BNN Full Interview for January 19th, 2018

BNN Jan 19

 

Market Call Interview

https://www.bnn.ca/video/full-episode-market-call-for-friday-january-19-2018~1301270

 

Past Picks:

https://www.bnn.ca/video/ross-healy-s-past-picks~1307955

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Black Hole Economics: Why The Rich are Getting Richer and You are Getting Poorer

image 1It wasn’t supposed to be like this, you know. Back in 1979, that glib snake oil salesman, Arthur Laffer, promised that with tax cuts for the corporations and the rich, everyone would benefit as the increase in economic growth that would result would trickle down to everyone’s benefit. 38 years later, the rich have certainly benefited but somehow the rest of us have largely become poorer as wealth has become massively concentrated in the hands of the top 1%. Today, so entrenched has the Laffer Curve “theory” become that finally one of those 1 percenters has reached the top office in the USA, on a platform of – yes – cutting taxes for the rich! And, heaven help us, many Americans – and, apparently, all of the Republican members of Congress – still believe the story. The last two exercises in tax cutting (and the resultant debt growth) has already led the US to the point where GDP growth has slowed to a crawl and the total indebtedness of the US economy has reached unprecedented highs. So what went wrong with ‘trickle-down’ economics that has brought us to the current state of affairs? And now that Congress has written ‘chapter three’ in the tax reduction tale, the Corporate Welfare Act of 2017 (a.k.a. “tax reform”), the question is where are we going from here?

Let’s start with the “what went wrong” question. Politicians love cutting taxes. For Ronald Reagan way back in 1980, that was easy and very popular. But if your income gets cut back, then your expenditures had better be cut back as well – or you will have to borrow to cover your household ‘deficit’. Reagan’s ‘household’ (so to speak) was the US government, but cutting government spending would not be popular – and he felt, unnecessary –when all the growth that Laffer promised would be coming soon. Tax collections would increase, and the government would then cover off any immediate spending deficits that would result from tax cutting.

Only that part never happened. US government deficits began to grow relentlessly and the total indebtedness of not only the federal government of the US but also the US states have soared more or less since then, with but one all too brief respite.

And so it was that the debt load on the US economy actually grew and grew, and the US economy grew increasingly more sluggish as deficits mounted. Following the election of 1992, new president, Bill Clinton, was so alarmed that he instituted a regime of raising taxes, slashing expenditures, and paying down the US government debt. His policies – which were completely antithesis to the tax reducing ‘Laffer strategy’ – worked like a charm. As the previously growing debt burden was lifted from America’s back, the economy soared, the stock market soared, consumer confidence soared, and the US dollar rose to new highs. To this day, thanks to the memory of his spectacular economic success, Bill Clinton remains one of the most popular and respected (ex) politicians in America. Parenthetically, by the year 2000, people in the investment industry actually began to be concerned that low risk US government bonds would vanish!

They need not have worried. Hanging chads killed Al Gore’s chance to be elected president following in Clinton’s footsteps, and George W. Bush Jr. was elected on a platform of slashing taxes in order to out-Reagan Reagan. By 2008 not only had that explosion of government debt triggered a massive real estate boom and bust, but it also led the US (and as it turned out, much of the Western economic world) to the brink of the economic Black Hole.

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At the same time as Laffer was propounding his “theory” of taxation and economic growth, the founder of Strategic Analysis Corporation, Dr. Verne Atrill, made some remarkable calculations based on a set of mathematical theorems that he had spent his life developing. He discovered that there is a precise point at which an economic entity (corporation, household, or entire country) stops expanding and begins to contract instead. This is a mathematical singularity, and, for the economy as a whole, can be measured by using the ratio of GDP/ Total Debt, This point is akin to the event horizon of a celestial ‘black hole’ and it acts in a similar manner. A celestial black hole draws energy (light and matter) into its vortex, and an economic black hole draws economic energy – GDP – into its ‘vortex’ due to the dead weight of massive debt. Below that point, if central banks continue to use so-called Quantitative Easing in all its forms, debt will continue to expand (and historically has done so with increasingly speed), but more and more GDP will be sucked in, eventually causing a collapse of the economy along with the value of the currency. Today, parts of the Euro Zone notably Greece and Spain, have already slid into that vortex, and Japan and the US are dancing on the rim!

