Why The Fed Can’t See A Bubble In Equity Valuations

In 'An Open Letter To The FOMC' John Hussman lays out in detail the true state of the world that asset-gatherers and Fed members alike seem blinded to. The intent of his letter is not to criticize, but hopefully to increase the mindfulness of the FOMC as to historical evidence, the strength of various financial and economic relationships, and the potentially grave consequences of further extreme and experimental monetary policy. Crucially, as we have heard numerous times in the last few weeks, the Fed sees no bubble, and so, a courtesy to both the investing public and the gamblers at the Fed, Hussman explains the reason that the Fed does not see an “obvious” stock market bubble (to use a word regularly used by Governor Bullard, as if to imply that misvaluations cannot exist unless they smack their observers with a two-by-four).

 

Excerpted from John Hussman's "Open Letter To The FOMC",

 

The reason that the Fed does not see an “obvious” stock market bubble (to use a word regularly used by Governor Bullard, as if to imply that misvaluations cannot exist unless they smack their observers with a two-by-four) is because while price/earnings multiples appear only moderately elevated, those multiples themselves reflect earnings that embed record profit margins that stand about 70% above their historical norms.

We can demonstrate in a century of evidence that a) profit margins are mean-reverting and inversely related to subsequent earnings growth, b) margin fluctuations are largely driven by cyclical variations in the combined savings of households and government, and importantly, c) valuation measures that normalize or otherwise dampen cyclical variation in profit margins are dramatically better correlated with actual subsequent outcomes in the equity markets.

 

[ZH: READ THAT AGAIN!!]

 

A few additional charts will drive this point home. The chart below shows the S&P 500 price/revenue ratio (left scale) versus the actual subsequent 10-year nominal total return of the S&P 500 over the following decade (right scale, inverted). Market valuations on this measure are well above any point prior to the late-1990’s market bubble. Indeed, if one examines the stocks in the S&P 500 individually, the median price/revenue multiple is actually higher today than it was in 2000 (smaller stocks were more reasonably valued in 2000, compared with the present). This is a dangerous situation. In this context, the dismissive view of FOMC officials regarding equity overvaluation appears misplaced, and seems likely to be followed by disruptive financial adjustments.

 

 

One obtains a similar view, with equal historical reliability, from the ratio of nonfinancial equity capitalization to nominal GDP, using Federal Reserve Z.1 Flow of Funds data. On this measure, equities are already beyond their 2007 peak valuations, and are approaching the 2000 extreme. The associated 10-year expected nominal total return for the S&P 500 is negative.

 

 

The unfortunate situation is that while the required financial adjustment may or may not be as brutal for investors as in 2007-2009, or 2000-2002, or 1972-1974, when the stock market lost half of its value from similar or lesser extremes, the consequences of extremely rich valuation cannot be undone by wise monetary policy. The Fed has done enough, and perhaps dangerously more than enough. The prospect of dismal investment returns in equities is an outcome that is largely baked-in-the-cake. The only question is how much worse the outcomes will be as a result of Fed policy that has few economic mechanisms other than to encourage speculative behavior.

And of course this speculative behavior ends with only one feature – bubble risk…

A discussion of bubble risk would be incomplete without defining the term itself. From an economist’s point of view, a bubble is defined in terms of differential equations and a violation of “transversality.” In simpler language, a bubble is a speculative advance where prices rise on the expectation of future advances and become largely detached from properly discounted fundamentals. Put another way, a bubble reflects a widening gap between the increasingly extrapolative expectations of market participants and the prospective returns that can be estimated through present-value relationships linking prices and likely cash flows.

 

As economist Didier Sornette observed in Why Markets Crash, numerous bubbles in securities and other asset markets can be shown to follow a “log periodic” pattern where the general advance becomes increasingly steep, while corrections become both increasingly frequent and gradually shallower. I’ve described this dynamic in terms of investor behavior that reflects increasingly immediate impulses to buy the dip.

