Month: July 2014

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Is the New Normal of ever-higher stock valuations sustainable, or will low volatility lead to higher volatility, and intervention to instability?

Though we're constantly reassured by financial pundits and the Federal Reserve that the stock market is not a bubble and that valuations are fair, there is substantial evidence that suggests the contrary.

The market is dangerously stretched in terms of valuation and sentiment, and it does not accurately reflect fundamentals such as earnings and sales growth.

Why do we care? If we own no stocks in a retirement or other account, we don’t care; it’s mere background noise.  But if we’re exposed to the gyrations of the stock market in any way, we should care, because those who sell near the top before the market drops preserve not just their initial capital, but their winnings from the 5+-year bull market. Those who fail to sell risk losing not just their gains, but quite possibly a material chunk of their initial capital.

Another reason to care is that those who bet the market will decline in a trend-reversal profit handsomely, just as those who buy at the bottom of a decline profit handsomely from the trend reversal from down to up.

Let’s start with the most fundamental truth: nobody knows the future.  If any technique of prognostication worked every time, anyone with three 100% accurate forecasts in a row could turn $5,000 into $100,000 in three trades using options (or futures contracts). A decent rise or drop will triple an option bought before the move:

$5K -> $15K

$15K -> $45K

$45K -> $135,000

That few manage the apparently simple task of making three accurate predictions in a row (and being confident enough in the technique to leave all the chips on the table) is powerful evidence that no such technique works consistently enough to last even three trades.

That said, the benefits from being correct even once are powerful enough to make it worthwhile to pursue increasing the odds in our favor—even if the odds will never be 100% in our favor.

New Normal: Cycles and TA Banished, or Hubris?

There are three basic tools of prognostication: cycles, technical analysis and fundamental analysis. While each subject is broad, we can boil each down:

In the past six years of unprecedented central bank intervention—quantitative easing (buying of assets such as Treasury bonds and mortgages), zero interest rate policy (ZIRP) and “free money” liquidity (unlimited credit extended to financial institutions and financiers)—the belief that this New Normal is immune to downturns/trend reversal has taken hold, mostly for the reason that every downturn has been reversed by some additional central bank monetary intervention.

If the New Normal is truly permanent, then cycles and technical/fundamental analysis have been mooted: they no longer work because the central banks can push stocks higher essentially forever.

There is another school of thought which holds that central bank intervention so distorts markets that their efforts to eliminate downtrends introduce the seeds of instability which eventually disrupt the market.

Believers in the New Normal hold that the Fed and other central banks have an unlimited ability to print money and buy assets, such that they can buy up the majority of markets to keep valuations elevated.

I see such linear thinking as dangerously simplistic in a non-linear world, and I make the case that the Fed is far more constrained by the bond and currency markets (recall that all these markets are interconnected) than the New Normal faithful believe: The Fed's Hobson's Choice: End QE and Zero-Interest Rates or Destabilize the Dollar and the Treasury Market.

We might also question the basic premise of the New Normal crowd which is that the recent past is an accurate guide to the future. To quote songwriter Jackson Browne: Don't think it won't happen just because it hasn't happened yet.

Though the New Normal faithful see cycles as banished by the godlike powers of central banks, I see a pattern in the New Normal:

Central bank intervention seems to have generated a new cycle: five years of a roaring bull market that reaches bubble heights and then crashes over the following two years.

Is there some reason to believe stocks can loft ever higher, other than central bank intervention?

The one fundamental metric that matters is profits.  Let’s look at corporate profits and the S&P 500 (SPX):

It appears the stock market is responding to central bank intervention to the degree the interventions have enabled corporate profits to soar.  How has intervention boosted profits? One easy way is that by lowering the cost of credit to near-zero, corporations have booked the savings in interest payments as profits.

The question of the New Normal boils down to: Can corporate profits continue soaring? Or perhaps more to the point: Can central bank intervention keep pushing profits higher? Since interest rates are already near 0%, the answer seems to be the fruit of QE and ZIRP have already been picked, and there is little more profit to be gained from these policies.