For those who are curious, the complete mathematics are freely available online by visiting my blogsite, The Occasional Contrarian. In an article entitled The Limits of Debt, I show the full mathematical development of the theorem of solvency from first principles, including the associated table of values, and the graphic relationship which results (shown below). This relationship is termed the (Atrill) Marginal Productivity of Debt Curve (MPD). In the chart, a GDP/Debt ratio of .289[1] ($3.50 of debt per $1.00 of GDP) is the financial equivalent of the “event horizon” of a celestial black hole. Like the celestial sort, economic ‘black holes’ keep increasing as the mass of debt increases, but in doing so, sucks in more and more GDP to support that debt (that is, stultifies and then starts to reverse the growth of GDP). Below that ratio value, the growth of real GDP turns negative while total indebtedness keeps expanding at a and faster and faster rate. Essentially, it becomes activity for the sake of activity, but that only serves to crush GDP itself and increase the dead weight of debt on an economy. For those who like hard numbers, the current total debt of the US stands at $66.5 trillion and current GDP is $19 trillion, a ratio of debt/GDP, or almost precisely 3.5:1.

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In the 20th Century, a considerable number of paper money-issuing governments and their central banks, faced with the problem of trying to stimulate growth at that .289 (and lower) level, have done so by trying to issue more and more paper (debt, both short and long term) to attempt to counter the failure of the real economy to catch fire. In the 20th century, according to a study by the Cato Institute, 55 governments have executed this ‘strategy’, all with devastatingly similar consequences for their economies and currencies. Thus far in the 21st Century, we have watched Greece, Spain, Venezuela and Argentina fail (among others). Initially, stock market values in those countries usually soar, so that the “stimulus” policies seem to “work”! However, looking at it another way, as the debt aneurism expands and the money has to go somewhere, it heads into the “safety” of the ownership of hard assets.  However, if history is a reliable guide, this eventually leads into a shrinkage of the GDP, then to price (and wage) hyper-inflation. The US is currently dancing on the edge of its own “event horizon”, and may only be still standing because it is the global key currency. While GDP growth has not proven to be self-sustaining without continuing stimulus, it is, however, ‘self-delusioning’.

At and then below a GDP/Debt ratio of .289, the growth of GDP (due to the weight of added debt) falls to and then below zero. We term this a scientific bankruptcy because the effects of bankruptcy hold. Debt compounds while value (GDP activity) recedes. Parenthetically, such a point must exist, because otherwise, Zimbabwe (for one) would be one of the richest countries in Africa, and Greece and Spain would be sitting atop all of Europe.

Implications of Economic ‘Black Holes’

As growth falls very close to zero – and since 2008-9, US growth has been extremely sub-par – then a number of things must happen as a consequence.