 

 

 

Along with this pattern, which has emerged with striking fidelity since 2010, we observe a variety of other features typically associated with dangerous extremes:

  • unusually rich valuations on a wide variety of metrics that actually have a reliable correlation with subsequent market returns; margin debt at the highest level in history and representing 2.2% of GDP (eclipsed only briefly at the 2000 and 2007 market extremes);
  • a blistering pace of initial public offerings – back to volumes last seen at the 2000 peak – featuring “shooters” that double on the first day of issue;
  • confidence in the narrative that “this time is different” (in this case, the presumption of a fail-safe speculative backstop or “put option” from the Federal Reserve); lopsided bullish sentiment as the number of bearish advisors has plunged to just 15% and bulls rush to one side of the boat;
  • record issuance of covenant-lite debt in the leveraged loan market (which is now spreading to Europe);
  • and a well-defined syndrome of “overvalued, overbought, overbullish, rising-yield” conditions that has appeared exclusively at speculative market peaks – including (exhaustively) 1929, 1972, 1987, 2000, 2007, 2011 (before a market loss of nearly 20% that was truncated by investor faith in a new round of monetary easing), and at three points in 2013: February, May, and today (see A Textbook Pre-Crash Bubble).

Many of us in the financial world know these to be classic features of speculative peaks, but there is career risk in responding to them, so even those who view the situation with revulsion can't seem to tear themselves away.

 

 

While I have no belief that markets follow any mathematical trajectory, the log-periodic pattern is interesting because it coincides with a kind of “signature” of increasing speculative urgency, seen in other market bubbles across history. The chart above spans the period from 2010 to the present. What’s equally unsettling is that this speculative behavior is beginning to appear “fractal” – that is, self-similar at diminishing time-scales. The chart below spans from April 2013 to the present. On this shorter time-scale, Sornette’s “finite time singularity” pulls a bit closer – to December 2013 rather than January 2014, but the fidelity to this pattern is almost creepy. The point of this exercise is emphatically not to lay out an explicit time path for prices, but rather to demonstrate the pattern of increasingly urgent speculation – the willingness to aggressively buy every dip in prices – that the Federal Reserve has provoked.


    



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The 10 Corporations That Control Almost Everything You Buy

We know the ten “people” that run the world, that 25 cities represent over half the world’s GDP, and that the world’s billionaires control a stunning $33 trillion in net worth… but who controls what the average joe-sixpack on Main Street buys? As PolicyMic notes, these ten mega corporations control the output of almost everything we buy – from household products to pet food and from jeans to jello. The so-called “Illusion of Choice,” that these corporations (and their nepotistic inter-relationships) create is remarkable…

(click image for gigantic legible version)

(Note: The chart shows a mix of networks. Parent companies may own, own shares of, or may simply partner with their branch networks. For example, Coca-Cola does not own Monster, but distributes the energy drink. Another note: We are not sure how up-to-date the chart is. For example, it has not been updated to reflect P&G’s sale of Pringles to Kellogg’s in February.)

 

Via PolicyMic,

Here are just a few examples: Yum Brands owns KFC and Taco Bell. The company was a spin-off of Pepsi. All Yum Brands restaurants sell only Pepsi products because of a special partnership with the soda-maker.

 

$84 billion-company Proctor & Gamble — the largest advertiser in the U.S. — is paired with a number of diverse brands that produce everything from medicine to toothpaste to high-end fashion. All tallied, P&G reportedly serves a whopping 4.8 billion people around the world through this network.

 

$200 billion-corporation Nestle — famous for chocolate, but which is the biggest food company in the world — owns nearly 8,000 different brands worldwide, and takes stake in or is partnered with a swath of others. Included in this network is shampoo company L’Oreal, baby food giant Gerber, clothing brand Diesel, and pet food makers Purina and Friskies.

 

Unilever, of soap fame, reportedly serves 2 billion people around the world, controlling a network that produces everything from Q-tips to Skippy peanut butter.


    



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A Look Inside The “New Normal” McMansion

And they’re back:

  • 2,277 sq.ft. – Median new-home size in 2007
  • 2,306 sq. ft. – Median new-home size in 2012

Just as that crowning achievement of the last housing bubble, the McMansions, have once again returned with the second and final return of the Fed-blown housing bubble, the Bluths picked a perfect time to also come bac on the scene.

But back to the triumphal return of McMansions.

Readers will recall that one of the prevailing themes in the early post-depression years, was a return to thrift – in spending and in housing size – and after the median home size hit a record high of 2,277 square feet in 2007, it declined progressively in the following two years according to Census Bureau figures (we can only assume these were not manipulated unlike the jobs numbers). As David Rosenberg at the time, and as the NYT pointed out a day ago, “It seemed that after more than a decade of swelling domiciles, the McMansion era was over. But that conclusion may have been premature.”

Because as data from 2010 and onward shows, now only is American fascination with size, in this case of one’s home, back but it has never been more acute:

In 2010, homes starting growing again. By last year, the size of the median new single-family home hit a record high of 2,306 square feet, surpassing the peak of 2007. And new homes have been getting more expensive, too. The median price reached $279,300 in April this year, or about 6 percent higher than the pre-recession peak of $262,600, set in March 2007. The numbers are not adjusted for inflation.

