in corporate profits emerged because the combined deficit of government and households allowed companies to keep on selling despite the fact that payroll expenditures had plunged to the lowest share of revenues in history. The chart below shows employee compensation as a share of corporate gross value-added. In recent quarters, revenue growth has turned down while labor costs (particularly unit labor costs) have advanced, putting pressure on corporate profits. From a the standpoint of sectoral surpluses and deficits, the combined deficit of government and households has narrowed, gross domestic investment is now in retreat, and the trade deficit has deteriorated, all predictably contributing to lower corporate profit margins in recent quarters.

If one invests by way of the rear-view mirror, the recent half-cycle could hardly present a more beautiful picture to investors: low interest rates, record-high profit margins, and equity prices that have appeared to climb to the sky without correction, seemingly guaranteed through the benevolence of central bankers toward the investor class.

Unfortunately, like the housing bubble and the tech bubble before it, this gleeful romp into the land of “this time it’s different” is likely to collapse in a smoldering pile of ruins. The reason is that the very things that have created this glorious rear-view landscape have been obtained by ripping prosperity from the future. By following a dogma that treats debt-financed consumption and financial speculation as a substitute for actual economic growth, policymakers have encouraged obscene valuations, extreme debt burdens, and speculative malinvestment; front-loading market returns to the point where there is little but risk on the financial horizon for the coming 10-12 years (though there will undoubtedly be excellent opportunities much sooner, at points where substantial retreats in valuations are joined by early improvements in market action). We currently estimate S&P 500 nominal total returns averaging just 1.4% annually over the coming 12-year period. The higher investors have driven market valuations, the lower prospective futurereturns have become. What looks beautiful in the rear-view mirror has been torn from the abyss that lies ahead in the windshield.

The most substantial risk is that a mountain of debt and overvalued financial securities has been built on the expectation of permanently high corporate profits, which were actually an artifact of temporary sectoral deficits and monetary interventions. The consequences will unfold as a tidal wave of debt defaults, earnings shortfalls, and pension crises in the years ahead. Unfortunately, in both real and nominal terms, the underlying growth rate of the U.S. economy has never been weaker outside of the Depression; and this is after one of the longest economic recoveries in history. If one couples a sub-3% nominal growth environment with any further retreat in corporate profit margins at all, investors should expect corporate earnings not to grow, but to contract, in the next few years.

On normalized margins, the cyclically-adjusted P/E is now at 36

Presently, S&P 500 reported GAAP earnings (based on generally-accepted accounting principles) are essentially where they stood at the 2007 market peak. Even Wall Street’s optimistic non-GAAP estimates for year-ahead “forward operating earnings” are no higher than they were in early-2014. Still, when we discuss profit margins, the argument is not that the financial markets are at risk simply because earnings will retreat over the next few years. Yes, given sluggish nominal growth, coupled with unit labor costs now outstripping the GDP deflator, the earnings weakness we’ve seen for several quarters does appear likely to continue. But that’s not the main risk.

Rather, the problem is that investors have priced stocks in a way that quietly embeds the assumption that record profit margins seen earlier in this cycle will persist forever. So regardless of whether margins normalize over two years or ten, investors have inadvertently priced stocks at an obscene multiple of representative long-term cash flows.

As I emphasized in Margins, Multiples, and the Iron Law of Valuation, the objective of a good valuation measure is to act as a “sufficient statistic”- not for earnings over the next year or two, but for the entire long-term stream of cash flows that will be delivered into the hands of investors over time.

There are numerous, historically-reliable valuation measures available to investors. While Robert Shiller’s cyclically-adjusted P/E (CAPE) is widely recognized to be more reliable across history than raw trailing price/earnings ratios, it actually underperforms Tobin’s Q, nonfinancial market capitalization/GDP and market capitalization/corporate gross value-added(our preferred measure) in market cycles across history. The reason is that despite using the 10-year average of inflation-adjusted earnings, the CAPE is systematically corrupted by variations in the embedded profit margin, and correcting for that substantially improves its reliability.

A couple of years ago, I showed that it’s necessary to adjust the CAPE by considering itsembedded profit margin. To illustrate why the adjustment is necessary, the chart below, from my May 5, 2014 weekly comment, shows a 3-dimensional scatter of the Shiller P/E, the embedded profit margin (the denominator of the Shiller P/E divided by S&P 500 revenues), and the actual subsequent 10-year nominal annual total return of the S&P 500 Index.

A reliable outlook for subsequent market returns requires investors to consider both the multiple and the embedded profit margin. Notably, when both the multiple and the margin are high, investors are essentially paying prices that represent a rich multiple of already-elevated earnings. Subsequent market returns are predictably dismal. The red dot corresponds to the margin, multiple, and expected return as of May 2014. Because valuations have become somewhat more extreme since then, the prospective 10-12-year market outlook is currently even worse.

