Tag: John Hussman (page 1 of 2)

Weekend Reading: You Have Been Warned

Authored by Lance Roberts via RealInvestmentAdvice.com,

Investors aren’t paying attention.

There is an important picture that is currently developing which, if it continues, will impact earnings and ultimately the stock market. Let’s take a look at some interesting economic numbers out this past week.

On Tuesday, we saw the release of the Producer Price Index (PPI) which ROSE 0.4% for the month following a similar rise of 0.4% last month. This surge in prices was NOT surprising given the recent devastation from 3-hurricanes and massive wildfires in California which led to a temporary surge in demand for products and services.

Then on Wednesday, the Consumer Price Index (CPI) was released which showed only a small 0.1% increase falling sharply from the 0.5% increase last month.

This deflationary pressure further showed up on Thursday with a -0.3 decline in Export prices. (Exports make up about 40% of corporate profits)

For all of you that continue to insist this is an “earnings-driven market,” you should pay very close attention to those three data points above.

When companies have higher input costs in their production they have two choices: 1) “pass along” those price increase to their customers; or 2) absorb those costs internally. If a company opts to “pass along” those costs then we should have seen CPI rise more strongly. Since that didn’t happen, it suggests companies are unable to “pass along” those costs which means a reduction in earnings.

The other BIG report released on Wednesday tells you WHY companies have been unable to “pass along” those increased costs. The “retail sales” report came in at just a 0.1% increase for the month. After a large jump in retail sales last month, as was expected following the hurricanes, there should have been some subsequent follow through last month. There simply wasn’t.

More importantly, despite annual hopes by the National Retail Federation of surging holiday spending which is consistently over-estimated, the recent surge in consumer debt without a subsequent increase in consumer spending shows the financial distress faced by a vast majority of consumers. The first chart below shows a record gap between the standard cost of living and the debt required to finance that cost of living. Prior to 2000, debt was able to support a rising standard of living, which is no longer the case currently.

With a current shortfall of $18,176 between the standard of living and real disposable incomes, debt is only able to cover about 2/3rds of the difference with a net shortfall of $6,605. This explains the reason why “control purchases” by individuals (those items individuals buy most often) is running at levels more normally consistent with recessions rather than economic expansions.

If companies are unable to pass along rising production costs to consumers, export prices are falling and consumer demand remains weak, be warned of continued weakness in earnings reports in the months ahead. As I stated earlier this year, the recovery in earnings this year was solely a function of the recovering energy sector due to higher oil prices. With that tailwind now firmly behind us, the risk to earnings in the year ahead is dangerous to a market basing its current “overvaluation” on the “strong earnings” story.

Don’t say you weren’t warned.

In the meantime, here is your weekend reading list.


Trump, Economy & Fed


VIDEO – It’s A Turkey Market


Markets


Research / Interesting Reads


“The only function of economic forecasting is to make astrology look respectable.” – Sir John Templeton

http://WarMachines.com

Why America’s Retail Apocalypse Could Accelerate Even More In 2018

Authored by Michael Snyder via The Economic Collapse blog,

Is the retail apocalypse in the United States about to go to a whole new level? 

That is a frightening thing to consider, because the truth is that things are already quite bad.  We have already shattered the all-time record for store closings in a single year and we still have the rest of November and December to go. 

Unfortunately, it truly does appear that things will get even worse in 2018, because a tremendous amount of high-yield retail debt is coming due next year. 

In fact, Bloomberg is reporting that the amount of high-yield retail debt that will mature next year is approximately 19 times larger than the amount that matured this year…

Just $100 million of high-yield retail borrowings were set to mature this year, but that will increase to $1.9 billion in 2018, according to Fitch Ratings Inc. And from 2019 to 2025, it will balloon to an annual average of almost $5 billion. The amount of retail debt considered risky is also rising. Over the past year, high-yield bonds outstanding gained 20 percent, to $35 billion, and the industry’s leveraged loans are up 15 percent, to $152 billion, according to Bloomberg data.

 

Even worse, this will hit as a record $1 trillion in high-yield debt for all industries comes due over the next five years, according to Moody’s.

Can you say “debt bomb”?

For those of you that are not familiar with these concepts, high-yield debt is considered to be the riskiest form of debt.  Retailers all over the nation went on a tremendous debt binge for years, and many of those loans never should have been made.  Now that debt is going to start to come due, and many of these retailers simply will not be able to pay.

So how does that concern the rest of us?

Well, just like with the subprime mortgage meltdown, the “spillover” could potentially be enormous.  Here is more from Bloomberg

The debt coming due, along with America’s over-stored suburbs and the continued gains of online shopping, has all the makings of a disaster. The spillover will likely flow far and wide across the U.S. economy. There will be displaced low-income workers, shrinking local tax bases and investor losses on stocks, bonds and real estate. If today is considered a retail apocalypse, then what’s coming next could truly be scary.

I have written extensively about Sears and other troubled retailers that definitely appear to be headed for zero.  But one major retailer that is flying below the radar a little bit that you should keep an eye on is Target.  For over a year, conservatives have been boycotting the retailer, and this boycott is really starting to take a toll

Target has been desperately grasping at ideas to recover lost business, including remodeling existing stores and opening smaller stores, lowering prices, hiring more holiday staff and introducing a new home line from Chip and Joanna Gaines. But Target stock remains relatively stagnant, opening at 61.50 today—certainly nowhere near the mid-80s of April 2016, when the AFA boycott began.

In the past, retailers could always count on the middle class to bail them out, but the middle class is steadily shrinking these days.  In fact, at this point one out of every five U.S. households has a net worth of zero or less.

And we must also keep in mind that we do not actually deserve the debt-fueled standard of living that we are currently enjoying.  We are consuming far more wealth than we are producing, and the only way we are able to do that is by going into unprecedented amounts of debt.  The following comes from Egon von Greyerz

Total US debt in 1913 was $39 billion. Today it is $70 trillion, up 1,800X. But that only tells part of the story. There were virtually no unfunded liabilities in 1913. Today they are $130 trillion. So adding the $70 trillion debt to the unfunded liabilities gives a total liability of $200 trillion.

 

In 1913 US debt to GDP was 150%. Today, including unfunded liabilities, the figure becomes almost 1,000%. This is the burden that ordinary Americans are responsible for, a burden that will break the US people and the US economy as well as the dollar.

The only possible way that the game can go on is to continue to grow our debt much faster than the overall economy is growing.

Of course that is completely unsustainable, and when this debt bubble finally bursts everything is going to collapse.

We don’t know exactly when the next great financial crisis is coming, but we do know that conditions are absolutely perfect for one to erupt.  According to John Hussman, it wouldn’t be a surprise at all to see stock prices fall more than 60 percent from current levels…

At the root of Hussman’s pessimistic market view are stock valuations that look historically stretched by a handful of measures. According to his preferred valuation metric — the ratio of non-financial market cap to corporate gross value-added (Market Cap/GVA) — stocks are more expensive than they were in 1929 and 2000, periods that immediately preceded major market selloffs.

 

“US equity market valuations at the most offensive levels in history,” he wrote in his November monthly note. “We expect that more extreme valuations will only be met by more severe losses.”

 

Those losses won’t just include the 63% plunge referenced above — it’ll also be accompanied by a longer 10 to 12 year period over which the S&P 500 will fall, says Hussman.

A financial system that is based on a pyramid of debt will never be sustainable. 

As I discuss in my new book entitled “Living A Life That Really Matters”, the design of our current debt-based system is fundamentally flawed, and it needs to be rebuilt from the ground up.

The borrower is the servant of the lender, and our current system is designed to create as much debt as possible.  When it inevitably fails, we need to be ready to offer an alternative, because patching together our current system and trying to re-inflate the bubble is not a real solution.

*  *  *

Michael Snyder is a Republican candidate for Congress in Idaho’s First Congressional District, and you can learn how you can get involved in the campaign on his official website. His new book entitled “Living A Life That Really Matters” is available in paperback and for the Kindle on Amazon.com.

http://WarMachines.com

‘Hindenburg Omen’ Meets ‘Titanic Syndrome’ For The First Time Since October 2007

Two weeks ago we warned that a cluster of the infamous Hindenburg Omens was forming. Since then stocks have suffered their biggest drop in 3 months…

However, the Hindenberg Omen is not exactly flawless and has false-alerted a number of times in the last few years.

Which is why, John Hussman has adapted the signals and is now warning of a very significant convergence of the 'Hindenberg Omen' and the 'Titanic Syndrome'…

I’ve noted over the years that substantial market declines are often preceded by a combination of internal dispersion, where the market simultaneously registers a relatively large number of new highs and new lows among individual stocks, and a leadership reversal, where the statistics shift from a majority of new highs to a majority of new lows within a small number of trading sessions.

– John P. Hussman, Ph.D., Market Internals Go Negative, July 30, 2007

Just a brief comment on market action.

On Tuesday November 14, the number of NYSE stocks setting new 52-week lows surged above the number of stocks setting new highs, with both figures representing more than 3% of total issues traded.

This “leadership reversal” joins the deterioration in our own measures of market internals last week, as well as ongoing dispersion in market breadth and participation.

As noted in the chart below, this couples a “Hindenburg” with a “Titanic,” and is actually the first time since July 2007 that we’ve seen this particular combination of internal deterioration. Each of the red bars below was also associated with unfavorable market internals on our own measures.

While the names of these indicators may seem silly and overly menacing, they actually get at something very serious.

They capture situations where the major indices are near new highs, yet market internals show much greater divergence. In my view, this type of market behavior is indicative of a subtle shift in the preferences of investors, away from speculation and toward risk-aversion. Coupled with the most extreme “overvalued, overbought, overbullish” syndromes on record, the behavior of market internals warrants close attention. Credit spreads are also worth monitoring, as junk bond yields have surged in recent days.

Importantly, we always have to allow for the possibility that market internals will recruit fresh strength. Our measures of internals reflect current, observable conditions, and suggest increasing investor risk-aversion, but this deterioration is not a “lock” on a negative outlook. We’ll take the evidence as it arrives, but today’s leadership reversal seems worth noting in the context of the other internal deterioration we’ve observed in recent days.

As a sidenote, if we expand the window for a leadership reversal to within 10 days of a 12-month high instead of 7 days, there would be one additional signal on the chart above, in October 2007.

That was also notable in the context of broader internal deterioration, including three “confirmed” Hindenburg signals on Peter Eliades’ criteria (which are more stringent than signals based on new highs and lows alone). Taken alone, I’ve often observed that signals like Hindenburgs and Titanics aren’t nearly as ominous as they sound. However, they are more informative when they are coupled with broader evidence of internal deterioration, particularly following extended periods of overvalued, overbought, overbullish market conditions.

As I noted in real-time, just after the what turned out, in hindsight, to be the 2007 peak:

Though I wouldn’t take the 3 consecutive signals last week as a compelling warning in themselves, I do think they deserve mention because they are occurring so close to unusually overvalued, overbought, overbullish conditions that independently warranted concern last week. With regard to our own measures relating to new highs and new lows, we observed a ‘leadership reversal’ last week – a sudden flip from new highs dominating to new lows dominating, with significant numbers of both, within a few days of a market peak. Those reversals are generally a signal that there is an underlying “turbulence” in market internals, which is a symptom of increasing skittishness by investors.

– John P. Hussman Ph.D., Forget the Lesson, Learn it Twice, October 22, 2007

http://WarMachines.com

Weekend Reading: It’s The Debt, Stupid

Authored by Lance Roberts via RealInvestmentAdvice.com,

As I noted last Friday, the recently approved budget was an anathema to any fiscally conservative policy. As the Committee for a Responsible Federal Budget stated:

“Republicans in Congress laid out two visions in two budgets for our fiscal future, and today, they choose the path of gimmicks, debt, and absolutely zero fiscal restraint over the one of responsibility and balance.

 

Passing fiscally irresponsible budgets just for the sake of passing “tax cuts,” is, well, irresponsible. Once again, elected leaders have not listened to, or learned, what their constituents are asking for which is simply adherence to the Constitution and fiscal restraint.”

I then followed this up this past Monday with “3 Myths Of Tax Cuts” stating:

“Tax cuts do not pay for themselves; they can create growth, but in the amount of tenths of percentage points, not whole percentage points. And they certainly cannot fill in trillions in lost revenue. Relying on growth projections that no independent forecaster says will happen isn’t the way to do tax reform.