There are a number of reasons to doubt this steep ascent is sustainable, for example, a rise in the U.S. dollar crimping profits earned in other currencies (About Those Forecasts of Eternally Rising Corporate Profits…  ), a weakening global economy and the stagnation of real household earnings.

Here is a chart which shows corporate profits have indeed rolled over in the first quarter of 2014:

There are a number of other reasons to suspect the New Normal market is stretched; for example, bearish sentiment is low and bullish sentiment is at multi-year highs:

Other conventional metrics of market activity such as corporate buybacks, mergers and acquisitions, issuance of junk bonds, margin debt, etc. are also at extremes.

A continuance of the New Normal requires these extremes to become even more extreme, with no blowback (unintended consequences) or snapback. 

The emergence of inflation is seen by some analysts as a precursor to a market correction:

Countdown to Another Market Peak Has Begun: If we consider two basic drivers of inflation, higher wages and expanding bank credit, there is evidence (via mdbriefing.com) that inflation is systemic:

Here’s a measure of inflation by good old price:

The last extreme to consider is volatility, which has slipped to multi-year lows on the complacency born of a belief that central banks can enforce the New Normal of ever-rising markets at will.

The Big Question: When?

Is the New Normal enforceable even as markets reach extremes, or is the faith in the central banks’ power to bend markets to their will just the latest manifestation of hubris?

No one knows at the moment, but as this article has shown, there are numerous persuasive reasons to be skeptical of the New Normal faith that markets can only loft higher in a permanent state of low volatility and rising profits.

In Part 2: The Signal That Will Tell Us A Stock Market Reversal Is Imminent, we present a number of markers that will indicate when the top is in and the uptrend has reversed. The cautious investor will do well to be attentive to these. Remember: locking in gains — even if that means still leaving some upside on the table — is vastly preferable than holding too long, and watching those gains evaporate.

Click here to access Part 2 of this report (free executive summary, enrollment required for full access)

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The post-weather rebound is over. Factory Orders, which were expected to fal lmodestly, dropped 0.5% – the biggest drop and biggest miss since January. On the flip side, if you were wondering where the recent data (survey) exuberance has come from… wonder no more – inventories in May rose 0.8% – the biggest rise since Oct 2011. More mal-investment-driven exuberance – if only wages were up? Oh, wait – subprime credit is soaring so that will take care of it.

Factory Orders have stalled the recovery.. falling back as bad as in January

But invenrtories are surging…

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Moments after the outlier ADP private payrolls jobs number, the highest since November 2012, was released Gallup offered its own poll-based take on the US jobs market with the release of its monthly US Jobs Creation Index. To some this useful datapoint may explain the ADP-reported surge in hiring, although a more nuanced read simply add to the confusion.

According to the headling job creation index, June saw a +27 print, the same as May, and tying the highest score of job creation in the six year history of the index. Here is how the index measures “job creation”:

Gallup’s Job Creation Index is a measure of net hiring activity in the U.S., with the monthly average based on a nationally representative sample of more than 16,000 full- and part-time workers in June. As was the case in May, June’s +27 index score is based on 40% of employees saying their employer is hiring workers and expanding the size of its workforce and 13% saying their employer is letting workers go and reducing the size of its workforce. Another 41% report no change in staffing.

This is what the index has looked like since inception:

So on the surface this is great news, and corroborates the ADP print, further laying the case for a consensus beating NFP print tomorrow.

However, Gallup also reported the components of the broader Index: namely non-government, or private jobs – those allegedly tracked by ADP – as well as government workers. This is what Gallup reported:

The Job Creation Index score among government workers increased four points from May, resulting in a net hiring score of +18 for June. This score is the highest since the +16 in August 2008, when Gallup first began to measure government employment. The index score increased in June among federal, state, and local government workers, though state and local government workers continue to report a more positive hiring situation than do federal workers.

What about non-government workers? The Job Creation Index score among nongovernment workers registered at +28 for June, a decline from the 29 registered in May.