The chart below shows just how high reliable measures of valuation have been driven by yield-seeking speculation. Presently, the Shiller CAPE stands at close to 26, which is already well above historical norms, and above anything seen prior to the sequential bubbles (and collapses) of recent cycles. But the CAPE only captures part of the risk, because that 10-year average of inflation-adjusted earnings actually embeds the highest profit margin in history. By accepting the CAPE at face-value, investors are quietly assuming that profit margins will remain at this level permanently. On the basis of normalized profit margins, which systematically produce a more reliable valuation measure across history, the CAPE would presently be at 36.

I get it. Investors don’t want to believe any of this. They prefer popular metrics like price/forward operating earnings despite the relatively weak correlation of that measure with actual subsequent market returns. Wall Street certainly prefers that measure because it can drive forward-earnings estimates up to elevated levels (which are virtually never realized), producing a P/E multiple that can be compared, through a bit of slight-of-hand, with historical “norms” that are based on entirely different earnings figures.

The problem is that stocks aren’t a claim on next year’s earnings. They’re a claim ondecades and decades of future cash flows that will actually be delivered into the hands of investors over time. The only reason to use a valuation multiple is as shorthand for a more detailed discounted cash-flow analysis. But if one uses a valuation multiple, it’s essential that the underlying fundamental should be a reasonably “sufficient statistic” that’s representative not of next year’s earnings, but of that very, very, long-term stream of underlying cash flows.

This is the same argument I made at the market peak in 2000, and again in 2007. While my concerns may have been the subject of debate at the time, the dismissive argument that “profit margins are fine, valuations should be higher, and stocks are going up” was settled by the steepest market plunge since the Great Depression. The fact that those losses have been stick-saved by creating the third speculative bubble since 2000 doesn’t mean that these concerns can be dismissed. No, it means that the spectacular collapse of yet another bubble is going to be replayed over the completion of the current cycle.

At present, we estimate prospective S&P 500 nominal total returns averaging just 1.4% annually over the coming 12 year horizon, with the likelihood of an interim 40-55% market collapse over the completion of the current cycle. It’s tempting to believe that the continued suppression of interest rates will prevent any normalization of valuations “this time.” But when one examines a century of market evidence, it turns out that the completion of every single market cycle in history has brought valuations to the point where prospective returns increased to the 8-10% range or higher. That’s true even of cycles where interest rates were quite low. Indeed, the level of interest rates at any point in time exerts a minuscule effect on the level of valuations observed even a few years later.

Even if we assume dismal enough economic growth that interest rates will remain low indefinitely, what investors might gain from the hope of higher future valuations would be taken away in the form of poor growth in revenues and earnings. Conversely, if we assume that the economic growth will normalize, it follows that the appropriate range of valuations for equities will be the same range that has prevailed for the past century, where the mean is actually less than half of present levels, at least on measures that are actually reliable. Historically, extreme valuations have been a very tight box, from which there has never been a bloodless escape.

To offer some statistical perspective on the subject, the chart below shows theautocorrelation profile of market capitalization/nominal GDP in data since 1926. Autocorrelation describes the relationship of a variable with previous values of that same variable. Autocorrelation is also essentially the “beta” of a regression of a variable on itself. So you can think of the profile below as the average time it takes for overvaluation or undervaluation to “decay.”

Since the autocorrelation profile doesn’t simply collapse to zero in the first year or so, it should be clear that valuations have relatively little effect on near-term outcomes. Instead, notice that the “half-life” of a given departure of valuations from their norms is about 3.5 years. On average, the relationship between current and previous valuations drops to zero after 12 years (which is why we often use a 12-year horizon in our estimates of future prospective S&P 500 total returns). Notably, there’s also a tendency for valuation extremes to “invert” to opposite extremes after about 20 years, which is what we observe as “secular” movements between extreme undervaluation and extreme overvaluation, typically spread across a series of cyclical bull-bear periods.

We often hear the argument “well, stocks were supposedly overvalued a few years ago, and they’re even higher now, so obviously valuations are wrong.” This is like imagining that a house of cards is more stable the taller it becomes. History has repeatedly crushed investors who think like that, because extended deviations from the norm that result in even more extreme valuations tend to be resolved by violent reversion in the opposite direction. If one hasn’t learned this from the extended advances that produced the 1929, 2000, and 2007 peaks, and the collapses that followed, one hasn’t actually studied market history.