 

As the chart below shows there is ZERO evidence that tax cuts lead to stronger sustained rates of economic growth. The chart compares the highest tax rate levels to 5-year average GDP growth. Since Reagan passed tax reform, average economic growth rates have only gone in one direction.”

On Thursday, Fitch confirmed the same in their dismal report on the reality of what the effect of the “tax cut”

“Such reform would deliver a modest and temporary spur to growth, already reflected in growth forecasts of 2.5% for 2018. However, it will lead to wider fiscal deficits and add significantly to US government debt. As such, Fitch has revised up its medium-term debt forecast. US federal debt was 77% of GDP for this fiscal year. Fitch believes the tax package will be revenue negative, even under generous assumptions about its growth impact. Under a realistic scenario of tax cuts and macro conditions, the federal deficit will reach 4% of GDP by next year, and the US debt/GDP ratio would rise to 120% of GDP by 2027.

 

Tax cuts may lead to a short-lived boost to output, but Fitch believes that they will not pay for themselves or lead to a permanently higher growth rate. The cost of capital is already low and corporate profits are elevated. In addition, the effective tax rate paid by large corporations is well below the existing statutory rate.

 

Fitch expects US economic growth to peak at 2.5% in 2018 before falling back to 2.2% in 2019. The US will enter the next downturn with a general government “structural deficit” (subtracting the impact of the economic cycle) larger than any other ‘AAA’ sovereign, leaving the US more exposed to a downturn than other similarly rated sovereigns. The US is the most indebted ‘AAA’ country and it is running the loosest fiscal stance. Long-term debt dynamics are also more negative than those of peers, with health and social security spending commitments set to rise over the next decade. “

There is nothing “good” in any of the statements above,  and drive to the same conclusions I discussed last Monday.

You can’t solve a debt problem, by issuing more debt. 

While Congressional members continue campaigning that the “tax plan” would give an $1182 tax cut to most Americans, and boost wages by $4000, such has never been the case. A recent study by the Economic Policy Institute suggested the same in a recent study:

“Cutting corporate tax rate cuts would do very little to boost employment generation. In fact, cutting corporate tax rates ranks as the least effective form of fiscal support for employment generation, since corporate tax cuts primarily benefit rich households—who are less likely to increase their consumption than low- or middle-income households when they receive tax cuts.”

This is a point I have made previously. Corporate tax rate cuts will unambiguously redistribute post-tax income regressively. The corporate income tax is a progressive tax, with the top 1% of households accounting for 47% of the corporate income tax.

Don’t be bamboozled by the idea that tax cuts and reforms will lead to sustained economic growth. There is simply NO evidence that such is the case over the long-term.

However, there is plenty of evidence to suggest that further costly reforms and run-away budgets will lead to an increase of the current national debt and the ongoing low-growth economy that has plagued the U.S. since the turn of the century.

In other words….“it’s the debt, stupid.”

In the meantime, here is your weekend reading list.


Trump, Economy & Fed

 


VIDEO – Tax Cut/Reform Discussion (Real Investment News)


Markets


Research / Interesting Reads


“In investing, what is comfortable is rarely profitable.” – Rob Arnott

http://WarMachines.com

The ‘Hyper-Crash’ Is Coming – It’s Not The Everything Bubble, It’s The Global Short Volatility Bubble

Two weeks ago, we discussed the recent report from Artemis Capital Management, “Volatility and the Alchemy of Risk – Reflexivity in the Shadows of Black Monday 1987”, authored by Christopher Cole. See “In the Shadows Of Black Monday – “Volatility Isn’t Broken…The Market Is”. The full report can be accessed here.

Perhaps because we posted it on a weekend, we feel that this must read report – one of the best reports we’ve read in years – has not received the profile it deserves. We think that it’s important to highlight it again, as it explains the mechanics which are likely to drive the next financial crisis. We begin with a ten bullet point summary.

In the Global Short Volatility Bubble:

  • We are in an unprecedented bear market in fear, i.e. falling volatility, thanks to the unconventional monetary policies of central banks;
  • Instead of being an external measure of risk, volatility has become a tradeable input – making it reflexive in nature;
  • As volatility falls, investors (using leverage) take bigger bets in the same direction, so lower volatility begets lower volatility.
  • The global short volatility trade is more than $2 trillion;
  • It consists of explicit short volatility trades and implicit short volatility trades, e.g. risk parity and accumulated equity share buybacks (price insensitive/buy the dip);
  • Due to reflexivity, in any shock to the system which starts an unwind in the global short volatility trade, higher volatility will reinforce higher volatility;
  • The markets are effectively converging into what’s known in option markets as a ‘naked short straddle’ – as volatility declines, the upfront premium (yield) declines while non-linear risk rises;
  • Non-linear risk has four components – rising volatility, gamma risk, unstable cross-asset correlations and rising interest rates;
  • Volatility is the most undervalued asset class in the world;
  •  The unwind of the global short volatility trade would lead to a sudden hyper-crash, similar but worse than 1987.

It’s become fairly common for the current central bank-created bubble in financial markets to be labelled the “Everything Bubble”. We can’t remember who coined the phrase, it might have been John Hussman, who describes current financial conditions as “the most broadly overvalued moment in market history”. No matter, here is one representation from the portfolio managers at Incrementum AG.


However, when you think about the markets in holistic fashion, there is no way that this is the “Everything Bubble”. It can’t be when some asset classes – and precious metals and many commodities immediately spring to mind – are far from all-time highs. Gold, especially, stands out, being a financial asset.

As keen students of the esoteric in markets and literature, we’ve found a kindred spirit in Artemis’s Christopher Cole. Cole refers to alchemy in the context of the ouroboros – the snake devouring its own tail. Besides demonstrating an understanding of true alchemy, rather than the profane, Cole uses the ouroboros as a metaphor for today’s central bank-driven financial markets. In Cole’s opinion, the financial markets are in the process of self-cannibalizing and, as he posits.

In nature and markets, when randomness self-organizes into too perfect symmetry, order becomes the source of chaos. The Ouroboros is a metaphor for the financial alchemy driving the modern Bear Market in Fear. Volatility across asset classes is at multi-generational lows. A dangerous feedback loop now exists between ultra-low interest rates, debt expansion, asset volatility, and financial engineering that allocates risk based on that volatility. In this self-reflexive loop volatility can reinforce itself both lower and higher. In a market where stocks and bonds are both overvalued, financial alchemy is the only way to feed our global hunger for yield, until it kills the very system it is nourishing.

This is not an “Everything Bubble” but, in our opinion, a multi-trillion dollar global short volatility bubble (GSVB). This is Cole's description.

The Global Short Volatility trade now represents an estimated $2+ trillion in financial engineering strategies that simultaneously exert influence over, and are influenced by, stock market volatility. We broadly define the short volatility trade as any financial strategy that relies on the assumption of market stability to generate returns, while using volatility itself as an input for risk taking. Many popular institutional investment strategies, even if they are not explicitly shorting derivatives, generate excess returns from the same implicit risk factors as a portfolio of short optionality, and contain hidden fragility.

Cole explains how the GSVB developed via the long-term bear market in volatility.

A short volatility risk derives small incremental gains on the assumption of stability in exchange for a substantial loss in the event of change. When volatility itself serves as a proxy to size this risk, stability reinforces itself until it becomes a source of instability. The investment ecosystem has effectively self-organized into one giant short volatility trade…At the head of the Great Snake of Risk is unprecedented monetary policy. Since 2009 Global Central Banks have pumped in $15 trillion in stimulus creating an imbalance in the investment demand for and supply of quality assets. Long term government bond yields are now the lowest levels in the history of human civilization dating back to 1285. As of this summer there was $9.5 trillion worth of negative yielding debt globally. Last month Austria issued a 100-year bond with a coupon of only 2.1% that will lose close to half its value if interest rates rise 1% or more. The global demand for yield is now unmatched in human history.

Within a background of extreme central bank intervention, the GSVB is a complex animal consisting of three main pillars.

  • Explicit Short Volatility – includes short volatility ETFs, VIX shorts, pension fund call and put writing;
  • Implicit Short Volatility – includes volatility control funds, risk parity, long equity trend following, risk premia strategies; and
  • Share buybacks in equity markets.

While there are explicitly short volatility strategies, strategies which are implicitly short volatility are bigger by magnitudes (think risk parity, for example) and this is what the vast majority of investors and market commentators are failing to appreciate – Cole explains.

Volatility as an asset class, both explicitly and implicitly, has been commoditized via financial engineering as an alternative form of yield. Most people think volatility is just about options, however many investment strategies create the profile of a short option via financial engineering. A long dated short option position receives an upfront yield for exposure to being short volatility, gamma, interest rates, and correlations. Many popular institutional investment strategies bear many, if not all, of these risks even if they are not explicitly shorting options. The short volatility trade, broadly defined in all its forms, includes up to $60 billion in strategies that are Explicitly short volatility by directly selling optionality, and a much larger $1.42 trillion of strategies that are Implicitly short volatility by replicating the exposures of a portfolio that is short optionality.

Besides explicitly and implicitly short volatility strategies, the $3.8 trillion of US share buybacks has grown into another under-appreciated pillar of the GSVB. In part, this is due to its BTFD characteristic.

Amid this mania for investment, the stock market has begun self-cannibalizing…literally. Since 2009, US companies have spent a record $3.8 trillion on share buy-backs financed by historic levels of debt issuance. Share buybacks are a form of financial alchemy that uses balance sheet leverage to reduce liquidity generating the illusion of growth…Any strategy that systematically buys declines in markets is mathematically shorting volatility. To this effect, the trillions of dollars spent on share buybacks are equivalent to a giant short volatility position that enhances mean reversion. Every decline in markets is aggressively bought by the market itself, further lowing volatility.

As Cole explains, the financial markets are, in practice, converging towards what is known as a naked short straddle in option markets.

Lower volatility begets lower volatility, rewarding strategies that systematically bet on market stability so they can make even bigger bets on that stability. Investors assume increasingly higher levels of risk betting on the status quo for yields that look attractive only in comparison to bad alternatives. The active investor that does his or her job by hedging risks underperforms the market. Responsible investors are driven out of business by reckless actors. In effect, the entire market converges to what professional option traders call a ‘naked short straddle’… a structure dangerously exposed to fragility.

If you are unfamiliar with the term, Investopedia has this to say about naked short straddles.

A short straddle is an options strategy carried out by holding a short position in both a call and a put that have the same strike price and expiration date. The maximum profit is the amount of premium collected by writing the options. If a trader writes a straddle with a strike price of $25 and the price of the stock jumps up to $50, the trader would be obligated to sell the stock for $25. If the investor did not hold the underlying stock, he or she would be forced to buy it on the market for $50 and sell it for $25. The short straddle is a risky strategy an investor uses when he or she believes that a stock's price will not move up or down significantly. Because of its riskiness, the short straddle should be employed only by advanced traders due to the unlimited amount of risk associated with a very large move up or down.

As Cole notes.

Volatility is now an input for risk taking and the source of excess returns in the absence of value. Lower volatility is feeding into even lower volatility, in a self-perpetuating cycle, pushing variance to the zero bound. To the uninitiated this appears to be a magical formula to transmute ether into gold… volatility into riches… however financial alchemy is deceptive. Like a snake blind to the fact it is devouring its own body, the same factors that appear stabilizing can reverse into chaos.

 

The danger is that the multi-trillion-dollar short volatility trade, in all its forms, will contribute to a violent feedback loop of higher volatility resulting in a hyper-crash. At that point the snake will die and there is no theoretical limit to how high volatility could go.

In effect, as volatility declines and the upfront premium, or yield, declines, non-linear risk rises. The rise in non-linear risk has four components.

  1. Rising volatility;
  2. Gamma or Jump Risk;
  3. Unstable Cross-Asset Correlations; and
  4. Rising Interest Rates.

Let’s deal with each one as briefly as possible. With volatility at multi-generation lows and the pervasiveness of the GSVB across multiple asset classes, Cole’s argues that.

Volatility is now the only undervalued asset class in the world.

While we might disagree that volatility is the only undervalued asset class, we know where he’s coming from. We do agree with Cole’s assertion that.

