Many of us chart watchers keep constant vigil on the activity of different indicators, looking for signs that help us to make better investment, or disinvestment, decisions. Some indicators are very arcane, the implications of which escape the understanding of many everyday savers. For much of the last 2 years, analysts and investment advisors (yours truly included) have been justifiably preoccupied with the threat of a rise in interest rates. The Federal Reserve raised rates in December 2015 and the US stock indices dropped as a result in January of this year.
Nevertheless, here we are at the end of August of 2016 and the S&P 500 is up 6.21%, while the SmallCap 2000 is up 9.47% and the Nasdaq is up 4.11%. What gives? If the value of corporations when compared to GDP exceeds the levels of the prior to the last recession, surely the US indices are headed for a correction, if not a precipitous fall. The reasons for concern are many (grey-shaded areas in FRED graphs are previous recessions):
- Low unemployment rate (4.9%)
- Corporate profits are receding from Q4 2014 highs
- Dwindling confidence in the Federal Reserve
- Two presidential candidates that are less than ideal
- High Shiller PE Ratio (www.multpl.com)
- Low commodity prices
- Historically high debt to GDP ratio
- Volatility Index is below its historical median (17.88)
- US Dollar Index that has been consolidating since March of 2015, after a sharp rise that began in June of 2014.
Some of the “positive” data points are purposefully included in the previous paragraph, because all mountains have peaks. In other words, when looking at cycles: unemployment doesn’t last forever, a strong US Dollar eventually is bad for exports & US GDP and the VIX (Fear Index) has a tendency to swing violently up when suppressed for any meaningful period of time. In other words, all good things come to an end, if only temporarily, and there are many other data points, domestic and foreign, that are clearly pointing towards a necessary adjustment in financial markets.
One of the best lessons I have learned in this business is that you cannot sit on your hands if you think a particular scenario is going to play out soon. Many investment advisors are losing business because they are under-performing the market. In a NIRP or ZIRP world, cash pays zip. Just ask the Japanese and Europeans. The Japanese government now owns around 60% of domestic ETF’s in their attempt to get inflation up and consumers spending. Sounds like a whole bunch of nonsense, right? Meanwhile, pension funds are warning that they will have difficulty in meeting their projected needs, thanks to these low interest rates. Who has benefited from the financial crisis and low interest rates? The very same people who caused the crisis. In my opinion, the movie “The Big Short” provided the best insight into the machinations of the big banks and the elite behind the housing crisis. While prepping for this post, I did a Google search of “financial crisis movies” and none of the images at the top of the search results were of that movie. A movie borne of the experiences of investors who recognized the bubble before the banks were willing to admit.
Some of my favorite analysts in the world are concerned and frustrated with Federal Reserve analysis and interest rate projections. One, former Dallas Fed insider, Danielle DiMartino Booth is so fed up with Fed communication and pandering to the elite that she has written a book titled “FED UP”, quite appropriately I might say. Financial market information provider Bloomberg has a screen that shows the probability of an interest rate hike each of the Fed meetings. As of yesterday, the probability of a hike in September was 42%. This number is very volatile, depending on economic data and Fed board member comments. My well documented stances is that the Federal Reserve, despite hawkish comments by several board members, will not raise rates before December to avoid being a political issue in the November elections. What makes the Fed communications so frustrating for Danielle and others is the Fed focus on raising rates when valuations are high, corporate profits are slowing and data points such as record-high student debt are alarming. Raising rates in a slowing, over indebted economy, will only prove to bring the economy to a stand still, possibly a full blown crash.
As I mentioned on Twitter this afternoon, there are a couple of data points that guide performance of some assets for the next year. First, the difference in yield an investor receives for buying US High Yield bonds versus US Treasury bonds (blue line) has come down, but usually takes a longer time to bottom, as observed in previous cycles. Additionally, the difference in yields between the US 2-year and 30-year treasuries (orange line) is also low. This is the best indication of a flattening yield curve, but again we have seen it lower and longer that the present trend. It is important to remind readers that an inverted yield curve, short dated bonds yielding more than longer dated bonds, has ALWAYS indicated and preceded a recession.