However, since we have already covered the return of the housing (and all other) bubbles previously, we will not comment on how the Fed is once again doing everything in its power to bring about the biggest credit and housing bubble crash in history. The NYT has done a rather good and concise job of that:

 Yet the economy remains weak. How can Americans keep buying bigger and more expensive homes? It turns out, of course, that not everyone can.

 

“It’s all about access to credit,” said Rose Quint, an economist at the National Association of Home Builders. “People who are less affluent and have less robust employment histories have been shut out of the new home market. As a result, the characteristics of new homes are being skewed to people who can obtain credit and put down large down payments, typically wealthier buyers.”

 

It’s another sign that in today’s economy, prosperity is not universally shared.

Much more can be added here, although at the end of the day all signs point, as usual, to the Fed and its “reflate everything” panacea.

So instead of analyzing the prevailing Keynesian lunacy in which one needs asset bubbles to fix the aftermath of prior asset bubbles, we will simply constrain ourselves to discussing… interior decoration.

The infographic below from BusinessWeek shows how times, and tastes, how to decorate one’s McMansion have changed in the past few years.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/7dC0YYCusGI/story01.htm Tyler Durden

A Look Inside The "New Normal" McMansion

And they’re back:

  • 2,277 sq.ft. – Median new-home size in 2007
  • 2,306 sq. ft. – Median new-home size in 2012

Just as that crowning achievement of the last housing bubble, the McMansions, have once again returned with the second and final return of the Fed-blown housing bubble, the Bluths picked a perfect time to also come bac on the scene.

But back to the triumphal return of McMansions.

Readers will recall that one of the prevailing themes in the early post-depression years, was a return to thrift – in spending and in housing size – and after the median home size hit a record high of 2,277 square feet in 2007, it declined progressively in the following two years according to Census Bureau figures (we can only assume these were not manipulated unlike the jobs numbers). As David Rosenberg at the time, and as the NYT pointed out a day ago, “It seemed that after more than a decade of swelling domiciles, the McMansion era was over. But that conclusion may have been premature.”

Because as data from 2010 and onward shows, now only is American fascination with size, in this case of one’s home, back but it has never been more acute:

In 2010, homes starting growing again. By last year, the size of the median new single-family home hit a record high of 2,306 square feet, surpassing the peak of 2007. And new homes have been getting more expensive, too. The median price reached $279,300 in April this year, or about 6 percent higher than the pre-recession peak of $262,600, set in March 2007. The numbers are not adjusted for inflation.

However, since we have already covered the return of the housing (and all other) bubbles previously, we will not comment on how the Fed is once again doing everything in its power to bring about the biggest credit and housing bubble crash in history. The NYT has done a rather good and concise job of that:

 Yet the economy remains weak. How can Americans keep buying bigger and more expensive homes? It turns out, of course, that not everyone can.

 

“It’s all about access to credit,” said Rose Quint, an economist at the National Association of Home Builders. “People who are less affluent and have less robust employment histories have been shut out of the new home market. As a result, the characteristics of new homes are being skewed to people who can obtain credit and put down large down payments, typically wealthier buyers.”

 

It’s another sign that in today’s economy, prosperity is not universally shared.

Much more can be added here, although at the end of the day all signs point, as usual, to the Fed and its “reflate everything” panacea.

So instead of analyzing the prevailing Keynesian lunacy in which one needs asset bubbles to fix the aftermath of prior asset bubbles, we will simply constrain ourselves to discussing… interior decoration.

The infographic below from BusinessWeek shows how times, and tastes, how to decorate one’s McMansion have changed in the past few years.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/7dC0YYCusGI/story01.htm Tyler Durden

The Cost Of An Ultrawealthy Uberclass: $1500 Per Worker

Submitted by mickeyman via The World Complex blog,

Interpretation of scaling laws for US income

It has been remarked that if one tells an economist that inequality has increased, the doctrinaire response is "So what?"

                                          – Oxford Handbook of Inequality

h/t Bruce Krasting

Social Security online has published a full report on income distribution in America.

Two years ago we looked at the distribution of wealth in America. Today we are looking at income.

There were a total of about 153 million wage earners in the US in 2012, which is why the graph suddenly terminates there.

As we have discussed before, in self-organizing systems, we expect the observations, when plotted on logarithmic axes, to lie on a straight line. Casual observation of the above graph shows a slight curve, which gives us some room for interpretation.