Volatility isn’t broken, the market is…the real story of this market is not the level of volatility, but rather its highly unusual behavior. Volatility, both implied and realized, is mean reverting at the greatest level in the history of equity markets. Any short-term jump in volatility mean reverts lower at unusual speed, as evidenced by volatility collapses after the June 2016 Brexit vote and November 2016 Trump US election victory. Volatility clustering month-to-month reached 90-year lows in the three years ending in 2015.

Why is this? Cole explains that the mainstream understanding of volatility is incorrect. i.e. instead of being an exogenous measure of risk, it is a tradeable input. Given the existence of the vast explicit and implicit short trades in volatility, we are once again back in the realm of reflexivity and the snake devouring its own tail.

…portfolio theory evaluates volatility the same way a sports commentator sees hits, strikeouts, or shots on goal. Namely, a statistic measuring the past outcomes of a game to keep score, but existing externally from the game. The problem is volatility isn’t just keeping score, but is massively affecting the outcome of the game itself in real time. Volatility is now a player on the field. This critical misunderstanding of the role of volatility modern markets is a source of great self-reflexive risk. Today trillions of dollars in central bank stimulus, share buybacks, and systematic strategies are based on market volatility as a key decision metric for leverage. Central banks are now actively using volatility as an input for their decisions, and market algorithms are then self-organizing around the expectation of that input…Low volatility reinforces lower volatility…  but any shock to the system will cause high volatility to reinforce higher volatility.

The point about gamma risk is the need to sell/buy more of an underlying asset “at a non-linear pace to re-hedge price fluctuations” in the underlying asset. Cole likens the risk in today’s markets with what happened during the Crash of 1987. Back then, it was the portfolio insurance strategy which accelerated the selling as stock prices fell. As Cole notes.

“Risk parity, volatility targeting funds, and long equity trend following funds are all forced to de-leverage non-linearly into periods of rising volatility, hence they have synthetic gamma risk. At current risk levels, we estimate as much as $600 billion in selling pressure would emerge from implicit short gamma exposure if the market declined just -10% with higher vol.

Given the BTFD of the current bull market, the following point from Cole deserves emphasis.

If the first leg of a crisis is strong enough to sustain a market loss beyond -10%, short gamma de-leveraging will likely kick-start a second leg down, causing cascading losses for anyone that buys the dip.

Having asserted that the mainstream understanding of volatility is incorrect, Cole goes on to make a similar point about the role of diversification as the “foundation” of portfolio theory. In Cole’s opinion, diversification doesn’t magically reduce risk since risk can only be transmuted, not destroyed. He argues.

All modern portfolio theory does is transfer price risk into hidden short correlation risk…Many popular institutional investment strategies derive excess returns via implicit leveraged short correlation trades with hidden fragility.

Once again, Cole highlights risk parity funds, pointing out that the negative correlation between stocks and bonds has performed well during the last two decades (especially during the 2007-08 crisis). However, over the past 130 years, stocks and bonds have spent nearly three times as long moving in tandem than moving opposite one another. Both stocks and bonds could be vulnerable to rising interest rates and, in Cole’s opinion, rising interest rates might be the catalyst for the dark side of GSVB reflexivity to kick-in.

Thirty years ago to the day we experienced that moment. On October 19th, 1987 markets around the world crashed at record speed, including a -20% loss in the S&P 500 Index, and a spike to over 150% in volatility. Many forget that Black Monday occurred during a booming stock market, economic expansion, and rising interest rates. In retrospect, we blame portfolio insurance for creating a feedback loop that amplified losses. In this paper we will argue that rising inflation was the spark that ignited 1987 fire, while computer trading served as explosive nitroglycerin that amplified a normal fire into a cataclysmic conflagration. The multi-trillion-dollar short volatility trade, broadly defined in all its forms, can play a similar role today if inflation forces central banks to raise rates into any financial stress. Black Monday was the first modern crash driven by machine feedback loops, and it will not be the last.

While we can’t fault Cole’s superb explanation of how the GSVB might unwind, we might place greater emphasis on China as one of the potential catalysts. However, let’s not get picky. Following Cole’s logic, it’s patently clear that the reflexivity inherent in the GSVB means that the longer it unfolds and the bigger it becomes, the greater the odds of a sudden reversal or, as Cole terms it, a hyper-crash. The probability that the GSVB reflexivity is in central banks’ models is, of course, ZERO. The problem we face right now, as Cole states, is.

The markets are not correctly assessing the probability that volatility reaches new all-time lows in the short term (VIX<9), and new all-time highs in the long-term (VIX>80).

http://WarMachines.com

“This Is The Broadest Episode Of Extreme Equity Market Overvaluation In History”

Excerpted from John Hussman's Weekly Market Comment,

Market valuations, on these measures, presently approach or exceed the 1929 and 2000 extremes, placing U.S. equity market valuations at the most offensive levels in history.

Indeed, with median valuations on these measures now more than 2.7 times their historical norms, there is strong reason to expect a market loss on the order of -63% over the completion of the current market cycle; a decline that would not even bring valuations below their historical norms (which we’ve typically seen by the completion of nearly every market cycle outside of the 2002 low).

"…unlike the 2000 valuation extreme, which was largely focused on a subset of extremely overvalued technology stocks, the current market extreme is the broadest episode of extreme equity market overvaluation in history. The chart below shows the median price/revenue ratio of S&P 500 component stocks, which set yet another record high in the week ended November 3, 2017, and now stands more than 50% above the 2000 extreme."

The following chart below shows our Margin-Adjusted CAPE as of November 3, 2017.

On this measure, market valuations are now more extreme than at any point in history, including the 1929 and 2000 market highs.

Finally Hussman reminds the complacent majority of how this well end:

The final chart is a reminder of how these speculative episodes end.

 

In 2000, most deciles experienced losses on the order of 30-50%, with the exception of the hypervalued top decile represented, at the time, by technology stocks.

 

In March 2000, I wrote: “Over time, price/revenue ratios come back in line. Currently, that would require an 83% plunge in tech stocks (recall the 1969-70 tech massacre). If you understand values and market history, you know we’re not joking.”

While it feels like it at the moment, trees can't grow to the sky, but as Hussman concludes, it’s clear from market internals that investors again have the speculative bit in their teeth.

What’s important, however, is to distinguish near-term speculative outcomes from longer-term investment outcomes.

 

If history is any guide, the first leg down from the current speculative blowoff is likely to be abrupt and rather vertical. Investors will be tempted to buy into that decline, and may very well be rewarded for it over the shorter-run. The problem is that while investors are reluctant to sell into strength here, they may also have no tolerance for selling into a market loss once internals break down. Instead, they will likely pass up their opportunity to reduce exposure to market losses even after market internals deteriorate clearly.

 

After that, the intermittent hope from fast, furious (but ultimately failing) rallies will likely encourage them to hold on all the way into a deep market collapse. That’s how severe market declines unfold.

http://WarMachines.com

Weekend Reading: Will Tax Reform Deliver As Expected?

Authored by Lance Roberts via RealInvestmentAdvice.com,

As I noted last Friday, the recently approved budget was an anathema to any fiscally conservative policy. As the Committee for a Responsible Federal Budget stated:

“Republicans in Congress laid out two visions in two budgets for our fiscal future, and today, they choose the path of gimmicks, debt, and absolutely zero fiscal restraint over the one of responsibility and balance.

 

While the original House budget balanced on paper and offered some real savings, the Senate’s version accepted today by the House fails to reach balance, enacts a pathetic $1 billion in spending cuts out of a possible $47 trillion, and allows for $1.5 trillion to be added to the national debt.

 

Make no mistake – this is a defining moment for the Republican party. After years of passing balanced budgets and calling for fiscal responsibility, the GOP is now on-the-record as supporting trillions in new debt for the sake of tax cuts over tax reform and failing to act on the pressing need to reform our largest entitlement programs.”

Passing fiscally irresponsible budgets just for the sake of passing “tax cuts,” is, well, irresponsible. Once again, elected leaders have not listened to, or learned, what their constituents are asking for which is simply adherence to the Constitution and fiscal restraint.

As the CFRB concludes:

“Tax cuts do not pay for themselves; they can create growth, but in the amount of tenths of percentage points, not whole percentage points. And they certainly cannot fill in trillions in lost revenue. Relying on growth projections that no independent forecaster says will happen isn’t the way to do tax reform.”

That is absolutely correct.

As the chart below shows there is ZERO evidence that tax cuts lead to stronger sustained rates of economic growth. The chart compares the highest tax rate levels to 5-year average GDP growth. Since Reagan passed tax reform, average economic growth rates have only gone in one direction.

However, the most likely unintended consequence of the proposed tax “cut” bill is that it will likely translate into a “hike” on middle class Americans. Take a look at the proposed tax bracket chart below.

Now, compare that with the actual breakdown of “who pays taxes.”

“The bottom 80% currently pay only about 18% of individual taxes with top 20% paying the rest. Furthermore, the bottom 40% currently have a NEGATIVE tax liability, and with the new tax plan cutting many of the deductions currently available for those in the bottom 40%, it could be the difference between a tax refund and actually paying taxes. “

“Of course, those in the top 20% of income earners are likely already consuming at a level with which they are satisfied. Therefore, a tax cut which delivers a few extra dollars to their bottom line, will likely have a negligible impact on their current levels of consumption.”

Given the newly designed tax brackets compresses individuals into fewer groups, it is quite likely a large chunk of the bottom 80% will likely experience either a hike or an inconsequential change. With the bottom 80% already consuming at max capacity, as discussed yesterday, a tax increase will hit the economy right where it hurts the most – in consumption expenditures. 

 “As the chart below shows, while savings spiked during the financial crisis, the rising cost of living for the bottom 80% has outpaced the median level of ‘disposable income’ for that same group. As a consequence, the inability to ‘save’ has continued.”

But while Congressional members were campaigning yesterday that the “tax plan” would give an $1182 tax cut to most Americans, it should not be forgotten that since they failed to “repeal and replace” the Affordable Care Act, any tax cut will only be diverted to offset a substantial rise in health care premiums in 2018.

Regardless, the proposed tax bill is just the first step.

Let the “horse trading” begin.

In the meantime, while we await the actual tax reform bill, here is your weekend reading list.


Trump, Economy & Fed


Markets


Research / Interesting Reads


“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations which do not meet these requirements are speculative.” – Benjamin Graham

http://WarMachines.com

“You Get Nothing” – World’s Largest Insurer Warns US Stocks Offer “No Returns” For The Next Decade

There will be "almost no prospective returns" from U.S. stocks over the next decade because the market is fully valued following years of gains, according to the global strategist at Allianz Global Investors, which manages $569 billion.

As Bloomberg reports, low interest rates and bond purchases by central banks have left cash and many other asset classes "significantly mispriced," Neil Dwane said Monday as part of a panel discussion on long-term investing at the Toronto Global Forum.

"The U.S. is fully valued," said Dwane, whose firm is owned by Munich-based insurance giant Allianz SE.

 

"There’s almost no prospective returns for the next 10 years from the U.S. equity market, and therefore investors have to look into Asia or Europe where valuations are significantly lower."

 

With interest rates close to zero around the world and bond markets "manipulated by central banks," it’s difficult to assess risk and return, he added.

 

Many investors have turned to high-yield bonds or emerging markets for income, which raises risks.

Dwane is not alone of course in this ominous view, as Bloomberg notes, Jim Keohane, chief executive officer of the Healthcare of Ontario Pension Plan, agreed that it’s not a good time to be buying assets of nearly any stripe.

"Right now assets are very expensive," said Keohane, whose firm manages more than C$70 billion ($54 billion).

 

"We need to be patient, to wait for better opportunities. Whenever the next crisis comes, assets are going to be on sale. You can buy them a lot cheaper than you can buy them today, but you have to have patience to be able to do that."

And finally, John Hussman, of Hussman Funds, warned that a century of reliable valuation evidence indicates that the S&P 500 is likely to experience an outright loss, including dividends, over the coming 10-12 year horizon, and we presently estimate likely interim losses on the order of -60% or more.

A rate of return of even 1% in cash is a much more desirable option than investors may imagine.