The hinge that determines whether an overvalued market will become more overvalued, or whether it will crash, is the prevailing attitude of investors toward risk. Specifically, returns over shorter segments of the market cycle are generally driven by the preference of investors toward risk-seeking or risk-aversion (which we infer from the uniformity or divergence of a broad range of market internals).

As I noted last week, various trend-following elements of our own measures have deteriorated, which moved our near-term outlook from a relatively neutral view to what is now effectively the most negative outlook we could adopt. Moreover, even withoutunfavorable market internals, we would not ignore current valuation extremes. Valuations have now reached the point where we simply observe no historical instances where similar levels were followed by anything but tepid returns or losses, even over a horizon as short as 18-months.

While weak nominal GDP growth over the preceding decade is correlated with both low interest rates and elevated market valuations, this combination actually turns out to be the worst possible setup for future investment returns. Investors are treating the artifacts of deteriorating U.S. structural economic growth as if somehow depressed interest rates and elevated valuations are a good thing. Nothing could be further from the truth. The chart below shows a 3-dimensional scatter of trailing 10-year nominal GDP growth, the ratio of nonfinancial market capitalization to corporate gross value-added (currently at a multiple of 1.9), and the actual subsequent 12-year annual total return of the S&P 500, in data since 1940. Investors are presently sitting near the far bottom corner of this scatterplot.

I remain convinced that whatever incremental returns investors expect from the U.S. stock market in the next few years should be tempered by an estimate of potential losses in the 40-55% range. That outcome would actually be fairly run-of-the-mill over the completion of the present market cycle, from the standpoint of current valuation extremes. Whatever your estimate of potential return, temper it with a historically-informed assessment of the potential risk. Virtually every result in portfolio theory instructs investors to align their exposure in response to two things; the expected return/risk profile of an investment, and the correlation of that investment with other elements in the portfolio. A seemingly “diversified” portfolio of U.S. and international stocks, emerging market securities, and low-grade debt is misleadingly unsound because these asset classes tend to be tightly correlated when risk-premiums expand (investors should demonstrate this to themselves with historical data before it’s too late). Even if investors believe that international equities represent a better value than U.S. equities, their betas still tend to approach 1.0 during general U.S. market declines.

My view remains that investors should make room in their portfolios for safe, low-duration assets, hedged equities, and alternative strategies that have a modest or even negative correlation with conventional securities. The opportunity to take significant exposure to conventional assets is when their risk premiums are elevated and being pressed lower, which typically occurs when a material retreat in valuations is joined by an early improvement in market action. At present, given the fresh deterioration in market internals that I noted last week, investors face exactly the opposite situation. Until this combination of unfavorable valuations and unfavorable market internals is reversed, the risk to capital will remain steep.

https://www.hussmanfunds.com/wmc/wmc160926.htm

[OriZ 3,157]

Having watched the debate I want to say a few words on where the candidates stand where the economy is concerned. Trump actually impressed me this time by realizing reality, while Clinton stuck to the same line as Obama's that they improved the economy and everything is fine and peachy. It's like he actually reads my thread or something, either that or he finally has some real smart people actually advising him. However they are both wrong about one thing and I can't stress it enough. There is virtually 100% chance of a recession during the next term no matter who sits. Also, While Trump was spot on about the market being a bubble and the Federal Reserve being political and enabling it(as I have written here), he is wrong that the only thing to make it pop would be raising rates.

As I wrote before, the hinge that differentiates an overvalued market that keeps going up from one that crashes is market internals. Market internals are not dependent on interest rates. This is why despite low rates the market crashed in 2000-2003, and 2007-2009. This is why despite low rates the market went down sharply last year for a while. Once market internals become unfavorable(as they are now, again, after a short lived improvement in recent months) no amount of Central Bank support can hold the market up. Low interest rates only encourage speculation when investors are already inclined to speculate. That said, I need to see more of this from him to actually back him so for now I'm still voting for myself. He has not retraced stuff he has said in the past yet, where he supported low rates and said he would keep them that way. I want to see him outline what he would do to change this situation, and all I've seen so far from him is support for it. So, while a step in the right direction, it was still not enough.

Regarding the market, this chart shows a composite of regional Federal Reserve and purchasing managers surveys (measured in terms of standard deviations from the mean). Of particular importance is the new orders component of these surveys, as the behavior of new orders and backlogs reliably leads changes in the headline and employment components. The most recent data have been notably weak in that regard.

Meanwhile,YOY growth in real GDP growth has dropped to just 1.2%, which is actually lower than what is normally seen at the beginning of US recessions. The same is true for the 1.9% growth rate of real final sales, not to mention US industrial production, which has contracted YOY. On the lagging side, even year over year payroll employment growth is sputtering at just 1.7%, not far from the 1.4% threshold that is commonly seen at the beginning of recessions.