  1. First and foremost, since growth grinds almost to a halt, there are few price pressures due to a lack of shortages – of almost everything. And without the pressure of rising demand on goods and services, we don’t experience price inflation. And without that demand pressure, wages and prices will either be steady or even decline. Everyone has been waiting for the “usual” increase in inflation that comes late in a business cycle – particularly late in an expansion that has been going on for almost 10 years – but thus far, there is no evidence of anything of the sort.
  2. Without growth, there is very little demand for money. Businesses notably have been paying down their debt, not increasing it as usually has happened following recoveries from past cyclical contractions. Indeed, Corporate America is paying out through share buybacks as much as or more than it is earning, which explains why loan growth hasn’t caught fire in this cycle, even with near zero interest rates. Fundamentally, if there is almost a zero or even negative demand for money, why would anyone expect anything but a low or even negative return on money?
  3. Of course, our central bankers may not be happy about the economic growth trajectory, but at least they can say that all that ‘pump priming’ that they have indulged in to keep the economy moving has not led to the kind of inflation that the economists of olden days warned us about. Interest rates have remained low and encouraging. ‘Monetarism’ and the ‘Philips Curve’ seem to be out the window (thanks to “wise” central bank guidance)! The bottom line for central bankers is that long term quantitative easing is not to be feared.
  4. The failure of wages, prices, and interest rates to react to massive monetary stimulus has lulled our central bankers into a sense that the real risks to the economy lie in deflation with falling prices, when in fact, we are indeed already facing rampant inflation, the problem being one of measurement.
  5. That critical item that Government and economists do not choose to identify or measure is the cost of a dollar of GDP. For most of the 20th century, it used to take (‘cost’) the US about $1.45-.50 of additional debt to generate $1.00 of additional GDP (the peak of the Atrill Curve). Since 1984-5, the marginal “cost” of an additional $1.00 of GDP has steadily escalated to $3.50. Yet central banks and main stream economists are completely mute on this issue. They certainly do not refer to this as “inflation”! However, referring to the 55 examples since 1900, all pursued massive monetary easing of some sort, and all of them ended with an inflationary collapse of both their economies and associated currencies.

For those are interested in the current US numbers, total GDP as of October 2017 stood at $19.0 trillion and the total debt figure stood at $66.5 trillion for a ratio of 0.289 (or looked at from a debt/GDP point of view, 3.5 times). That ratio has pretty much held virtually dead steady since the 3rd quarter of 2007!

Of course, there has been some real economic growth in the US economy, for which the US can thank net immigration of ¾ of 1% per year (and the quantitative easing programme). Since the US economy first achieved the GDP/Debt ratio of 0.289 in the third quarter of 2007, the US economy has expanded at an average rate of 1.4%, despite all efforts to grow at a faster rate, far short of the “usual” 3%+ annual rate in earlier decades. In order to achieve this rate of growth, however, total debt in the US economy has grown at a compound rate of 2.9%.

Some Consequences that flow from the Atrill Curve

  • Money On Strike: Velocity Declines Endemically

Velocity of Money – US (Source: FRED)

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One of the truly striking features of the US, Japan, and Europe is that the velocity of money is not only declining but has been in a steady decline for a long time, in some cases going back three decades (“money zero maturity”, or MZM in the US). This is a key characteristic of all increasingly insolvent economies that we have examined – Europe, Japan and the US. Money does less and less “work’, in essence ‘trying’ to counteract the increasing financial inefficiencies brought on by excess debt.

Note that the velocity of MZM – the loosest definition of ‘money’ – peaked out in 1980 at the peak of the balance sheet strength of the US, M2 peaked out at the end of Clinton’s presidency when Bush began to weaken the balance sheet (again), and finally M1, so-called high-powered money – only peaked when the solvency of the US finally fell to .289, the start of the scientific bankruptcy condition of the US.

  • When Money Goes On Strike, The Printing Presses Go To Work

The challenge to monetary authorities is that of trying to overcome what is effectively falling money availability caused by falling velocity. Historically, they have done this by issuing more and more money through programmes equivalent to very aggressive ‘quantitative easing’. Unfortunately, the MPD Curve shows all too clearly that this makes the problem worse.

In all those 55 countries referred to above, there is a tipping point when price and wage inflation suddenly start to accelerate, as currency values and GDP implodes. Price and wage inflation then reverses their moribund course and velocity re-accelerates massively as well (as Weimar Germany, for one, shows. By the way, Germany has left an excellent record of that period for anyone to see, and I recommend the records of the Bundesbank to all students of national insolvencies.). At that point, holders of those currencies in question try to exchange their money for things – anything – which can hold their value as the purchasing power of those currencies collapses. Seen in this light, we should all hope that the current quest by central banks to stimulate an uptick in inflation (as measured by wages and prices) fails, as they are likely to waken a sleeping tiger. Germany, alone among advanced Western economies, has already been there but can’t seem to convince the unfortunate Greeks (and the rest of us) that far worse things may lie ahead!