For a while, Bernie Madoff’s investors felt great about their impressive “returns.” For a while, investors in dot-com stocks felt the same. For a while, investors in mortgage bonds felt the same. But when investors focus on returns rather than the very long-term structure, stability, and even existence of the underlying cash flows, terrible things can happen.

All that’s required to get the snowball rolling is the creeping recognition that there’s no “there” there.

In response to the delusion that low interest rates “justify” virtually any level of market valuation, regardless of the growth rate of the underlying cash flows, the speculation of recent years has created a situation where there is effectively no way out for investors in aggregate. Every security that is issued must be held by someone until it is retired.

When one investor sells a share, it simply means that another investor buys it. The only question is who will hold the bag.

http://WarMachines.com

Dow 500,000?

Authored by Lance Roberts via RealInvestmentAdvice.com,

I genuinely admire Morgan Housel. I think he is a brilliant and talented writer. However, he sent out a tweet on Friday that really struck a chord with me.

It’s an innocuous tweet, meant with the best of intentions to leave you with a sense of optimism as you headed into your weekend.

I get it. Really.

As Bob Farrell once quipped:

“Bull markets are more fun than bear markets.” 

Bull markets also “sell” financial products, services, and offerings. Wall Street makes money selling products and services to “Main Street” who makes money with higher prices. Financial media makes money as advertisers market their “wares.” Being bullish also gets views, likes, comments, and shares. Bull markets thrive when “greed” erases the memories of previous “bear market” losses.

As Gordon Gecko said:

“Greed is good.” 

The problem with being “bullish all the time” is that it is also very dangerous.

This is particularly the case in late-stage “bull markets,” where poor investment decisions, and excessive portfolio “risk,” are masked by seemingly ever-rising prices. Previously bad investment ideas, products, and strategies tend to resurface in a different form or package. Investment strategies like “buy and hold” and “dollar cost averaging” become popular even though they are absolutely guaranteed to leave you well short of your financial objectives in the future.

So, what does this have to do with Morgan’s tweet?

It has everything to do with one of my “pet peeves,” and the biggest fallacy pushed by Wall Street today – “compound returns.”

Markets Don’t Compound

Morgan states that in 30-years, if the Dow grows at just 5% annually, it will hit 500,000. However, if the Dow actually compounded returns at 5%, in the future, as Morgan suggests, it would have done so in the past and would ALREADY be at 500,000. 

But it’s not. We are just stuck here at a crappy ole’ 23,000.

There is a huge difference between compound returns and average returns. The historical return of the markets since 1900, including dividends, has averaged a much higher rate of return than just 5% annually. Therefore, the Dow should actually be much closer to 1,000,000 than just 500,000.

But it’s not.

Nope…we are just hanging out way down here at 23,000.

Why? Because crashes matter. This is particularly the case when it comes to your financial goals and investing time horizons.

Think about it this way.

If “buy and hold” investing worked the way that it is preached, then why are the financial statistics of 80% of Americans so poor?

The three biggest factors are: 

  1. Destruction of capital;
  2. Lack of savings, and;
  3. Time.

While lost capital gain be regained, the time lost “getting back to even,” cannot be. Unfortunately, we don’t live forever, and time is our ultimate enemy. This is also, after two major bear markets, the majority of “boomers” are simply unprepared financially for retirement. 

It is also the reason why we are facing a massive “pension crisis” in the not so distant future as capital destruction, low contribution rates, and over-estimation of returns has led to massive shortfalls to meet required distributions in the future.

Who wouldn’t love a world where everyone just invests some money, the markets rise 6% annually and everyone one’s a winner. 

Unfortunately, there is a vast difference between an “index” which benefits from share buybacks, substitutions, and market capitalization weighting versus a portfolio invested in actual dollars. The chart below shows the S&P 500 index (nominal since that is the way it is primarily discussed) versus the actual, inflation-adjusted value, of a $100,000 investment and compared to the 6% annual return rate promised by Wall Street.

See the problem? People 30-years ago who were hoping to retire, simply can’t. It will likely be the case for individuals today looking to retire 30-years from now.

With markets now back to the second highest level of valuations on record, forward returns over the next 10-years are going to be substantially lower than they have been over the past 10-years.

That isn’t being bearish. That is just math.

Dr. John Hussman previously wrote the most salient point on this topic.

“Put simply, most apparent ‘opportunities’ to obtain investment returns above zero in conventional assets over the coming decade are based on a misunderstanding of valuations, total returns, and historical yield relationships. At current valuations, virtually everything is priced for a decade of zero.” 

Throughout history, bull market cycles are only one-half of the “full market” cycle. This is because during every “bull market” cycle the markets, and economy, build up excesses which are “reverted” during the following “bear market.”

As Sir Issac Newton once stated:

“What goes up, must come down.” 

Looking beyond the very short-term overly optimistic view of “this time is different,” the coming unwinding of current speculative extremes will occur with the completion of the current market cycle. As I noted in this past weekend’s missive:

“Also, when we look at 20-year trailing returns, there is sufficient historical evidence to suggest total, real returns, will decline towards zero over the next 3-years from 7% annualized currently. 

(These are trailing 20-year total real returns, not forward)”

“Re-read that last sentence again and look closely at the chart above. From current valuation levels, the annualized return on stocks by the end of the current 20-year cycle will be close to 0%. A decline in the next 3-years of only 30%, the average drawdown during a recession, will achieve that goal.”

The second-half of this current cycle will begin likely sooner, rather than later. As stated, it is a function of time (length of market cycles), math (valuations) and physics (price deviations for long-term means.)

I am not bullish or bearish.

My job as a portfolio manager is simple; invest money in a manner that creates returns on a short-term basis while reducing the possibility of catastrophic losses over the long-term.

While “bulls have more fun” while markets are rising, both “bulls” and “bears” are owned by the “broken clock” syndrome during the completion of the full-market cycle.

The biggest secret in achieving long-term investment success is not necessarily being “right” during the first half of the cycle, but by not being “wrong” during the second half.

It’s okay to be “always be bullish” with your attitude, just not with your money.

http://WarMachines.com

Buffett’s Wrong – Why Market Valuations Are Not Justified By Low Interest Rates

As is his way, Billionaire investor Warren Buffett calmed an anxious nation earlier this month with his comments that:

"Valuations make sense with interest rates where they are."

And it seemed to work as stocks hit new record highs and Americans have never, ever been more sure that stocks will continue rising for the next 12 months

Why wouldn't they – Buffett knows all, right?

Wrong, says John Hussman

Via Hussman Funds.com

It’s such a comforting, even satisfying assumption; the idea that “lower interest rates justify higher valuations.” The idea is one of the most basic principles of finance. Indeed, investors could consider it a law of investing. Except for the fact that it’s an incomplete sentence. Unfortunately, the convenience of investing-by-slogan, rather than carefully thinking about finance and examining evidence, is currently leading investors into what is likely to be one of the worst disasters in the history of the U.S. stock market.

Here are the propositions that are actually true:

  • An investment security is nothing but a claim on some stream of expected future cash flows that will be delivered into the hands of investors over time.
  • Provided that the stream of expected future cash flows is held constant, discounting those future cash flows at a lower rate (which is the same as accepting a lower future rate of return), will result in a higher “justified” price today, and this impact can be quantified.

Below, we’ll also establish and demonstrate some additional propositions:

  • If interest rates are low because growth rates are also low, no valuation premium on stocks is “justified” by the low interest rates. Prospective returns are reduced without the need for any valuation premium at all.
  • Provided that a valuation ratio is based on a “sufficient statistic” for long-term cash flows, the logarithm of that valuation ratio will, in turn, act as a sufficient statistic for long-term investment returns.
  • Revenues and margin-adjusted earnings have historically been far more reliable “sufficient statistics” of future cash flows than year-to-year earnings, or even 10-year averages of earnings.
  • Currently depressed interest rates are indeed associated with unusually weak current and prospective U.S. growth rates, implying that elevated stock market valuations are not, in fact, “justified” by interest rates at all.
  • Margin-adjusted valuation ratios behave as sufficient statistics for likely future stock market returns, and adding information about interest rates improves neither the reliability of return projections, nor the current level of those projections.

By the end of this comment, all of these will be clear. The upshot of these propositions is this. At present, the most reliable measures of U.S. equity market valuation – the measures that are best-correlated with actual subsequent market returns in market cycles across history – are 2.75 times (175% above) their historical norms. Given that depressed interest rates are matched by commensurately low U.S. growth rates, little or none of this premium is actually “justified” by interest rates. Rather, the S&P 500 is likely to post negative total returns over the coming 10-12 year horizon, with a likely interim loss in excess of -60%.

Moreover, even if the growth rates of nominal GDP, S&P 500 revenues, and other fundamentals were to literally double to historically normal rates, yet Treasury bond yields could be held 2.5% below their historical median for another decade, the combination would only “justify” a valuation premium for the S&P 500 of about 2.5% x 10 years = 25% above its corresponding historical valuation norms. We’re already 175% above those norms. There's no way to make the arithmetic work without assuming an implausible and sustained surge to historically normal economic growth rates, a near-permanent suppression of interest rates despite a full resumption of normal economic growth, and the permanent maintenance of near-record profit margins via permanently depressed real wage growth, despite an unemployment rate that now stands at just 4.2%.

There’s little doubt that the general level of long-term interest rates should be markedly lower than historical norms. But that’s because prospects for long-term growth are also markedly lower than historical norms. Again, the problem is that this combination deserves no valuation premium at all. Expected future stock market returns would be commensurately lower even in the absence of a valuation premium. That’s just how the arithmetic works.

Today’s obscene market valuations are largely the result of a) ignoring the growth side of this relationship, and b) activist central bank policies that have repeatedly driven short-term interest rates to levels that create a mentality of yield-scarcity among investors; where they stop quantifying the effect of rates and simply decide that “there is no alternative” to blindly speculating in risky assets regardless of their valuations. That’s what created the mortgage bubble that ended in the global financial crisis, and it’s what has created the “everything” bubble today. With deep respect, my impression is that Warren Buffett’s statement reflects that same lack of quantification.

What follows is an exposition that includes both theory and evidence. I’ve drawn freely on some of my prior commentaries, so parts will look familiar to long-time readers. But this is important, particularly at present extremes, so I hope you’ll spend some time with it.

The nerve of this Hussman guy

Before we continue, let’s get my own stress-testing narrative in the half-cycle since 2009 right on the table, so my admitted stumble doesn’t quietly draw the focus away from objective data.

In late-October 2008, after the market had collapsed more than 40% in a decline we fully anticipated, I wrote a piece called Why Warren Buffett is Right, and Why Nobody Cares, observing that stocks had become undervalued and the S&P 500 was likely to enjoy strong returns over the decade ahead. Consider today's comment as a companion piece expressing the opposite view. That late-2008 shift to a constructive outlook, aligned with a material improvement in valuations, was similar to those I had made after every bear market in what is now more than three decades as a professional investor, following a discipline that had repeatedly navigated complete market cycles admirably.

In 2009, I brought a half-cycle’s worth of ignominy upon myself, by insisting on stress-testing our methods against Depression era data, in the face of job losses and banking strains that were wholly outside of the post-war data that then informed our methods of classifying expected market return/risk profiles. It was a reasonable fiduciary decision, but very badly timed. In the midst of that “two data sets” ambiguity, the decision truncated our late-2008 constructive shift, and we missed a rebound that both our pre-2009 and our current methods could have captured. Worse, based on the historical tendency for extreme “overvalued, overbought, overbullish” syndromes to be closely followed by abrupt market losses and deterioration in market internals, the resulting methods prioritized those syndromes ahead of market internals themselves.

Market internals are an important gauge of speculative pressures, because when investors are inclined to speculate, they tend to be indiscriminate about it. Our overreliance on “overvalued, overbought, overbullish” syndromes turned out to be our Achilles Heel in the recent half-cycle. Faced with the novelty of quantitative easing and zero interest rates, investors continued to speculate long after those extreme syndromes emerged. Those syndromes can still justify a rather neutral outlook, but amid the novelty of quantitative easing, the central lesson (and required adaptation) was this: in a zero interest rate environment, it is necessary to wait for explicit deterioration in market internals, indicating a shift in investor preferences toward risk-aversion, before adopting a hard-negative outlook.