Still, enough labor market slack has been taken up in recent years that we’re finally observing upward movement in wages. It was reported the other week that the 2015 Census figure for real median household income grew by 5.2% from 2014. It’s a bit challenging to tie that figure out to Department of Labor figures showing that average weekly earnings for all employees grew by just 2.3% in 2015 (1.6% after inflation), since neither household size nor the labor force participation rate budged in 2015. Still, to the extent that employment growth has done anything in recent years, the main impact has been to make labor scarce enough that wages have increased faster than the general price level.

OK, so the leading economic data is showing weakness, but lagging employment data has been strong enough to push wage growth above the level of general price inflation. One would expect that greater household income will result in greater spending and higher corporate profits, no?

Well, it depends. See, if wages were rising because workers were more productive, then we might expect a kind of “virtuous circle” where greater output generates greater incomes, which are then available to purchase the output, so that incomes and profits both rise together. But without productivity growth, the pie doesn’t expand; it simply gets divided differently.

Unfortunately, one of the consequences of an economic system that has persistently encouraged and rewarded debt financed consumption and speculative misallocation of capital is that the growth of US real gross domestic investment has dropped since 2000 to just 1/5 of the growth it enjoyed in the preceding half century. Real US gross domestic investment is at the same level it was a decade ago. With that lack of productive investment, weak growth in US productivity has followed.

That’s a problem for corporate profits here. Rising wages without productivity growth mean that “unit labor costs” - the cost of the labor used to produce one unit of output - are rising. Of course, labor costs represent by far the largest share of corporate costs. Now suppose that unit labor costs rise faster than the prices that companies can sell the output. One would naturally expect profit margins to be pressured lower. It turns out that this expectation is exactly right.

In the chart below, a blue line below zero means that unit labor costs have increased faster than the GDP deflator over the preceding 6 quarters. The red line shows the growth of corporate profits over the same period. Clearly, the weakness we’ve observed in corporate profits is directly related to the fact that unit labor costs have been accelerating; partly because of less labor market slack, but also partly because of tepid productivity growth. The current situation doesn’t bring the phrase “virtuous circle” to mind.

We can also understand why corporate profits are under pressure from the standpoint of the savings-investment identity. In recent quarters, gross private investment has declined, household savings have increased, and both the current account and government spending deficits have been fairly unchanged. Investment must equal saving (household + corporate + government + foreign). Notice that if investment has declined, and household saving has increased, while government and foreign saving are unchanged, it must be that corporate saving (profits - payouts) has declined.

From here, the worst outcome for corporate profits would involve some combination of falling domestic investment, greater household saving, a deteriorating trade deficit (greater “foreign saving”), or a narrower government deficit (greater “government saving”). The best outcome for corporate profits would involve some combination of rising domestic investment, reduced household saving, a narrower trade deficit (lower “foreign saving”), or a larger government deficit (less “government saving”).

Taken together, the big picture is this: First, the evaluation of the expected return/risk profile in US stocks has now again shifted to a substantially more hostile classification, as a result of deterioration in market internals. Several trend following components of those measures have held the near term outlook to a fairly neutral view in recent months. Last week, that view shifted to the most negative outlook yet again. That outlook will shift again, possibly in response to fresh improvement, possibly after substantial deterioration. I'll take the evidence as it arrives.

The best reason to take another step toward normalizing policy has nothing to do with the real economy, and has everything to do with the fact that the Fed has created the third financial bubble since 2000. Unfortunately, if the Fed hopes to reduce the risk of another financial crash, that ship has already sailed. My sense is that the Fed will realize, much too late, that its last opportunity to avoid yet another speculative episode came and left port years ago. As in prior market cycles, the consequences will come. Then again, so will fresh investment opportunities as the current cycle is completed.

[OriZ 3,157]

“In the ruin of all collapsed booms is to be found the work of men who bought property at prices they knew perfectly well were fictitious, but who were willing to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit.”

Chicago Tribune, April 1890

Presently, the broad NYSE Composite Index is at a lower level than it set more than 2 years ago, in July 2014. Including dividends, the index has gained hardly 2%. Several indices dominated by large capitalization or speculative growth stocks, particularly the S&P 500, have performed better, but even here, the index is only a few percent above its December 2014 high. Over the past two years, the behavior of the stock market can be described less as an ongoing bull market than as the extended topping phase of what is now the third financial bubble since 2000.