And visually:

In other words, job creation in the US was scorching hot in June…. among government workers. Meanwhile the private job arena actually posted a relative decline in hiring intentions, which clearly conflicts with what ADP reported was a surge in private job additions in June. Gallup’s own conclusion: “After five months of U.S. workers reporting increased hiring at their workplaces, June’s index score maintained the level from May. June’s score could represent a brief halt in the consistent increases in the index so far in 2014, but it could also signal that job creation perceptions are leveling off after a five-month period of progress for the job market.”

So what does this conflicting data mean? Simple: the BLS random number generator will be busy today (supposedly Yellen will know the NFP print when she speaks today at 11 am) ahead of its public dissemination tomorrow.

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Submitted by F.F.Wiley of Cyniconomics blog,

It stands to reason that when the Fed eventually lifts interest rates, we’ll see the usual effects. After a sustained rise in rates, you can safely bet on:

1. Fixed investment and business earnings dropping sharply
2. GDP growth following investment and earnings lower
3. Many people losing their jobs
4. Risky assets performing poorly

These consequences follow not only from the arithmetic of debt service and present value calculations, but also from the mood swinging psychology of entrepreneurs, lenders and investors.

Yet, policy economists claim that interest rates can be “normalized” at no cost.

For example, while speaking last week about the fed funds rate, St. Louis Fed President James Bullard said the economy was strong enough to “tolerate at least a little bit of the central bank getting back to a more normal stance.”

And how should we interpret “a little bit”?

According to FOMC projections, a little bit of normalization gets underway sometime next year and then leads to a steady pace of policy adjustments that doesn’t stop until the fed funds rate reaches almost 4%. These projections are accompanied by predictions for an improving economy as policy tightens.

Escape velocity or escape from reality?

The FOMC simply doesn’t acknowledge the time-tested effects of rising interest rates noted above. Instead, central bankers argue that today’s monetary stimulus will produce such economic vitality that there’s no sting in tomorrow’s tightening. In other words, they forecast an “escape velocity” where the economy is presumed immune to monetary restraint.

But is there any basis for their beliefs in the economy’s actual workings?

Or, is escape velocity merely a convenient story for central bankers predisposed towards easy money and short-term thinking?

We’ve argued that the Fed’s current policymakers have exactly this predisposition, and that there’s no such thing as escape velocity. We’ve also shared historical evidence supporting our views – in “M.C. Escher and the Impossibility of the Establishment Economic View,” for example – and take another look at history in this post.

Our analysis starts with a breakdown of interest rate changes over all 4 and 8 quarter periods since 1955:

We then review economic outcomes conditioned on the rate buckets above, recording the median outcome for each bucket. In most cases, we compare interest rate changes to outcomes for subsequent (lagged) 4 and 8 quarter periods.

(See this technical notes post for further detail. Also, look for a future follow-up post where we’ll contrast the history shown below to the Fed’s forecasts.)

Here are the results for fixed investment, corporate earnings, GDP and unemployment:

And here are charts showing the effects of changing interest rates on stock and house prices:

Now, many readers will surely dismiss these results by insisting that “this time is different.” We beg to differ. By our estimates, the economy and financial markets are as vulnerable to higher rates as they’ve ever been. Here are a few reasons:

1. The present expansion is weaker than any other post-World War 2 expansion, suggesting that it won’t take much of a slowdown to push the economy into recession.
2. Monetary policy has been exceptionally loose for longer than ever before, allowing financial markets more time to become overpriced and complacent.
3. There are many more risk-takers in the global economy who’ve learned how to exploit cheap dollar policies than there were in, say, 1955, the start of the period shown in the charts.
4. Most importantly, aggregate debt is at or near record levels, not only in the U.S. but also in other large economies.

Bottom line

Our conclusion is to reject forecasts calling for the economy to power right through interest rate hikes without stumbling. A more likely scenario is that policy “normalization” leads us directly into the next bust. Alternatively, the Fed might abort its planned rate hikes, allowing economic and financial market imbalances to continue growing. Either way, we can expect recurring booms and busts until our monetary approach is rebuilt on stronger policy principles.

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