I have drawn two possible "ideal states"–the yellow line and the green line.

Those who feel the yellow line best represents the "correct" wealth distribution in the US would argue that the discrepancy at the lower income (below about $100k per year) represents government redistribution of wealth from the pockets of the ultra-rich to those less deserving.

 

Followers of the green line would argue the opposite–that the ultra-wealthy are earning roughly double what they should be based on the earnings at the lower end.

Which is it? Looking at the graph you can't tell. But suppose we look at the numbers. Adherents of the yellow line would say that roughly 130 million people are getting more than they should. The largest amount is about 40%, so if we assume that on average these 130 million folks are drawing 20% more than they should (thanks to enslavement of  the ultra-wealthy), we find that these excess drawings total in excess of $1 trillion. Thanks Pluto!

The trouble with this analysis is that the combined earnings of the ultra-wealthy–the top 100,000–earned a total of about $400 billion. They simply aren't rich enough to have provided the middle class with all that money.

Now let's consider the green line. Here we are suggesting that the ultra-wealthy are earning about twice as much as they should be, and let's hypothesize that this extra income is somehow transferred from the middle and lower classes.

As above, the total income of the ultra-rich is about $400 billion. If half of this has been skimmed from the aforementioned 130 million, they would each have to contribute about $1500.

I expect a heavier weight has fallen on those at the upper end of the middle-class spectrum; but even so, $1500 per wage earner does seem doable. Of the two interpretations, the green line looks to be at least plausible, and we are forced to conclude that those who believe the ultra-wealthy are drawing a good portion of their salaries from everyone else have a point.

But isn't $1500 per year a small price to pay to create a really wealthy super-class?

Paper on causes of income inequality full of economic axiomatic gibberish here (pdf).

 


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/yRQgOT6Jawc/story01.htm Tyler Durden

There is No Such Thing as a Smooth Fed Exit

 

The primary theme driving US stock markets, is that of whether the Fed will taper or not.

The mere fact that this is the single most important theme for the markets goes a long way towards explaining how busted our financial system has become. Before 2007, the talk concerned whether the Fed would change interest rates. Today we talk about whether scaling back from $85 billion in asset purchases per month represents tightening.”

 

At the end of the day, the fact is that the Fed can never exit its strategies. I realize there are a lot of smart people with smart explanations for why the Fed can exit, but they are missing a critical component: human nature.

 

We saw this in real-time back in May 2013 when the Fed first floated the idea of tapering its QE programs. The Fed had hoped it could float this idea and let the markets get used to it, instead interest rates spiked with rates on the 10-year moving up from 1.5% to nearly 3% in a matter of weeks.

 

 

At the time, the financial media began to write articles about the market’s “taper tantrum” as though metaphorically aligning the capital markets with s spoiled brat explained the reaction.

 

The Fed then did a 180 despite all but promising it would taper QE. Bernanke even went so far as to negate the call for a taper in his July Q&A.

 

Why did he do this? It’s simple. He like the rest of the Fed saw in simple terms that there is no such thing as a smooth exit. The market rebelled at the mere hint of tapering at a time when the Fed is buying $85 billion per month. If the Fed were to actually go ahead and taper what would rates do?

 

Moreover, with the financial system now even more leveraged than it was going into 2007… what would happen if interest rates moved back to their historical averages of 4% on the ten year Treasury?

 

Ka-Boom.

 

So now, there is talk of the Fed tapering in December. Maybe it will, maybe it won’t. I have no idea. No one does. If we were going to try to analyze the Fed’s moves via logic or economic fundamentals, we would have tapered months if not years ago.

 

Instead we’ll get more of the same: talk of taper to talk the markets down, then a surprise decision to not taper so market take off again. The Fed is now managing expectations more than anything. The Fed has acted in 90+% of the months since the Crisis began. This tells us precisely what the game plan is going forward.

 

At some point, and I cannot say when, this whole mess will come unhinged. When it does 2008 will look like a joke.

 

If you have not taken steps to prepare for a market collapse, we have a FREE Special Report that outlines how to prepare your portfolio. To pick up a copy, swing by:

http://phoenixcapitalmarketing.com/special-reports.html

 

 

Best Regards

 

Phoenix Capital Research

 


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/9tBBOMMZk1E/story01.htm Phoenix Capital Research

BTFATH Continues; Dow Opens +70 Points, Oil -1%

An Iran deal that is kinda sorta a deal but really is not a deal is all we need in the new normal to justify adding another few fractions onto the equity multiple valuation tree of hope. The S&P is up 9 points, Dow up 70 points, and WTI Crude is down around 1% on the news. Interestingly, stocks have no support from the almost ubiquitous carry traders as this appears more like a rip through the stop order stack more than another greater fool adding to their position.