What does this mean for the majority of us who are simply trying to build our savings for retirement? My perspective is based on an ongoing interest in keeping things as simple as possible. Too much data can sometimes lead to confusion. In a NIRP/ZIRP world, participants have become accustomed to low rates. The “New Normal” Mohammed El-Erian famously described at the 2010 Per Jacobsson lecture is simply something that was previously abnormal has become commonplace. John Mauldin likes to refer to this current period as a great “Muddle Through”. Both are simplistic descriptions of an economic force that has taken hold and is extremely difficult to get out of.
If it wasn’t difficult enough, elite academics and popular economic figures have taken a curious stand, that if acted upon, will reduce global competitive advantages and undoubtedly result in even less inflation and further damage future savings. In case you weren’t aware,this week the European Union found Apple to have illegally gained tax benefits from their operations through Ireland and ordered Apple to pay up to 13 billion Euros in back taxes, plus interest. Think about that. Ireland, a sovereign nation, has tax laws that were constructed to attract international corporations to operate there. A nation of 4.8 million inhabitants, on an island of almost 70k sq km, less than tiny Panama and its 4m people on 77k sq km. Apple’s arrangement dates back to tax rulings in 1991, which were replaced by another in 2007. This week’s ruling has opened the legal door for other European nations to charge Apple taxes retroactively. As stated in the Customer Letter response provided yesterday, the money isn’t the issue, Apple had more than $23 billion in cash at the time of its June 2016 10-Q . Apple is taking issue with who takes money, which invariably means higher tax rates to be paid in countries such as France (33%), Sweden (22%) and Germany (30%), compared to the 12.5% levied by Ireland.
The EU ruling comes at a time when the ECB is utilizing a negative interest rate policy, in addition to an asset buy-back program that is costing it over 60 billion euros a month, while trying to find solutions for the fiscal black holes in some of its member states. Getting Apple and other multinationals to pay more in taxes would help place a bandage on a bleeding wound. Unfortunately, the problem with the EU runs much deeper than an Ireland tax issue.
To add more salt to the wound, Joseph Stiglitz was quoted today as saying the following about the Irish government, “…you got a few jobs at the cost of stealing revenues from countries around the world” and “…the fact is that you were encouraging tax avoidance, you knew it.” So, the war on the competitive advantages of tax rates continues. My sense is that one of the goals of the elite is to put all developed markets on the same playing field, which lends to the strength of the larger, more dominant “teams” and killing the competitive advantages the smaller teams had in hand. To top it off, EU rulings like this punish a relatively more productive nation for doing it right and forcing them to share with the laggard and corrupt nations of the union. This in essence is the reason why the UK voted to leave the EU. The lack of competitive advantage renders pricing power inelastic, which in turn when faced with a stagnant consumer spending environment forces to companies to continue to cut costs and not invest in growth. Sounds familiar? That is exactly why productivity in the US is stagnant. Company CFO’s are cutting costs, buying back shares, manipulating EPS and not investing in organic growth.
Please forgive the rant, it was necessary to set the stage for the next graph.
All my previous comments regarding the loss of competitive advantage and the long term effects of cost cutting are explanations for why developed markets are on a path of “lower for longer” (thanks Mark Yusko). The magic elixir of low rates has infected the patient and we have a junkie on your hands. The psychological damage is done and one has to contemplate what kind of effect another 1/4 point rise in rates could have on a country that has made hopeless attempts at reaching 2% inflation. The falling Civilian Labor Force Participation Rate is doing exactly what you would expect for domestic sales rates in the US, it is not at historically normal levels. (Alhambra Investment Partners)
To tie everything together, it helps to add another data point to the earlier graph, the S&P 500 (gray line):
All the concerns about spreads and rates are well founded, though I must highlight the fact that expectations of low inflation expectations in 5-10 years continues to be a great indicator of suppressed pricing power at the Fed.
Judging by historical precedent, it seems as though high yield spreads still have a ways to go before really being overextended vs Treasuries. In addition, the US Treasury curve has yet to invert and historically has persisted at low ranges for long periods of time, providing support to the S&P 500 and equities in general. This allows me to remain cautiously constructive in equities for the remainder of the year. Still, I will continue to count on my Absolute Return strategy to indicate the time to bail.
The only thing standing in the way of the next crisis is Janet Yellen and the Fed. Let’s hope they stop talking BS about raising rates and target inflation, because they keep utilizing the wrong models for their projections and seem to be ignoring what the market is already well aware of. Raising rates before December, or in 2016 will set off a chain of events they do not want on their hands.