At present, we observe extreme overvalued, overbought, overbullish conditions, interest rates are well off the zero bound, and market valuations, even given proper consideration of interest rates, are at the most offensive levels in history. Still, as I noted a few weeks ago, while I view hedges and safety nets as essential here, there’s no need to “fight” a continued advance, if it emerges, with even larger hedges or higher safety nets. With the S&P 500 far beyond twice the level at which I expect it will end this cycle, it will be fine if the initial few percent lower do nothing for us.

Understand that my error in the recent half-cycle traces to my insistence on stress-testing our methods in the face of undervaluation that our own measures clearly identified, and that I openly recognized (but where similar levels in the Depression were still followed by massive market losses). The resulting methods prioritized extreme “overvalued, overbought, overbullish” syndromes ahead of market internals, and amid the novelty of QE and zero-interest rates, led us to fight too hard against objectively extreme valuations and the persistent speculation of investors. It’s a mistake we’ve adapted to, and that we won’t make again. Understanding that narrative doesn’t require investors to overlook that the market was undervalued in 2009, but is wickedly overvalued today.

Recent years have encouraged the illusion that investors will never again feel anything but sheer euphoria. As one of the few observers who anticipated both the tech collapse and the global financial crisis, and who has adopted a constructive or leveraged outlook after every bear market decline in more than three decades, my sense is that this complete lack of imagination about the range of investor emotions is likely to have brutal consequences.

A final note before we get into the data. I’m a great admirer of Warren Buffett. Not because he’s a mysterious Oracle that can be treated as a black box, but because his views have historically lined up with reliable objective evidence on valuations. Buffett was right about rich valuations in 1972, and 2000. He was right about undervaluation in 1974, and 1982, and late-2008. But even humbled by the narrative that followed my stress-testing decision in 2009, I can say one thing with confidence. From the standpoint of a value-conscious, historically-informed, full-cycle investment discipline, it is utterly incorrect to maintain that “valuations make sense with interest rates where they are.”

Meanwhile, I’ve got no personal conflict with people who choose to be bullish here. My motive is to be of service to others, particularly over the complete market cycle. Most of what I’ve made in my lifetime has gone to philanthropic efforts, and the rest is invested in our value-conscious, historically-informed, full-cycle discipline. I’ll continue to follow our discipline on behalf of those who trust my work, whether others agree or not; adapting it where the evidence requires, and maintaining patience where patience is what’s needed most. Despite speculation that has gone beyond every historical precedent in the recent half-cycle, I know that my open concerns about valuations in prior bubbles, as well as the constructive outlooks I’ve adopted after previous bear market declines, have ultimately proved to be of service to others by the time the market cycle has been completed.

Valuation basics

Look across the room you’re in, and imagine there’s a $100 bill taped in the far upper corner, where the walls and ceiling meet. Imagine you’re handing over some amount of money today, in return for a claim on that $100 bill 12 years from now.

Drop your hand toward the floor. If you pay $13.72 today for that future $100 cash flow, you can expect an 18% annual return on your investment over the next 12 years.

Raise your hand a little higher. If you pay $25.67 today for that future $100 cash flow, you can expect a 12% annual return on your investment over the next 12 years

Raise your hand just above chest-level. If you pay $39.71 today, you can expect an 8% annual return. Move your hand to the top of your head. If you pay $70.14 today, you can expect a 3% annual return. Raise your hand above your head. If you pay $78.85 today, you can expect a 2% annual return.

Now imagine jumping up and touching the ceiling with your hand. If you pay $100 today for that future $100 cash flow, you’ll earn nothing on your investment over the next 12 years.

The chart below shows the relationship between the current price and the embedded future return for our simple 12-year security. Notice that I’ve put the price axis on log scale, which is why the relationship is linear rather than curved.

[Geek’s note: Technically, the relationship above is linear in log(1+r), but to a close approximation, that’s the same as being linear in r itself. You can see why the relationship is linear by observing that P = C/(1+r)^T and taking the log of both sides.]

Notice that the impact of a change in interest rates can be quantified. For example, moving from a 3% rate of return to a 2% rate of return for 12 years results in a price change from $70.14 to $78.85, a gain of about 12%. As a general rule of thumb, if we change the interest rate by X% for a period of T years, the impact on the present value of a given cash flow will be roughly X% times T. It’s not an exact rule, but it’s useful.

An additional feature of the relationship above is extremely important. Notice that once we are given the expected future cash flows and the current price, no additional information is required in order to calculate the expected future rate of return. In particular, while the general level of interest rates may be partly responsible for bringing the price to whatever level one observes, once the price is actually established, the expected future investment return can be directly estimated from the level of valuation. No additional “adjustment” for interest rates is needed. Stop and think about this before continuing.

Because present value involves exponents, we’ll generally discover that if we calculate a valuation ratio by dividing the price of the security by some reasonably representative fundamental that’s proportional to the future expected cash flows, there will be a roughly linear relationship between the log valuation ratio and actual subsequent long-term investment returns. Adding information about interest rates will emphatically not improve our estimates of future returns, because the valuation measure will already act as a “sufficient statistic” for those returns. We’ll examine this proposition in actual U.S. market data later in this comment.

Valuations and growth

Let’s imagine a slightly more complicated security. This one pays the holder one payment annually, starting at $10 a year from today. In addition, we’re going to assume that the cash payment grows at a constant rate over the coming 30 years. The chart below shows the present value of that stream of cash flows, depending on the rate of growth, as well as the long-term rate of return that the investor accepts on the investment.

Notice something very important here: if the long-term rate of return is lower, but the growth rate of cash flows is also lower, the “justified” price of the security does not change.

Put simply, if interest rates are low because growth rates are also low, no valuation premium is “justified.” The long-term rate of return on the security will be low anyway without any valuation premium at all. This observation has enormous implications for current U.S. stock market prospects. We’ll demonstrate those implications shortly, across a century of actual market data.

As a side note, we can also quantify the effect of a change in interest rates on the value of the securities above, though the process is slightly more complicated. Even though they’re 30-year securities, changing interest rates by 1% will change the value by much less than 30%, because many of the cash flows come in earlier years. If the interest rate change is permanent for the entire 30-year span, we can estimate the impact of the change using what’s called the “duration” of the security. Duration is essentially an “average” maturity that weights the number of years until each payment is received by the proportion of the total present value that's paid in each year. If the interest change isn’t permanent, the “justified” impact of the interest rate change on the security price will be smaller than its duration.

Earnings, revenues, and sufficient statistics

In much of my work, I use the phrase “sufficient statistic,” which is a concept drawn from probability theory. A sufficient statistic is basically a number that summarizes all relevant information, so providing additional data doesn’t change one’s expectation.

Consider the very long-term stream of cash flows that a security actually throws off to investors over decades and decades. I’ve regularly observed that while corporate earnings are necessary to generate deliverable cash to shareholders, comparing prices to earnings is actually quite a poor way to estimate future investment returns. The reason is simple. Stocks are not a claim to next year’s earnings, but to a very long-term stream of cash flows that will be delivered into the hands of investors over time. Most of the variation in earnings, particularly at the index level, is uninformative. Corporate earnings are more variable, historically, than stock prices themselves.

So year-to-year earnings are not very useful “sufficient statistics” for that very long-term stream of cash flows. Though “operating” earnings are less volatile, all earnings measures are pro-cyclical; expanding during economic expansions, and retreating during recessions. As a result, to quote the legendary value investor Benjamin Graham, “The purchasers view the good current earnings as equivalent to ‘earning power’ and assume that prosperity is equivalent to safety.”

Not surprisingly, the valuation measures having the strongest correlation with actual subsequent investment returns across history are smoother, and act as more representative “sufficient statistics” for the relevant long-term cash flows. In the valuation of broad equity market indices, and in the estimation of probable future returns from those indices, revenues are actually a better sufficient statistic than year-to-year earnings (whether trailing, forward, or cyclically-adjusted).

Don’t misunderstand – what ultimately drives the value of stocks is the stream of cash that is actually delivered into the hands of investors over time, and that requires earnings. It’s just that profit margins are so variable over the economic cycle, and so mean-reverting over time, that year-to-year earnings, however defined, are flawed measures of the long-term stream of cash flows that determine the value of the stock market at the index level.

The best way to see that revenues dominate earnings as “sufficient statistics” for valuation is to examine which valuation measures are most strongly correlated with actual subsequent 10-12 year S&P 500 total returns in market cycles across history. Invariably, measures that are based on revenues, or that adjust for variation in profit margins, have a much stronger relationship with actual subsequent market returns than unadjusted earnings-based measures. Our preferred measure is MarketCap/GVA, which I introduced in 2015, and we calculate as the ratio of nonfinancial market capitalization to corporate gross value-added (corporate revenues, excluding the double-counting of intermediate inputs) including estimated foreign revenues. As a reminder, we generally prefer a 12-year horizon because that’s where the “autocorrelation” of valuations reaches zero, meaning that prior overvaluation or undervaluation decays most reliably over that period.

With regard to “sufficient statistics,” remember two things.

  • First, revenues and margin-adjusted earnings have historically been far more reliable “sufficient statistics” of future cash flows than year-to-year earnings, or even 10-year averages of earnings.
  • Second, provided a valuation ratio is based on a sufficient statistic for future cash flows, the log of that valuation ratio will act as a sufficient statistic for actual subsequent returns. In particular, interest rates may very well affect the level of valuations that we observe, but once a given level of valuation is established, adding information about interest rates will not improve our projections of subsequent market returns.

A note on profit margins

It’s important to recognize that the unusual elevation of profit margins in recent years is largely a temporary artifact of the extraordinary slack in the labor market that emerged in the aftermath of the global financial crisis. Specifically, the elevation of profit margins in recent years has been a nearly precise reflection of declining labor compensation as a share of output prices. To illustrate this below, I’ve shown real unit labor costs (labor compensation per unit of output, divided by price per unit of output) in blue on an inverted left scale, with profit margins in red on the right scale. Real unit labor costs are de-trended, reflecting the fact that real wage growth has historically lagged productivity growth by about 0.4% annually.

What’s notable here is that the process of profit margin normalization is already underway. Though there will certainly be cyclical fluctuations, this process is likely to continue in an environment where the unemployment rate is now down to 4.2% and demographic constraints are likely to result in labor force growth averaging just 0.2% annually between now and 2024 (see below). Total employment will grow at the same rate only if the unemployment rate remains at current levels. That creates a dilemma for profit margins: if economic growth strengthens in a tightening labor market, labor costs are likely to comprise an increasing share of output value, suppressing profit margins. If economic growth weakens, productivity is likely to slow, raising unit labor costs by contracting the denominator.

Thus far, we’ve established a few propositions. First, provided that the stream of expected future cash flows is held constant, discounting those future cash flows at a lower rate (which is the same as accepting a lower future rate of return), will result in a higher “justified” price today. However, we’ve also observed that if discount rates are low because growth rates are also low, no valuation premium is “justified” at all.

As for “sufficient statistics,” we’ve observed that valuation measures that are relatively insensitive to variations in profit margins are better correlated with actual subsequent market returns than measures that are sensitive to year-to-year fluctuations in earnings (even when one uses operating earnings or smoothed 10-year earnings, as the Shiller CAPE does). It should also be clear from the examples above that as long as we base our valuation measures on “sufficient statistics” for long-term cash flows, we can expect a fairly linear relationship between log valuations and subsequent investment returns.

We have two remaining propositions to demonstrate. The first is that currently depressed interest rates are indeed associated with unusually weak current and prospective growth rates (which implies that low interest rates do not, in fact, “justify” elevated valuation multiples). The second is that margin-adjusted valuations act as sufficient statistics for likely future investment returns, so adding information about interest rates improves neither the reliability of return projections, nor the current level of those projections.

On the prospects for U.S. economic growth

Real U.S. GDP growth is driven by two engines: the growth rate of the labor force, plus the growth rate of output per worker (productivity). On the labor side, based on population growth and other demographic factors, the U.S Bureau of Labor Statistics (BLS) projects that the U.S. labor force – the number of people working or looking for work – will reach 163.8 million in 2024. As of September 2017, the U.S. labor force stood at 161.1 million. Accordingly, the growth rate of the U.S. labor force is projected to average just 0.2% annually over the coming 7 years.