The chart below shows the current setup in the context of monthly bars since 1995. After the third longest bull market advance on record, fresh deterioration in key trend-following components within our measures of market internals (see Support Drops Away) recently joined this extended, overvalued, overbought, overbullish peak, even as the S&P 500 hovers at the top of its monthly Bollinger bands (two standard deviations above the 20-period average) and cyclical momentum rolls over from a 9-year high. Taken together with other data, we continue to classify present conditions within the most hostile expected market return/risk profile we identify.

The great victory of the Federal Reserve in the half-cycle since 2009 was not ending the global financial crisis; the crisis actually ended in March 2009 with the stroke of a pen that changed accounting rule FAS157 and eliminated mark-to-market accounting for banks (instantly removing the specter of widespread insolvencies by allowing “significant judgment” in valuing distressed assets). The victory was not economic recovery; the trajectory of the economy since 2009 has been no different than the trajectory that could have been projected using wholly non-monetary variables. No, the great Pyrrhic victory of the Fed has been to enable the third most extreme financial bubble in history, on the basis of capitalization-weighted indices, and the single most extreme bubble in history from the standpoint of individual stocks.

Greater fools

Every financial bubble rests on the presumption that there is still some greater fool available to purchase overvalued assets, no matter how overvalued they might become. In the recent half cycle, central banks have intentionally extended this speculation by promising that they, themselves, could be relied upon to be those greater fools. Yet despite the most extreme version of these assurances in Japan, where the Bank of Japan has driven long-term interest rates to negative levels and has purchased stocks outright, the Nikkei 225 index is no higher than it was in November 2014. Indeed, the Nikkei is no higher than it was 30 years ago, having lost more than -60% of its value on three separate occasions, two of them in a period when interest rates were pegged at zero, and never rose above 1%. Investors have been lulled into believing that an endless horizon of weak growth, easy money, and zero interest rates is desirable, when it is actually a syndrome of flat-lining vital signs.

What will drive the next crisis is not some rate hike by central banks (whose activist interventions have essentially zero correlation with subsequent real economic outcomes). Instead, the collapse will emerge both naturally and inevitably, as the progression of the economic cycle takes its course, and investor preferences shift from risk-seeking to risk-aversion. Virtually any commonplace shock is now capable of being a pin-wielding butterfly on this increasingly vulnerable financial bubble. Debt defaults, insolvencies, and pension crises are already unavoidable. Year-over year growth in real GDP, real gross domestic income, durable goods orders, real retail sales, industrial production and other measures are all down to levels typically observed at the beginning of recessions. We won’t pound the tables about imminent recession until we observe fresh weakness in the equity market (even a 7-8% market loss would sharply raise our probability estimates), but it’s important to recognize that financial risks are already fully developed, and as in other bubbles, one usually finds “catalysts” to blame for a collapse only well after the downturn is in full-swing.

The impact of central bank intervention has already weakened progressively in recent years, because it relies on the ability of fools to constantly raise the ante. Pay 82 euros today for a bond that delivers 100 euros a decade from now, and you’ll make 2% annually on your money. Pay 100 euros today and you’ll get a return of zero. Immediately following the Brexit vote, central banks tried to extend that game as global economic conditions weakened. Pay 105 euros today for 100 euros a decade from now, and you’ll actually lose -0.5% annually, but investors will still accept a negative yield in the short-run if they’re convinced the central bank is willing to pay an even higher price that produces an evenmore negative yield.

The problem is that the central bank has to keep following through, which effectively means buying assets at prices that ensure central bank balance-sheet losses - these would essentially be government expenditures of funds that could otherwise be used to benefit the public. At that moment, monetary policy ceases to be monetary policy and becomes fiscal policy. In the past few weeks, both the BOJ and the ECB have flinched in their willingness to cross that rubicon. Meanwhile, the Federal Reserve is legally restricted to buying only government and government agency securities, and even its $4 trillion balance sheet pales in comparison to $300 trillion of global equities and bonds, along with about $1.5 quadrillion in derivatives, that have evidently been bid up on the expectation that central banks are the greater fools willing and able to buy all of it.

The impact of central bank asset purchases on the financial markets remains wholly dependent on investor psychology, particularly the willingness of investors to chase yield and to ignore any risk of capital loss. As I’ve previously demonstrated using both U.S. and Japanese data, monetary easing is only reliably supportive to the financial markets when investors are already inclined to embrace risk (when they aren’t, prices collapse despite aggressive and persistent easing, as they did in 2000-2002 and 2007-2009). The size of central bank intervention has been enormous in terms of the amount of base money that has been created since the global financial crisis, but is also distressingly small in terms of its ability to actually support prices in the absence of investor risk-seeking. The only reliable effect of asset purchases is to increase the amount of zero-interest base money that somebody in the economy has to hold until it is retired. As the 2000-2002 and 2007-2009 plunges demonstrated, when investors become risk-averse enough to prefer safe, low-interest liquidity to risky securities, all the intervention central banks can muster doesn’t do much to halt a collapse.