In very modern times, when both Greece and Spain fell to that .289 condition, and then pushed (hard) to go stimulate further, their respective economies virtually immediately collapsed to the tune of about -25%. At that point, lenders stop allowing those governments to borrow anything more, and both governments have been brought (more or less) kicking and whining to heel. While lenders do recognize what is essentially a bankrupt, there is nothing in current economic theory that shows that any limit has been surpassed. Worse, to confront the problem head-on is to threaten the solvency of many European banks which hold Greek and Spanish debt. And, naturally, those bankrupt governments are unwilling to stop borrowing, as borrowing is so much easier and more popular than instituting the austerity needed to reverse their sad condition.

One may well ask, if a decline through the .289 breakpoint has triggered hyper-inflation in those 55 countries in the Cato study, why has modern Spain and Greece avoided a similar hyper-inflationary fate? The answer is very simple. Being monetarily constrained by being in the Euro-zone, neither country controls a money printing press the way that the other 55 failures did. So their economies collapsed as the MPD Curve predicted, but exploding prices could not occur. Modern day Venezuela is, of course, another story and is suffering both outcomes.

  • The Disappearance of Public Companies

Roughly one third of all US public companies have disappeared since 2008, in a sort of fit of corporate cannibalism. When a company cannot expand in the usual way because of a lack of demand growth, but has shareholder pressures to achieve greater growth and enjoys a high valuation, then growth by acquisition makes sense. But growth by acquisition is inevitably followed by reducing expenses in the combined firm through achieving efficiencies and eliminating what may now be overlapping jobs.

As a sidebar to this, predatory hedge funds have actively sought out companies with strong balance sheets and therefore ‘spare’ investment resources, with the intent of forcing them to divest (pay out) their ‘surplus’ investment resources to shareholders. This may have prevented some companies from making unfortunate acquisitions but it puts pressure on corporations to divest themselves of the surplus liquidity which otherwise might have been used for expansion purposes when and if opportunity knocks. It has become a sort of mantra in the US that returning money to shareholders is a ‘good thing’ and the stock market often rewards companies that do this with high – and sometimes extreme – market valuations. But a high market valuation without a concomitant business expansion doesn’t do anything for the economy, even though it does enrich shareholders (“the 1%”).

  • The Disappearance of Jobs

The ‘Participation Rate’ of the US – the ratio of persons who are working against those who are eligible to work – has fallen steadily for some years now. To gloss over this reality, with in a clear attempt to throw sand in the eyes of its citizens, the so-called Unemployment Rate has been steadily falling (thereby coming under the heading of ‘good policy’), not by increasing the number of persons working but by redefining “unemployment” to mean those who have only been looking for work within the past year, and eliminating from being counted as ‘unemployed’ everyone else.

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John Williams, in his excellent service, Shadow Government Statistics, shows the participation rate as well as his own determination of the US Unemployment Rate, which suggests that the actual US unemployment rate is close to 22% when measured on the scale last used in the early 1960s. That may be on the high side, but it is close to matching the potential for the increase in GDP that I have calculated would occur assuming that the US returned to a degree of optimum solvency. That big jump in Williams’ alternate unemployment rate occurred, as one would expect, once the US hit its ‘Black Hole’ event horizon at .289 – and it has not changed materially ever since (the blue line on the chart).

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  • Infrastructure Spending Dies a-Borning

In 2016, the election of Donald Trump came with a platform of a strong increase in spending on new and very much needed infrastructure. However, with no ability to expand the public balance sheet (government debt) and no incentives for private monies to fund such projects due to the lack of visible demand growth, it is no surprise that infrastructure spending has pretty much died on the vine, at least so far. The Corporate Welfare Act of 2017 should pretty much seal the coffin shut on any such initiatives as there will simply be no money available at all going forward. Worse, the pressures on the states to match the federal largess in terms of corporate taxation should close off any state and local spending here as well.