To illustrate what’s going on, the chart below shows the 10-year growth rates of the U.S. working age population, the civilian labor force, and civilian employment since the 1960’s. It’s clear from this chart that the central tendency of the “labor force” contribution to U.S. GDP growth has been steadily declining, having peaked in the 1970s and early 1980s.

It’s also worth noting that periods of rapid and sustained economic growth invariably begin from points of steep unemployment, because that’s the point from which the economy can enjoy a great deal of growth in the “labor force” contribution to growth. We hear a lot of hope that corporate tax cuts will prompt the kind of growth the U.S. enjoyed following the tax reforms of the 1950’s and the 1980’s. What’s often lost in this conversation is that the principal engines of economic expansion were already loaded with fuel at those points, mainly in the form of rapid underlying labor force growth and slack labor market capacity. That is not at all true today.

On the productivity front, over the past decade, productivity growth has declined from a post-war average of 2% to a growth rate of just 1.2% annually, with growth of just 0.6% annually over the past 5 years. The gap between dismal productivity and the most productive economic environment in U.S. history is only about 2.5% annually.

Over the long-term, the growth of U.S. productivity is largely driven by the growth of U.S. domestic investment, particularly net of depreciation. As technology increases the speed of obsolescence, depreciation rates have progressively increased in recent decades, so a given amount of gross domestic investment does progressively less to expand the U.S. capital stock. The chart below shows the 10-year averages of U.S. domestic investment (net of depreciation) as a share of GDP, along with the growth rate of real output per labor hour.

It’s worth noting that rapid growth in U.S. domestic investment is also typically associated with rapid deterioration in the U.S. trade deficit (an implication of the savings-investment identity, as explained below). For that reason, we observe a very strong regularity across history: the quickest way to “improve” the U.S. trade balance is to torpedo gross domestic investment, and the quickest way to “worsen” the U.S. trade balance is to enjoy a boom in gross domestic investment. The chart below illustrates this regularity in post-war data.

From a cyclical perspective, the problem is that once the trade balance is already at a significant deficit, there is little remaining slack for rapid expansion in either gross domestic investment or, by extension, U.S. productivity growth.

Periods of rapid economic growth typically emerge from points of high unemployment – not when unemployment is already quite low. Likewise, periods of rapid economic growth typically emerge from points where the trade balance (exports – imports) is elevated as a share of GDP – not when it is already at a steep deficit.

Presently, the Federal Reserve estimates the central tendency of long-run real GDP growth to average just 1.85% annually. Understand that even a 1.85% average economic growth rate in the coming years already builds in some optimistic assumptions. See, even if U.S labor force growth grows at the projected rate of 0.2% annually, this growth will transfer to a similar rate of employment growth only if the unemployment rate remains constant at the current 4.2% level. Meanwhile, with labor productivity growing at only about 0.6% annually, well below the post-war average of 2%, the baseline expectation for U.S. GDP growth, given no change in the present trajectory, is actually just 0.2% + 0.6% = 0.8%. So a 1.85% growth trajectory for real GDP assumes that some combination of labor force growth and productivity growth will accelerate from the current baseline.

The upshot is this. Over the coming 7-10 years, the central tendency of U.S. GDP growth is likely to average less than 2%, a result that is largely baked-in-the-cake because of the underlying drivers already in place. On a cyclical horizon focused on the coming 4-year period, the diminished slack in core economic drivers is consistent with a material slowing of economic growth relative to its average in recent years. Given that real U.S. GDP growth has averaged just 2% annually over the past 5 years, and that the current starting positions of labor force growth, unemployment, and the trade balance suggest a deceleration even from that average, we shouldn’t be surprised if real U.S. GDP growth amounts to just a fraction of a percent annually over the coming 4-year period.

The chart below shows the 7-year average growth rate of real GDP, excluding the impact of fluctuations in the unemployment rate. I’ve chosen a 7-year lookback, specifically to exclude the impact of the global financial crisis from the latest data point. At a 4.2% unemployment rate, future economic growth is unlikely to benefit from a substantial further retreat in unemployment. Without that contribution, it should be clear that the underlying drivers of U.S. economic growth, even during the recent economic recovery, have never been weaker.

Notably, the growth rates of S&P 500 earnings and revenues have also slowed considerably in recent years, at a pace commensurate with economic growth itself. Indeed, in recent decades, these growth rates have plunged to less than half their historical rate. Given these facts, it’s worth repeating the following: If interest rates are low because growth rates are also low, no valuation premium on stocks is “justified” by the low interest rates. Prospective returns are reduced anyway, without the need for any valuation premium at all.

Valuations, sufficient statistics and interest rates

Our final proposition left to demonstrate is that (log) margin-adjusted valuations are sufficient statistics for likely future investment returns, and that adding information about interest rates improves neither the reliability of the associated return projections, nor the current level of those projections.

For decades, I’ve observed that the reliability of every earnings-based valuation ratio, as measured by its correlation with actual subsequent returns, is substantially improved if one adjusts that ratio for variation in its embedded profit margin. It’s easy to prove this to yourself.

1: Obtain data on your preferred price/earnings measure over several market cycles, and calculate the embedded profit margin (the denominator of your preferred P/E, divided by S&P 500 revenues). If you can’t get that margin data, you can proxy it with U.S. corporate profits divided by U.S. corporate gross value-added (or even divided by U.S. GDP if needed). Calculate the margin the same way you calculate the denominator of your P/E, so if you’re using 10-year average earnings, do the same with the margin data. Just for fun, get data on the long-term Treasury bond yield as well.

 

2: Now use ordinary least-squares or any other approach to obtain three estimators of actual subsequent S&P 500 10-12 year returns: one using the log valuation measure alone (I prefer the natural logarithm ln for reasons I can detail another time), one using the log valuation measure and the log profit margin, and one using the log valuation measure, the log profit margin, and the level of interest rates.

Here’s what you’ll discover. When you include information on the log profit margin, your estimator will suck it up like a sponge, dramatically increasing the accuracy of your fit, and most likely giving the log margin a very similar (negative) coefficient as your log valuation measure alone. Once you’ve included both the valuation and margin information, adding information on interest rates will do virtually nothing further for the accuracy of your fit.

The reason for this result is that even though you think you care about earnings, history actually cares about revenues, which serve as far better “sufficient statistics” of the very, very long-term cash flows provided by stocks. Observe that price/revenue = price/earnings x earnings/revenue. Taking the log of both sides, you’ll get log(price/revenue) = log(price/earnings) + log(embedded margin). Your predictor will celebrate the inclusion of that margin information, and give it nearly the same coefficient as the log(P/E), because what it actually wants is the log price/revenue ratio. You may not like that result at all, but that’s what you’ll find.

The chart below is based on my margin-adjusted variant of Robert Shiller’s cyclically-adjusted PE (CAPE). Specifically, the CAPE (calculated here as the ratio of the S&P 500 to the 10-year smoothing of inflation-adjusted earnings) is multiplied at each point in time by a factor equal to the 10-year smoothing of corporate after-tax profits to GDP, divided by the historical norm of 5.4%. The resulting measure is similar to the S&P 500 price/revenue multiple, the ratio of market capitalization to corporate gross value-added, and other measures that share a correlation near 90% or higher with actual subsequent 10-12 year S&P 500 total returns in market cycles across history.

As expected, the (log) margin-adjusted CAPE acts as a “sufficient statistic” for actual subsequent S&P 500 total returns, particularly on horizons of 10-12 years (which is the point where deviations from historically normal valuations most reliably damp out). Also as expected, adding additional information about interest rates (green) does virtually nothing to improve the reliability of the resulting projections; a result that can be understood from our earlier valuation examples. If anything, low interest rates actually worsen expected future market returns here. If extreme valuations were not enough, depressed interest rates suggest the likelihood of below-average economic growth as well.

A century of reliable valuation evidence indicates that the S&P 500 is likely to experience an outright loss, including dividends, over the coming 10-12 year horizon, and we presently estimate likely interim losses on the order of -60% or more. A rate of return of even 1% in cash is a much more desirable option than investors may imagine. Moreover, I have little doubt that we’ll observe a spike in prospective returns over the completion of the current cycle, as we’ve observed in every market cycle across history. These spikes are associated with material retreats in valuation. Historically, the best opportunities to embrace market exposure tend to emerge when material retreats in valuation are coupled with early improvements in market action.

It’s worth emphasizing again that while the general level of interest rates may be partly responsible for bringing the price to whatever level one observes, once the price is actually established, the expected long-term return can be directly estimated from the level of valuation. No additional “adjustment” for interest rates is needed. It’s fine to estimate the expected return from the level of valuation and then compare it to the level interest rates to decide whether it’s reasonable to take the risk. But it’s important to realize that once the price is established, the valuation level alone is sufficient to make that estimate. Investors may not like this fact, but it’s a basic implication of security pricing, properly understood.

The chart below shows this relationship in three dimensions. While it’s true that lower interest rates have generally been associated with higher market valuations (particularly during the inflation-deflation cycle from 1970 until the late-1990’s), those low interest rates did absolutely nothing to mitigate the dismal market returns that actually followed extreme market valuations. Interest rates can certainly contribute to the emergence of rich valuations. But once those valuations are set, so are the prospects for subsequent market returns.

It’s tempting to imagine that if interest rates remain low even 10-12 years from now, everything will work out somehow. Unfortunately, the fact is that interest rates at the end of any 10-12 year period are strongly correlated with the economic growth rate over that period itself. So whatever gains are not taken away by reversion of valuations would instead be taken away by weak interim growth.

In summary, current market valuations are consistent with negative expected returns for the S&P 500 over the coming 10-12 years, with a likely market loss of more than -60% in the interim. The proposition that “lower interest rates justify higher valuations” has become a rather dangerous slogan, and is a distressingly incomplete statement that ignores the other half of the sentence: “provided that the stream of expected cash flows is held constant.” Our refusal to accept the incomplete statement as a given is in no way a rejection of basic finance. To the contrary, it’s a reminder that investors need to quantify the effect of interest rates, to consider the fundamental drivers of growth, and to carefully examine the relationship between their preferred valuation measures and actual subsequent market returns.

What investors apparently want to believe is that low interest rates “justify” rich valuations, yet at the same time, those “justified” valuations will be associated with future returns similar to those that have historically been associated with valuation norms less than half of present levels. This mindset is wholly disconnected from any actual principle of finance. A full understanding of the extreme risks inherent in the current financial precipice calls on investors to recognize the following:

  • An investment security is nothing but a claim on some stream of expected future cash flows that will be delivered into the hands of investors over time.
  • Provided that the stream of expected future cash flows is held constant, discounting those future cash flows at a lower rate (which is the same as accepting a lower future rate of return), will result in a higher “justified” price today, and this impact can be quantified.
  • If interest rates are low because growth rates are also low, no valuation premium on stocks is “justified” by the low interest rates. Prospective returns are reduced without the need for any valuation premium at all.
  • Provided that a valuation ratio is based on a “sufficient statistic” for long-term cash flows, the logarithm of that valuation ratio will, in turn, act as a sufficient statistic for long-term investment returns.
  • Revenues and margin-adjusted earnings have historically been far more reliable “sufficient statistics” of future cash flows than year-to-year earnings, or even 10-year averages of earnings.
  • Currently depressed interest rates are indeed associated with unusually weak current and prospective U.S. growth rates, implying that elevated stock market valuations are not, in fact, “justified” by interest rates at all.

Valuation update

The following charts will provide a sense of where the U.S. equity market currently stands.

The first chart shows our margin-adjusted CAPE, which as noted above has a correlation of about -0.89 with actual subsequent market returns across U.S. market cycles since the 1920’s.

Based on the consensus of the most historically-reliable market valuation measures we identify, the U.S. equity market is now at the most offensive level of overvaluation in history, exceeding even the levels observed in 1929 and 2000. Because investors appear to have a speculative bit in their teeth, our very near-term outlook is rather neutral, allowing for both further speculation and abrupt market losses. Again, as I noted a few weeks ago, I view hedges and safety nets as essential here, but there’s no need to “fight” a continued advance, if it emerges, with even larger hedges or higher safety nets. With the S&P 500 likely to lose more than -60% by the completion of the current market cycle, it will be fine if the initial few percent lower do nothing for us.