Sizing up the bubble

As I’ve frequently demonstrated, while earnings are essential to generate the long-term stream of cash flows that securities deliver to investors over time, they are poor “sufficient statistics” for that long-term stream because of variations in profit margins over the economic cycle. For that reason, the measures best correlated with actual subsequent market returns are those that are less subject to those cyclical variations. Among these, the ratio of nonfinancial market capitalization to corporate gross value-added has the strongest correlation (about -93%) with subsequent 12-year S&P 500 total returns. The correlation is negative because higher valuations imply weaker subsequent returns.

Since corporations have to deliver cash flows both to stock holders and bondholders, the combined financial claims on a company are often measured using “enterprise value,” which includes the value of both. In order to respond to the “cash on the balance sheet” argument, I’ve subtracted out the amount of cash held by corporations, so the chart below includes market capitalization and net debt. Notably, the net debt of U.S. corporations, as a fraction of corporate gross-value added, is presently about 2.5 times the historical norm, which largely offsets the impact of low interest rates on the overall financial claims faced by corporations. As my friend Jesse Felder has observed, the ratio of enterprise value to corporate gross value-added is now nearly equal to the level observed at the 2000 market peak.

I’ve noted before that while the bubble peak in 2000 was the most extreme level of valuation in history on a capitalization-weighted basis, the recent speculative episode has actually exceeded that bubble from the standpoint of speculation in individual stocks. The most reliable measures of individual stock valuation we’ve found are based on formal discounted cash flow considerations, but among publicly-available measures we’ve evaluated, price/revenue ratios are better correlated with actual subsequent returns than price/earnings ratios (though normalized profit margins and other factors are obviously necessary to make cross-sectional comparisons).

The chart below shows the median price/revenue ratio across all S&P 500 components, in data since 1986. I should note that from a long-term perspective, the valuation levels we observed in 1986 are actually close to very long-term historical norms over the past century, as the pre-bubble norm for the market price/revenue ratio is just 0.8 in data since 1940. With the exception of 1986, and the 1987, 1990 and 2009 lows, which were moderately but not severely below longer-term historical norms, every point in this chart is “above average” from the standpoint the longer historical record. Presently, the median stock in the S&P 500 is more overvalued than at any point in U.S. history, easily exceeding the overvaluation observed at the 2000 and 2007 pre-crash extremes.

Given the extreme valuations observed in 2000, before the S&P 500 lost half of its value and the Nasdaq 100 lost 83% of its value, it may seem preposterous to think that current valuations are beyond that level for the vast majority of stocks. To show what’s going on, we broke the S&P 500 components into price/revenue deciles, presented in the chart below (thanks to our resident mathematician Russell Jackson for pulling the data together). You’ll notice that the overvaluation at the 2000 peak was really dominated by extreme valuation in the top decile of price/revenue ratios. But you should also notice that for the 80% of stocks outside of the two most expensive groups, recent extremes have gone well beyond the corresponding 2000 levels. Even within the two most richly-valued deciles, current valuations are higher than at any point in history outside of that 1999-2000 extreme.

The picture becomes clearer still if we normalize each decile. For each decile, we’ve subtracted the 1986-2016 average price/revenue ratio for that decile, dividing the result by the standard deviation of valuations in that decile (again from 1986-2016). That gives us a figure measured in standard deviations from the average. I’ll emphasize again that from a longer-term perspective, 1986 valuations were actually historically run-of-the-mill, so recognize that the valuations we presently observe are actually far beyond two standard deviations above the norm for U.S. stocks since 1940.

Put simply, the reason that the capitalization-weighted S&P 500 was more richly valued in 2000 is that its largest, highest price/revenue components were breathtakingly overvalued. Yet if investors didn’t want to invest in hypervalued tech stocks, they still had somewhere else to go. That’s not true today. The chart below shows the minimum and maximum standardized valuation across the 10 deciles of S&P 500 stocks. What’s notable here is that unlike 2000 and even 2007, when at least some of the valuation deciles were trading at somewhat reasonable valuations, we currently observe a situation where investors effectively have nowhere to go. Even the decile with the best relative valuation is at the most extreme level in history.