  • Austerity Does Work

In 1992, Bill Clinton took the reins of office the US and set out to clean up the insolvent US government balance sheet by raising taxes and cutting costs. When he left office in 2000, the US was on top of the world, its currency was at an all-time high, consumer confidence was at an all-time high, the stock market was booming, and the economy was on fire. Small wonder that he is still revered today. Revisiting the MPD Curve, it is, or should be apparent that the impact of an increasingly solvent government spills directly and immediately over into the real economy. From 1992 to 2000, the decline in leverage pushed the US economy up the MPD Curve.

 

Additional Outcomes

  • The Lifeboat Economy

When overall growth ends or slows drastically, there are two possible outcomes, either share what is there or grab everything that one can. I call this a Lifeboat Economy because growth can no longer skate our overall desire for more onside. In the US, the expansion of government entitlement rights has grown from a modest percentage of total government revenues to more than 100% of annual tax revenues as the more powerful groups seek to protect what they now have against others looking to enhance their own interests. Cooperation between political parties has fallen below zero because to share what we already have is to take away from what we now have. The US political scene has bifurcated into two parts, those who are at least trying to expand the sharing process, although they have nothing to share that doesn’t belong to someone else in the absence of real growth, and the One Percent Party which is determined to keep even more of what they have at the expense of the rest of the populace (i.e., through cutting taxes). Internationally, Greece is a caricature of the lifeboat phenomenon. Having eaten themselves out of house and home, they came demanding that others support them. Germany (alone) is on the right track about fixing, not pandering to, their debt problem.

  • Does an Economic and Currency Collapse Necessarily Occur?

Japan is a story about the failure of Quantitative Easing. It has been 20 years since Japan became a second-order insolvent with a GDP/Debt ratio of .289. Curiously, however, Japan has hung right there and hasn’t got any worse (or any better). However, Government Debt as a percentage of GDP rose from 100% in 1995 to more than 200% today. GDP has essentially flat-lined. In the meantime, household and corporate debt fell to keep the overall national solvency ratio constant. Ben Bernanke is widely considered to be the cause of the current militant QE in Japan by chiding Prime Minister Abe that the problem with Japanese stimulus was that it was not enough. Well, Japan has tried harder. The results? Japanese GDP growth remains extremely tepid, and their central bank is increasingly ending up owning a growing percentage of the country’s equity market wealth. So far, however, Japan has remained right at the .289 level.

For what it is worth, the US appears to be emulating Japan with very slow GDP growth, rising government debt but flat or falling private sector borrowing, notably in the corporate (productive) sector, and a central bank that has (had??) been steadily acquiring financial assets. The past years have been very interesting as corporate America has basically used virtually all of its reported net earnings for dividends and share buy-backs. With essentially no investment in future growth, the US GDP outlook would have to be characterized as questionable.

  • Let’s Retire the Miller/Modigliani Hypothesis

Anyone with an ounce of common sense “knows” instinctively that debt does count in the valuation process that the market carries out. However, having proved that debt does not seem to particularly matter in the valuation process (using the debt/equity ratio), Messrs. Miller and Modigliani did inspire at least one ‘client’, government, to cheerfully ignore the impact of too much debt…on everything.

Leverage does count. Using the Atrill Solvency Ratio as defined in The Limits of Debt, below .5 on the MPD curve, GDP growth really slows and at .289, real economic growth starts to go into reverse. One of our board members did his Ph.D. thesis on forecasting currency and interest rate movements using the Atrill Solvency mathematics, with excellent success. In our common stock valuation work, it is a maxim that price follows solvency (leverage). In short, it is time to expunge the M/M ‘Theorem’ from the books of both government and academia.