 


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/40OdFTkF1TI/story01.htm Tyler Durden

Greenspan Still Doesn't Get It

Submitted by Tomas Salamanca via the Ludwig von Mises Institute of Canada,

Until recently, Alan Greenspan’s main argument to exonerate himself of responsibility for the 2007-2009 financial crisis has consisted in the claim that strong Asian demand for US treasury bonds kept interest rates on mortgages unusually low. Though he has not given up on this defense,  he is now emphasizing a different tack, as manifest in an article published in the current issue of Foreign Affairs. The article captures key themes elaborated in his latest book on the problem of forecasting, The Map and the Territory. His new tack is no better than the old tack.

Reprising what has lately become a very common refrain in financial commentary, Greenspan points the finger at the emotional side of human nature. This is the side where behavioral economics has recently made a name for itself in formulating its accounts of investor behaviour. Actually, this approach has a much older provenance, most famously conveyed in Keynes’ invocation of “animal spirits” in the General Theory of Employment, Interest, and Money.  On the Keynesian view that behavioral economics adopts, investors do not buy and sell securities by rationally processing all available information and calculating expected returns. Rather, their decision making is distorted by cognitive biases and swayed by the oscillating passions of fear and hope.

In Greenspan’s rendering of the “animal spirits”, investors swing between phases of risk loving and aversion. Greenspan also maintains that “animal spirits” show themselves in herd behaviour. Inasmuch as investors take their cues from others, they tend to be either risk loving, or risk averse, all at the same time.  You know where all this is going with respect to the financial crisis. According to Greenspan, the herd on Wall Street bought up mortgage backed securities while underestimating their risks, and then as soon as those risks became all too clear, everyone headed to the exits simultaneously.

No doubt, an understanding of human psychology is helpful in making sense of economic phenomena. But we have to be precise in distinguishing the role of psychology in economics. As Mises argued, economics is a deductive science. All its conclusions ultimately proceed from the axiom that human beings act by choosing between alternative means to realize their subjective ends. All the psychology that economics needs is the rather obvious proposition that an overriding goal of human beings is the quest to attain a more favorable state of affairs in their lives. Only when the attempt is made to illustrate the operation of economic principles in the real world, as happens when one is engaged in the writing of economic history,  does psychology become illuminating. A psychological analysis might, for example, tell us what goals a particular individual or group are pursuing as well as the degree to which they prioritize considerations of the present over those of the future. Psychology can help economists tell richer stories; it cannot help them derive better economic theories.

Still, this is not the most significant of Greenspan’s errors. Yes, very few people are truly independent thinkers. Not being confident in any opinion unless it is socially confirmed somehow, people are inclined to think as others around them do.  And so, yes, this means human beings are subject to herding behaviour. Yet in order for a herd to develop in favor of some opinion, such as that sub-prime mortgage securities are a great investment, that opinion must initially gain traction. This is what Greenspan’s account is missing. He seems to think that investor herds come out of nowhere, mysteriously emerging more often than would be expected from a bell curve distribution of asset price changes. How, in other words, did sub-prime mortgage trend higher in the first place so as to generate all the enthusiasm it subsequently attracted?

The answer, of course, involves the loose monetary policy that Greenspan himself ran in the 2000′s as chairman of the Federal Reserve. By injecting so much money into the financial system, he supplied market participants with the means of raising the demand for financial assets. By greatly reducing the yields on low risk government bonds, Greenspan shifted that demand towards higher risk mortgage securities offering more appealing rates of return. Yield spreads narrowed between private sector and government bonds. Concomitantly, there was a steady upward movement in the prices of mortgage bonds, which the “animal spirits” then exacerbated through investor herding.

So if Greenspan hadn’t run an easy money policy in the first place, there would have been nothing in the mortgage arena for the “animal spirits” to have latched onto. This is always the case with financial asset bubbles. Excess hope only comes into play after the central bank has set the boom in motion. Excess fear is the inevitable follow-up once the bubble is popped.

Ironically enough, we can appeal to psychology to explain why Greenspan is unable to recognize this point. Human beings are strongly inclined to maintain their self-esteem. Admitting your own complicity in one of history’s greatest financial crises goes against that fundamental drive. Greenspan would be well advised to apply psychology not just to others, but to himself.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/7ihLeqqQiD4/story01.htm Tyler Durden