The chart below shows the median drawdown among stocks in each decile over the subsequent 30 months. Clearly, investors paid dearly for the overvaluation of that top decile in 2000, as the median loss in that group over the subsequent 30-month horizon was more than -80%, very similar to the loss experienced by the Nasdaq 100 index. From their 1999 levels, all of those deciles lost more than one-third of their value over the following 30-months, with the losses in most groups approaching -50%. The 2007-2009 decline was even worse for most groups, with no group losing less than -50%, and some experiencing median losses of -70% or more from their highs. One might think that the losses should segregate more across price/revenue groups, but such cross-sectional comparisons are more complex. For example, grocers almost always stay in the very low price/revenue deciles because they operate in a low-margin business, yet fluctuations in their price/revenue ratios over time are still very informative about subsequent returns. What you see below is that, especially during market declines that follow broad market overvaluation, losses tend to be unmerciful across-the-board.

We forget all of this so easily, don’t we? It’s important to remember how deep those losses were in the 2000-2002 and 2007-2009 periods (even among less overvalued groups that would recover over the longer-term), and that there are now even fewer places to hide. Given current valuation extremes, I doubt that the median loss for any decile of stocks will be less than -40% over the completion of the current market cycle, and I expect that losses will approach -60% more typically than not. At some point in the not-too-distant future, my impression is that the “pain” of earning near-zero interest rates in safe liquidity will be far less daunting to investors than the pain of losing the bulk of their capital. Again, when risk-aversion kicks in during the completion of a market cycle, central bank liquidity does notreliably support stocks, because safe liquidity is seen as a desirable asset rather than an inferior one.

I started this comment with a 126 year-old quote to emphasize that every cycle in history warns investors against relying on speculative extremes to be permanent. I recognize that some of you are going to insist on re-learning this the hard way. We’ve certainly learned our own lessons about the ability of zero interest rate policy to postpone the kind of market collapses that reliably followed overvalued, overbought, overbullish syndromes in other cycles across history (see the “Box” in The Next Big Short for the full narrative). But that temporary suspension of consequences entirely depends on investors remaining inclined toward risk-seeking (which we measure from the behavior of market internals). Following a brief post-Brexit strengthening in a few trend-following components, market internals havedeteriorated again. The danger is that investors seem to believe that easy money supports overvalued financial markets regardless of market internals or the attitude of investors toward risk. The failure of investors to grasp this critical subtlety is likely to be the source of a great deal of pain over the completion of this market cycle.

https://www.hussmanfunds.com/wmc/wmc161003.htm

[OriZ 3,157]

Investors/savers are now scrappin' like mongrel dogs for tidbits of return at the zero bound. This cannot end well.

Bill Gross investment outlook: https://www.janus.com/insights/bill-gross-investment-outlook

[OriZ 3,157]

Different measures of market internals that I watch, such as but not limited to, percentage of S&P500 stocks as well as NYSE Composite stocks above their 50 and 200 day moving averages, NYSE advance/decline, new highs/lows, and more, have again deteriorated to the point where I would not expect any significant advance in the market so long as they remain this way. In recent weeks, we’ve seen a series of abrupt but still shallow and uncoordinated retreats in U.S. and German government bonds, precious metals, and utility shares, along with a brief “flash crash” in the British pound. My impression is that these may be the initial tremors of a more systematic “risk off” shift among investors, but that remains more a possibility than a forecast. Indeed, the current profile on a blended horizon of 2-weeks to 18-months is among the most negative in post-war data outside of the market peaks in 2000 and 2007.

Notably, the broad market has essentially flat-lined since mid-2014, with the NYSE Composite still below its July 2014 level. Market behavior has also increasingly featured sequences of small, marginal advances punctuated by abrupt “air pocket” losses. This behavior reflects what John Hussman often called “unpleasant skew.” See Impermanence and Full-Cycle Thinking for a chart of what the underlying return/risk distribution looks like. From Hussman:

My impression is that one of the “air pockets” ahead is likely to be accompanied by an initial but meaningful credit event, quickly devolving into an outright bear market collapse as trend-sensitive and volatility-targeting investors attempt a coordinated exit on the break of widely-monitored support levels. It’s worth repeating that once risk-aversion kicks in strongly, monetary easing has historically failed to support the markets, because at that point, low-interest liquidity is viewed by investors as a desirable asset rather than an inferior hot-potato. Creating more of the stuff, as investors should recall from the persistent and aggressive easing of the Fed during the 2000-2002 and 2007-2009 collapses, doesn’t promote much more than a few days of risk-seeking.