  • Reducing Debt Will Lead to Strong Growth

If, at the peak of the Atrill Solvency Curve, it takes $1.50 of debt to generate $1.00 of GDP in a normal, healthy, and solvent economy, then there is an astonishing amount of excessive debt outstanding today in Europe, Japan, and the US, all of which is weighing down on their economic potential. US economist Ken Rogoff identified the value .289 ($3.50 of debt per $1.00 of GDP) as quite possibly having considerable economic significance for countries, but without the Atrill solvency mathematics to back his findings up, Rogoff could not defend his findings and therefore he could be, essentially, simply ignored. The assertion of possible importance without a rigorous mathematical proof could not stand up to his critics with their neo-Keynesian, pro-debt-issuance axes to grind.

The resolution of the current debt problem is (axiomatically) simple. How would a bankruptcy lawyer or accountant deal with bankruptcy? He would direct the bankrupt to sell assets and pay down debt, write off any and all debt which the bankrupt is unable to pay down, and then live within one’s means (no credit cards!). From the MPD curve, that outcome for the US would bring a large increase in GDP as a result of the government debt burden being lifted. However, governments do not like, nor want to abide by, what is essentially the banking discipline and Greece is proving to be, perhaps, merely the first example of a 21st Century government to outright reject Germany’s ‘sell assets’ suggestion and solution!

As Bill Clinton’s presidency clearly showed, if that excessive debt load can be lifted, then two things occur. The GDPs of those bankrupts will lift to a considerable degree. Elsewhere, using the numerical data from the MPD curve, one can readily calculate that the GDP of the US should be in the order of 18-22% higher than it is today without that excess debt. Indeed, we have calculated that the average US household income would rise by something in the order of $10,000 if the US were solvent.

The Pathology of Insolvency

Armed with the suggestions below, I expect that economic historians like Kenneth Rogoff will find that there are some general characteristics of overall economies which are heading into (a mathematical or ‘scientific’) bankruptcy. These seem to mark the lull before the storm, and have probably been present in all those 55 countries where the currency ended up collapsing under the eventual pressure of national bankruptcy and hyper-inflation:

  1. Velocity of money falls endemically
  2. Private sector borrowing (and corporate investing) dries up
  3. Interest rates fall towards zero as there is no demand for money, thereby hurting the middle-class in the economy (in particular) by – effectively – looting their savings
  4. Although the real economy slows, hurting the economically weak man in the street, the financial economy (the stock and bond markets) soars, helping the wealthy to become even more wealthy
  5. Inflation, as measured by prices, falls towards zero due the lack of demand growth
  6. The government balance sheet gets steadily worse
  7. Internal political harmony turns to intense dissonance (‘its not my greed, its yours’)
  8. Central banks are, in effect, left holding the bag in the absence of any political will or agreement to find policy solutions for weakening economies
  9. In the absence of any mathematics to the contrary, to central banks, every ‘weak economy’ problem can best be resolved by printing more money in one form or another

My expectation (based on the Weimar reported experience) is that when a country crosses the .289 threshold and their currency really begins to fall and internal prices (i.e.: inflation) really start to rise, their central banks do not react by slowing their money printing, because to curtail that monetary growth would be to “kill any possible expansion just as it got underway”. These same fears stopped Greenspan from acting responsibly (as he openly admitted in his book) and were probably always there among those 55 countries noted above, as they were in the US. The actual linkage would be fascinating to discover – but for students of the subject, now we know where (and why) to look.

  • The “Chinese Miracle” Explained…and a Myth Exploded

Can we use the Atrill MPD Curve to explain the “Chinese Growth Miracle” (and for that matter, the ‘Japanese Miracle’ after WWII)?  By referring to the complete curve below, you can see that on the right hand side of the peak of the curve that there is an area in which additional debt adds to the generation of value (GDP).