Don’t confuse the extreme nature of our market loss projections with a requirement that they must be immediate. My expectation is that the initial market losses will be strikingly abrupt, in the sense that the first whack will emerge seemingly out of the blue. I also expect that the initial decline will immediately wipe out any residual gains the market may enjoy from current levels. Still, given the speculative bit that investors seem to have in their teeth here, an element of our patience here involves the willingness to tolerate any residual advance without raising safety nets further.

The chart below shows the median price/revenue ratio across all S&P 500 components (thanks to Russell Jackson, our resident math guru, for compiling this in data from FactSet and Standard & Poors). What’s notable here is that unlike the 2000 peak, when overvaluation was concentrated in the top two deciles of stocks (primarily representing large-cap tech stocks at the time), the current valuation extreme is uniform across every decile. Based on the historical relationship between the valuations of various deciles and their subsequent losses over the completion of prior market cycles, I expect nearly every decile of stocks to experience losses in the 50-70% range as this cycle completes, much like the losses that I projected at the 2000 and 2007 peaks (recall that the tech-heavy Nasdaq 100 lost -83% in the 2000-2002 rout), but with the losses extending to a much broader set of stocks in this instance.

To offer a longer historical perspective, and further insight into the difference between the 2000 peak and the present extreme, the chart below overlays the median price/revenue ratio along with the margin-adjusted CAPE. Notice that the extreme valuation of the S&P 500 Index in 2000 was not associated with anything close to the broad overvaluation among S&P 500 components that we currently observe. Indeed, at the 2000 peak, nearly half of all U.S. stocks were at valuations that we viewed as reasonable. This is certainly not the case at present.

With valuations at the most offensive extremes in history, careful investment analysis has been replaced with investing-by-slogan. The problem is that stocks still represent a claim on future cash flows, and over time, reality shows up as those cash flows are delivered. By the completion of the current cycle, I expect that the total return of the S&P 500 will have lagged Treasury bills all the way back to about October 1997, just as by the end of the 2007-2009 decline, the index had lagged Treasury bills all the way back to June 1995.

One of the challenges with securities, banks, and other objects of finance is that while they actually rest on a very long-term stream of future expected cash flows, investors focus mainly on returns, rather than the quality of those underlying factors. That feature allows enormous departures between what investors think is true and the underlying reality that will unfold over time. Those departures can exist and deteriorate for years before they inevitably become common knowledge. It’s exactly the feature that Ponzi schemes rely on, whether those schemes are sold by crooks or central bankers (and it’s sometimes hard to know the difference).

For a while, Bernie Madoff’s investors felt great about their impressive “returns.” For a while, investors in dot-com stocks felt the same. For a while, investors in mortgage bonds felt the same. But when investors focus on returns rather than the very long-term structure, stability, and even existence of the underlying cash flows, terrible things can happen. All that’s required to get the snowball rolling is the creeping recognition that there’s no “there” there.

In response to the delusion that low interest rates “justify” virtually any level of market valuation, regardless of the growth rate of the underlying cash flows, the speculation of recent years has created a situation where there is effectively no way out for investors in aggregate. Every security that is issued must be held by someone until it is retired. When one investor sells a share, it simply means that another investor buys it. The only question is who will hold the bag.

Market conditions are impermanent, and all of this will change over time. As has been the case in every market cycle, the strongest estimated market return/risk profiles we identify emerge when a material retreat in valuations is joined by an early improvement in market action. I have no doubt that we’ll observe similar opportunities over the completion of the current market cycle.

http://WarMachines.com

Weekend Reading: $7 Trillion To Manipulate Prices

Authoreed by Lance Roberts via RealInvestmentAdvice.com,

As the stock market continues to press new highs, the level of optimism climbs with it. I discussed yesterday Richard Thaler’s, a recent recipient of the Nobel Price in Economics, comments about not understanding the current “irrationality of investors relating to their investing behavior.”

What is interesting is that Thaler’s received his Nobel Prize for his pioneering work in establishing that people are predictably irrational — that they consistently behave in ways that defy economic theory. For example, people will refuse to pay more for an umbrella during a rainstorm; they will use the savings from lower gas prices to buy premium gasoline; they will offer to buy a coffee mug for $3 and refuse to sell it for $6.

The fact that a man who studies the “irrationality of individuals” is stumped by current investor behavior should be alarming at the least.

But as earnings season gets underway we once again return to quarterly Wall Street “beat the estimate game,” in which companies are rewarded by beating continually lowered estimates. Of course, the primary catalyst used to beat those estimates was not a rise in actual revenue, or even reported earnings, but rather ongoing accounting gimmickry and stock buybacks. As shown below, through the second quarter of this year, reported EPS, which includes “all the bad stuff,” actually declined in the latest quarter and has remained virtually unchanged since 2014. (But, even that is an illusion as shares have been aggressively bought back in order to sustain that same level of EPS.)

The difference between reported earnings with and without the benefit of share repurchases is substantial. The chart below shows the net difference between gross reported earnings with and without the buyback impact. Importantly, the net effect of buybacks is having less impact which, as was the case in 2007, was a precursor to the crash. 

Ralph Nader just recently did an in-depth expose on the problems with share repurchases. To wit:

The monster of economic waste—over $7 trillion of dictated stock buybacks since 2003 by the self-enriching CEOs of large corporations—started with a little-noticed change in 1982 by the Securities and Exchange Commission (SEC) under President Ronald Reagan. That was when SEC Chairman John Shad, a former Wall Street CEO, redefined unlawful ‘stock manipulation’ to exclude stock buybacks.”

Yep, stock buybacks used to be considered stock manipulation, yet today, it is widely accepted by investors as “just the right measure to boost earnings in the ongoing “beat the estimate” game.

As Ralph Nader points out – there is a problem.

“The stock buyback mania was unleashed. Its core was not to benefit shareholders (other than perhaps hedge fund speculators) by improving the earnings per share ratio. Its real motivation was to increase CEO pay no matter how badly such burning out of shareholder dollars hurt the company, its workers and the overall pace of economic growth.

The bottom line is that while companies take trillions of dollars and buyback shares, it only benefits the executives of the company at the expense of both workers and, ultimately, shareholders as companies with excessive stock buybacks experience a declining market value.

The interview is worth watching, and read the article, and think about it.

Here’s your reading list to for the weekend.


Trump, Economy & Fed


Markets


Research / Interesting Reads


“Making it, and keeping it, are two different things.Anonymous

 

http://WarMachines.com

Rationality Versus The Market

Rationality Versus The Market

Posted with permission and written by John Rubino, Dollar Collapse

 

Rationality Versus The Market - John Rubino

The late stages of financial bubbles are always tough for rational analysts. Focused as they are on the numbers, such analysts are relatively immune to the emotion that drives the action at market extremes, so they find themselves making predictions that turn out to be “wrong” for months and sometimes years.

 

Then the cycle turns and the rational analyst is vindicated – though often far too late for his bruised ego and diminished client base to easily recover.

 

[Recall the scene in The Big Short where hedge fund manager Michael Burry, after suffering months of abuse from his clients for shorting the 2006 housing bubble a bit early, is lambasted by a client who can’t believe Burry has, after the crash, gone long equities — because they’re clearly going to zero. In both cases Burry was right and his clients wrong, but he nevertheless closed up shop and quit the business.]

 

Anyhow, we’re there again, with governments manipulating all major markets to valuation levels at which previous crashes have occurred. This is leading analysts who focus on historical norms to issue warnings, which turn out to be wrong (stocks are setting new records as this is written), which draw derision from people who see no reason why the party ever has to end.

 

A good example is John Hussman, whose eponymous family of funds has been on the wrong side of this market for an uncomfortably long time. Yet he persists, because the numbers don’t lie. From his most recent report to clients:


So the mindset, I think, goes something like this. Yes, market valuations are elevated, but, you know, low interest rates justify higher valuations. Besides, there’s really no alternative to stocks because you’ll get what, 1% annually in cash? Look at how the market has done in recent years. There’s no comparison.

Value investors who thought stocks were overpriced in recent years have been wrong, wrong, and wrong again, and even if they’re eventually right, being early is just the same as being wrong. The best bet is just to invest in a passive index fund for the long-term, and ignore the swings. There’s really no alternative.

What’s notable about this mindset is its excruciating reliance on three ideas. The first is that low interest rates “justify” rich valuations. The second is that market returns simply emerge as a kind of providence from a higher power, perhaps magical gnomes, or the Federal Reserve if you like, and that those returns have no particular relationship to valuations even in the long-term. The third is that market returns during the recent advancing half-cycle are an accurate guide to future outcomes.

In effect, stocks are viewed as good investments because they have been going up, and the evidence that stock prices will go up is that stock prices have gone up. Every additional market advance makes stocks look even better, based on past returns. Indeed, the more extreme valuations become, the more convinced investors become that extreme valuations don’t matter.

And that’s why we’re all gonna die.

A few insights may help to deconstruct this mindset. First, if one is going to invest one’s financial future in the stock market here, it’s worth making at least a cursory study of 5, 10 or even 20-year growth rates in population, labor force, productivity, S&P 500 revenues, earnings, real GDP, nominal GDP, and virtually every other measure of fundamentals. That exercise will quickly inform investors not only that the growth rate of fundamentals has persistently slowed from post-war norms in recent decades, but also that the underlying drivers of growth (primarily labor force demographics and productivity growth) are now running at rates that are likely to produce real GDP growth on the order of just 1% annually over the coming decade, while even a sizeable jump in productivity would likely result in sustained real GDP growth below 2% annually.

Unfortunately, this has implications for how one responds to interest rates, because the argument that “low interest rates justify higher valuations” relies on the assumption that the growth rate of underlying cash flows is held constant. Any basic discounted cash flow analysis will demonstrate that if interest rates are low because growth is also low, then no market valuation premium is “justified” by the low interest rates at all. Indeed, if both growth rates and interest rates are x% lower than their historical norms, then even a historically normal level of market valuation would be associated with subsequent market returns that are x% below historical norms. No valuation premium is required to produce this result.

The most reliable valuation measures we identify (those most strongly correlated with actual subsequent market returns) are about 2.5 to 2.7 times their historical norms here. Paying a valuation premium in this case simply causes prospective future market returns to collapse.

In order to provide the longest perspective possible, and also to offer a measure that can be easily calculated and validated should one choose to do so, the chart below shows my variant of Robert Shiller’s cyclically-adjusted P/E (CAPE), which has a correlation near 90% or higher with actual subsequent 10-12 year S&P 500 total returns in market cycles across history.

What investors presently take as a comfortable environment of pleasant market returns and mild volatility is actually, quietly, the single most overvalued point in the history of the U.S. stock market.

Hussman’s conclusion is, obviously, that a horrendous crash is coming. The problem is that this – and most other valuation measures – started flashing red in 2013, so warnings based on them now have a hollow ring.

 

Will they end up being be right? Without a doubt. And the longer the current exuberance goes on the bigger will be the subsequent crash. Somewhere out there is the perfect moment to short the hell out of this and pretty much every other country’s stock market. But only a tiny handful will nail it.

 

 

Questions or comments about this article? Leave your thoughts HERE.

 

 

 

Rationality Versus The Market

Posted with permission and written by John Rubino, Dollar Collapse

 

http://WarMachines.com

Weekend Reading: Bull Market In Complacency

Authored by Lance Roberts via RealInvestmentAdvice.com,

With the market recently breaking above 2500, there seems to be nothing to dampen the bullish exuberance. The recent run, which has largely been focused on areas in the market with the most sensitivity to tax cuts, has exploded over the last two weeks to record highs.

That explosion has also lead to a surge in the Market Greed/Fear Gauge which comprises different measures of market complacency and bullishness.

But the rush to chase performance can be clearly seen in the chart below of the S&P 600 index (small cap) which is now 4-standard deviations above the 6-month moving average.

Then there is the widely viewed CNN Fear/Greed Index.

Of course, not surprisingly, with investors as optimistic and bullish as they can be equity to money market ratios are at extremes.

And “Dumb Money” is continuing to pile into markets as “Smart Money” is willing to sell positions to them.

After 9-years of a bull market, and pushing a 270% gain from the lows, investors have now decided it is now time to get back into the market. But that is the nature of a bull market, and particularly one that has entered into the final stages of long-term cyclical advance, where the last of the “holdouts” are sucked back into the game.