History teaches that once rich valuations are joined by unfavorable market action, particularly when deterioration emerges across multiple asset classes, steep losses can emerge without specific and identifiable “catalysts” (e.g. 1987). Even when a catalyst is present, it’s typically only a symptom of a larger set of risks, and investors only ascribe it with pivotal importance in hindsight (e.g. Lehman). Still, with regard to specific risks, the most salient vulnerability today is still the European banking system, and while Deutsche Bank has the highest gross leverage ratio among major institutions, the largest French and Swiss banks are close behind. Other risks include unbalanced growth and a property bubble in China, heavy use of leverage in price-insensitive investment strategies, and U.S. corporations that are now more highly leveraged as a ratio of gross value-added than at any point in history. In a very late-stage global financial bubble, which we’re in whether Wall Street or policy makers realize it or not, it’s not really necessary to identify which risk will blow up first as economic growth slows, profit margins narrow, and risk aversion increases. Once a barrel of lit matches rolls into a field of dynamite sticks, you don’t try to predict which one will explode; you just get the heck out of there.

I’m not encouraging investors to sell everything - in aggregate, that’s not even possible. Every security that’s issued has to be held by someone until that security is retired. Despite what I view as wicked overvaluation, someone has to take a hit for the team over the completion of this market cycle. It’s still best if those investors do so after reviewing history and considering or dismissing our own concerns. Whatever your investment strategy, just make sure that it’s sufficiently disciplined and historically informed that you’ll remain willing to follow it, without abandoning it in the face of steep market losses. Again, from Hussman:

Every disciplined strategy has challenging periods over the course of a market cycle. They just come at different times. We’re seeing numerous hedge funds close, across a wide range of investment disciplines, as advisors and pension funds move away from strategies that involve discretion and selective investment, in preference for strategies that are always fully-exposed to market risk. I see this as pure, unadulterated, late-cycle, market-top behavior. Whether you’re a passive buy-and-hold investor or a tactical one, the dumbest thing a smart investor can do with a disciplined, historically-informed, full-cycle strategy is to abandon it after the portion of the cycle where it didn’t do well, and chase a different strategy that did well in hindsight. “Risk-on, all-the-time” has done well in recent years precisely because nearly every asset class has been driven to obscene valuations. By making a shift into passive strategies after-the-fact, investors are locking in the worst prospects for 10-12 year portfolio returns in history, along with the likelihood of awful interim losses.

None of this means that every investment has to be held forever. It’s just that investors can destroy themselves over time by repeatedly chasing companies or strategies they see as “winners” and abandoning companies or strategies they see as “losers.”

With regard to risk, investors should recognize: 1) the potential risk of equity market losses on the order of 40-55%, which would still represent only a run-of-the-mill cycle completion from current valuations; 2) the tendency for seemingly “safer” assets (e.g. dividend-paying stocks, utilities, international stocks in countries with generally lower valuations) to be highly correlated with the S&P 500 when U.S. stocks collapse; and 3) the potential for meaningful bond market losses on Treasuries, corporate bonds, and junk debt in response to yield spikes, given compressed yields, narrow risk-premiums on bonds, and a resulting elevation of durations.

I continue to believe that investors should make room in their portfolios for safe, low-duration assets, hedged equities, and alternative strategies that have a modest or even negative correlation with conventional securities. Even low-yielding cash has significant option value, because it provides investors with the future opportunity to establish exposure to conventional assets after a material retreat in valuations.

“Understand that the worst market declines typically emerge from conditions where value-conscious investors have been defensive for quite some time, and where trend-following speculators have been rewarded for quite some time. The most severe price losses are those where trend-followers are ‘all in,’ followed by an initial deterioration in market action that prompts them to reduce their desired holdings. In contrast, the strongest market advances are those where trend-followers are out (offset by value-conscious investors being all-in) and an initial improvement in market action prompts trend-followers to abruptly increase their desired holdings.

“In market cycles across a century of history, the strongest market return/risk profiles we identify are associated with a material retreat in valuations that is then joined by an early improvement in market action. By the time value investors are all-in, trend-followers are out. They then have to pry stock away from committed value investors once market action begins to improve, driving prices sharply higher. Conversely, the most severe market collapses are associated with steep overvaluation that is then joined by initial deterioration in market action. By the time trend-followers are all-in, value investors are out, and attempts by trend-followers to exit require prices to decline until skittish value-conscious investors are willing to absorb the shares being offered for sale.”

Put simply, current market conditions are associated with small potential returns and enormous latent risks across nearly every asset class. The combination of extreme valuations, weak prospective returns, and emerging risk-aversion suggests that market losses could unfold abruptly, creating an interconnected Rube Goldberg chain of consequences because of the steep leverage that investors and corporations have taken on in recent years. The image that comes to mind is that of speculators scrounging around on their hands and knees to pull a few pennies from the catch of a mousetrap whose hammer is tied to the lid of a box of angry bees and a switch that drops an anvil. Even if there are rewards in the short-run, the situation isn’t likely to end well.

Edited October 17, 2016 by OriZ