As we enter into earnings season, we once again enter into the “beat the estimates game,” where analysts act surprised that companies “beat” lowered estimates. In the short-term, these “beat rates” will provide support for the bullish case, but in the long-term, it is valuations and actual revenue growth that matters.

I agree with Doug’s sentiment yesterday:

  •  Massive injections of liquidity from the world’s central bankers
  • Passive investing (quants and ETFs) are now dominating markets (at nearly 40%) at the margin
  • Machines and algorithms, as well as many individual investors, are behaving differently as they are now programmed and conditioned to buy the dips.
  • 17% of the listed shares outstanding have been retired in corporate stock repurchases since the Generational Low in March, 2009.
  • More than half of the listed companies on the exchanges have disappeared over the last eight years

“We have a Bull Market in Complacency.” – Doug Kass

Clearly.

Here’s your reading list to for the weekend.


Trump Tax Cuts…


Markets


Research / Interesting Reads


“In a bear market all stocks go down and in a bull market they go up.Jesse Livermore

http://WarMachines.com

Bull Trap: The False Promise Of Tax Cuts

Authored by Lance Roberts via RealInvestmentAdvice.com,

Last week, I did a fairly extensive analysis on the release of the 9-page “Trump Tax Cut” plan. 

The most important aspect of that discussion was the difference between 1982, the last time there was permanent tax reform, as compared to today.

Comparing Trump’s economic policy proposals to those of Ronald Reagan. For those that deem that bullish, we remind you that the economic environment and potential growth of 1982 was vastly different than it is today.  Consider the following table:‘”

1982-today

The differences between today’s economic and market environment could not be starker. The tailwinds provided by initial deregulation, consumer leveraging and declining interest rates and inflation provided huge tailwinds for corporate profitability growth.

Most importantly, when tax cuts were implemented in the mid-80’s, the U.S. economy was just coming out of back-t0-back recession versus being in the third longest economic expansion on record to date.

However, besides the fact the economic backdrop is diametrically opposed to what is was during the “Reagan years,” we also need to look at the backdrop of who actually pays taxes to begin with.

Who Pays Taxes

While the current tax plan has not defined actual income levels as of yet, we can make some assumptions from previous iterations of proposals. The entire premise behind the tax cuts is that it will unleash economic growth, generate millions of jobs, bring back manufacturing to America and lead to higher wage growth.

However, given that roughly 70% of economy is driven by personal consumption, the tax cuts will need to increase the amount of disposable incomes available to individuals to expand consumption further, thereby increasing overall economic growth.

So, here is the issue of tax cuts for the middle class. The chart below shows “who pays what in Federal taxes.”

Look at that chart closely.

  • 50% of ALL taxes are paid by the top 10% of income earners.
  • The other 50% of ALL taxes are paid by remaining 90%.
  • The BOTTOM 80% only pay 36% of ALL taxes.

But it is even more glaring when we look at the taxes paid by just the top 20% of income earners.

Given that roughly 2/3rds of income taxes are paid by the top 20%, the reality is that tax cuts will have their greatest impact in reducing the tax burden of those individuals.

The picture gets worse when you look at just INDIVIDUAL tax liabilities. The bottom 80% currently pay only about 18% of individual taxes with top 20% paying the rest. Furthermore, the bottom 40% currently have a NEGATIVE tax liability, and with the new tax plan cutting many of the deductions currently available for those in the bottom 40%, it could be the difference between a tax refund and actually paying taxes. 

Of course, those in the top 20% of income earners are likely already consuming at a level with which they are satisfied. Therefore, a tax cut which delivers a few extra dollars to their bottom line, will likely have a negligible impact on their current levels of consumption.

The problem, as I have detailed previously, is that the vast majority of Americans are living paycheck to paycheck. According to CNN, almost six out of every ten Americans do not have enough money saved to even cover a $500 emergency expense. That lack of savings can be directly contributed to the lack of income growth as noted recently by Bloomberg:

“Newly released income and wealth data from the Federal Reserve Board’s triennial Survey of Consumer Finances show that America’s richest families enjoyed gains in income and net worth over the last decade. Not part of the top 10 percent? Then your income probably fell. The data show that families ranked in the highest percentile saw an income gain of $16,300 from 2007 to 2016. Those below are still making less money.”

So, with 80% of Americans living paycheck-to-paycheck, the need to supplant debt to maintain the standard of living has led to interest payments consuming a bulk of actual disposable income. The chart below shows that debt has exceeded personal consumption expenditures. Therefore, any tax relief will most likely evaporate into the maintaining the current cost of living and debt service which will have an extremely limited, if any, impact on fostering a higher level of consumption in the economy.

But again, there is a vast difference between the level of indebtedness (per household) for those in the bottom 80% versus those in the top 20%.

But Corporate Tax Cuts Are The Key, Right?

Yes, corporate tax cuts will immediately drop to the bottom lines of corporate income statements. When that earnings boost is combined with any repatriated dollars to buy back shares, there will be an earnings expansion for the first year. (You didn’t REALLY think they would use repatriated dollars to expand production and hire workers did you?)

Importantly, while there is a boost to bottom line earnings, there was NO increase in top-line revenues.

However, from an economic perspective, tax cuts for corporations will have only a minor impact in reality. The first chart below shows total federal tax revenue by source.

As you can see, corporate taxes are less than 10% of the total taxes collected by the Government.

But more importantly, it is the promise of cutting the corporate tax rate from 35% to 20% that has gotten the financial markets all excited.

There’s just one problem. Roughly 80% of all corporations already pay rates far lower than 20% and any reduction in deductions for corporations will actually lead to higher taxes being paid. As shown below, 90% of all corporations currently have a tax rate below 10%.

It is a myth that the U.S. has the highest corporate tax rate in the world. We simply don’t.

This was also an observation made by Dr. John Hussman this week:

“I’ll add that another feature of Wall Street’s blissful delusion is the notion that ‘U.S. corporate taxes are the highest in the world.’ It’s striking how disingenuous this claim is. The fact is that among all OECD countries, the U.S. is also the only country that does not levy any tax at all on corporate value-added in the production of goods and services.”

“The main point is this. The argument that U.S. taxes on corporate profits are somehow oppressive relative to other countries is an apples-to-oranges comparison. It wholly ignores that the U.S. levies no value-added tax on corporations at all, whereas the value-added tax is the principal revenue source for most other countries. The rhetoric on corporate taxes here is unfiltered effluvium.

The chart below presents a clearer picture of U.S. corporate profits taxation. Actual taxes paid by U.S. companies, as a share of pre-tax profits, have never been lower, outside of the depths of the global financial crisis.”

Again, as with individual taxes, today ain’t 1982 or 1986.

The effective outcome of tax cuts at this juncture will result in:

  • Only a minimal impact to economic growth, if any at all. 
  • An expansion of the debt of between $2-5 Trillion depending on next recessionary drag.
  • A ballooning of the budget deficit as entitlements rise with the expansion of child tax credits. 
  • A further divide in the “wealth gap” between those in the top 10% and the bottom 90%. 

This issue of whether tax cuts lead to economic growth was examined in a 2014 study by William Gale and Andrew Samwick:

“The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

 

In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

Again, the timing is not advantageous, the economic dynamics are not supportive and the structure of the tax cut itself is not self-supporting.

As Hussman concludes:

“The potential effect of even a substantial percentage reduction in statutory rates for several years is quite small when the present value of the tax reduction is compared with existing equity market capitalization. The likely cumulative impact comes to just a few percent of stock market value.

 

Against that, consider that the most reliable market valuation measures we identify (as measured by their correlation with actual subsequent S&P 500 total returns in market cycles across history) are currently between 2.5 and 2.7 times their historical norms (that is, 150% to 170% above those norms).

 

Put simply, it seems misguided to imagine that ‘tax reform’ will somehow make the most obscene speculative bubble in U.S. history something other than the most obscene speculative bubble in U.S. history.”

Put simply, you can’t solve a debt-problem with tax cuts.

http://WarMachines.com

Hussman Eyes The Market’s “Remarkable Moment Of Blissful Delusion”

"The present moment of blissful delusion is remarkable to witness. Take it in…" says John Hussman of Hussman Funds.

In the following few words and updated charts, Hussman exposes the farce even further…

The first chart below updates our variant of Robert Shiller’s cyclically-adjusted P/E (CAPE), where we’ve adjusted the measure to account for variation in the embedded profit margin; an adjustment that substantially improves the correlation of the resulting measure with actual subsequent market returns across history.

Few investors recognize that one of the reasons why valuation multiples were so rich in 2000 is that profit margins were actually below historical norms at the time. It's also worth noting that the benefit of normalizing the embedded profit margin comes not just from muting margins that are above historical norms, but also from normalizing margins in periods where they are below historical norms.

The next chart shows the margin-adjusted CAPE on an inverted log scale (left, blue line), along with the actual subsequent S&P 500 nominal average annual total return over the subsequent 12-year period (right, red line).

The next chart updates our best estimate of the likely 12-year prospective total return on a conventional portfolio mix invested 60% in the S&P 500 Index, 30% in Treasury bonds, and 10% in Treasury bills.

The current projection is the lowest in history, and I expect these weak passive investment returns, as they unfold, to trigger a rather broad crisis of pension underfunding in the years ahead.

To estimate the S&P 500 component here, we’re using another measure I’ve introduced over time: the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues).

While we’re on the subject of corporate gross value-added (which essentially measures corporate revenues without double-counting intermediate inputs), I’ll add that another feature of Wall Street’s blissful delusion is the notion that “U.S. corporate taxes are the highest in the world.” It’s striking how disingenuous this claim is. The fact is that among all OECD countries, the U.S. is also the only country that does not levy any tax at all on corporate value-added in the production of goods and services.

Without getting deep into the relative merits and challenges of a value-added tax, suffice it to say that 1) the “incidence” of a value-added tax (whether it’s paid by consumers in the form of higher prices, or corporations in the form of lower profits) varies depending on the demand and supply characteristics of each sector, and 2) because a value-added tax tends to be “regressive” all by itself (hitting lower income individuals proportionally more since it functions much like a tax on sales), the appropriate way to introduce a value-added tax is to require additional features of the tax code such as low-income exclusions. Countries can also use policies such as tax credits for investment, R&D, job training, and other arrangements to strengthen incentives for productive investment and job creation.

The main point is this. The argument that U.S. taxes on corporate profits are somehow oppressive relative to other countries is an apples-to-oranges comparison. It wholly ignores that the U.S. levies no value-added tax on corporations at all, whereas the value-added tax is the principal revenue source for most other countries. The rhetoric on corporate taxes here is unfiltered effluvium.

The chart below presents a clearer picture of U.S. corporate profits taxation. Actual taxes paid by U.S. companies, as a share of pre-tax profits, have never been lower, outside of the depths of the global financial crisis.

As for the stock market, understand that total annual U.S. corporate taxes presently amount to only about 1.2% of current U.S. equity market capitalization, and even if a cut was to pass, it would be unlikely to endure for more than a few administrations. The potential effect of even a substantial percentage reduction in statutory rates for several years is quite small when the present value of the tax reduction is compared with existing equity market capitalization. The likely cumulative impact comes to just a few percent of stock market value.

Against that, consider that the most reliable market valuation measures we identify (as measured by their correlation with actual subsequent S&P 500 total returns in market cycles across history) are currently between 2.5 and 2.7 times their historical norms (that is, 150% to 170% above those norms).

Put simply, it seems misguided to imagine that “tax reform” will somehow make the most obscene speculative bubble in U.S. history something other than the most obscene speculative bubble in U.S. history. Corporations are already enjoying strikingly light tax burdens from a historical perspective, and investors are already paying extreme valuation multiples on elevated earnings.

We are observing an episode that will make future investors wince. Just like the two closest analogs, the 1929 high and the tech bubble, I expect that future investors will shake their heads in wonder at the stark raving madness of it all, and ask what Wall Street could possibly have been thinking. In any event, I've shared what I see as my truth, and I experience no need to change anyone's mind. I remain content to abide our value-conscious, historically-informed, full-cycle discipline, and to follow our path. Others are free to continue along their own.

http://WarMachines.com