Using the MPD Curve, we can readily understand that the emergence of China as a global economic power has not been due to some superior insight into the economic growth process as they like to claim, but simply to the growing use of debt after about 1970. The advantage of debt is that you can get lots of money for expansion with the wave of the hand and growth will follow almost magically! The disadvantage comes when an economy roars up and over the peak and heads down the slippery slope towards the Black Hole condition. Suddenly, debt has a cost: and the economy will slow drastically at the .289 point, and retrenchment
will become the order of the day.

image 6

China has not discovered a ‘new way’ of managing the economy. It just followed the exact same roadmap left behind by post-war Japan, “the Japanese miracle” which followed a similar solvency trajectory. When 20 years ago, Japan crossed the .289 boundary condition, their growth came to an abrupt halt as that country reached the event horizon of its own ‘Black Hole’. It should be noted that the Debt/GDP Ratio of China (as reported) has risen from a very low level to more than 3 times. My guess is that China will soon experience the same lesson that Japan has to this day failed to understand!

It is no surprise that global GDP growth has been so slow with US, Japan and much of Europe in a very weak solvency condition (as defined) along with a few other major countries including Venezuela. Give China another (very few) years and global growth should be a thing of the history books. We will then all have fallen under the spell of modern central bank solutions for slow-growth economies.

So Where Do We Go From Here?

I can see three possible outcomes for the US stemming from the current situation:

  1. increasing debt and a push below the .289 ratio should a recession rear its head
  2. decrease the debt and follow the Clinton solution
  3. do nothing much either way, and continue to follow the Japanese path.

One thing that flows from the MPD Curve is that the process does not heal itself. As Japan and now the US have shown, the .289 breakpoint is remarkably stable – a sort of stasis point of balance. From real time observation of Zimbabwe for one, it takes a powerful and concerted effort to push the economy below the .289 level as there is a powerful pushback from the players in the economy, and certainly from the banking system, as shown by the falling velocity measure. But improving that ratio is very difficult because the austerity that is initially entailed is politically difficult to swallow – as Greece has clearly shown.

An economic historian with time on his/her hands should be able to examine other economies that have gone through this phase to find parallels – as there must be. The private sector also systematically responds by reducing its own indebtedness to balance the expanding balance sheet of government. I have to conclude (from a limited sample) that the entire system does not go into the Black Hole willingly and without a strong effort by the private sector participants to resist that move. Stasis is therefore a very real and continuing possibility going forward – in which case, the rich will continue to get richer!

Because the US GDP/Debt ratio has remained virtually steadfast at 0.289 since the third quarter of 2007, no increase in the basic economic growth rate can occur no matter how many economists and pundits attempt to forecast a return to the faster historical rates of growth. Every year since the recession following the 2008 market collapse, a growth rate of 3%+ for the coming year has been the standard forecast. And every year, the final number comes in around that 1.4-2.0% rate. Heading into 2018, economists are again looking for accelerating global growth of 3%+, and this against a background of slower economic readings from a number of international sources, including Japan, China and Canada. I would not be holding my breath in the expectation of anything like the forecast number!

What About The Corporate Welfare Act?

Having not referred to it since page 1, did anyone think that I had forgotten about the Corporate Welfare Act of 2017 (a.k.a “tax reform”)? Heaven’s no! It’s the crowning glory in 30 out of the 38 years of the history of US fiscal mismanagement. Referring to the newly-passed “tax reform” bill, and based on the experience of previous US tax cutting exercises, the main outcome will be a rise in government debt, with a very tiny proportion (maybe 6-8% at the most) of the corporate “savings” flowing into actual expansion. The stock market has done well and may continue to do so! However, this late in the business cycle and with this level of slow growth, I cannot see that US corporations are going to be undertaking much new capital spending expansion, while the impact on the weakening US government balance sheet should be immediate and fairly severe.

The timing of this round of tax cutting for corporations and the wealthy is very unfortunate. When Reagan undertook his tax cutting exercise, the solvency condition of the US placed it at the peak of the Atrill Curve. In other words, the US was in great shape, and could withstand the stunning load of debt that Reagan and Bush thrust on to it. By 1992, the solvency ratio had declined to .5, leading Bill Clinton to clean up the deficit mess that they left behind. When George Bush Jr. sponsored The Homeland Investment Act, or what we would classify as Round 2 of tax cutting, in 2004, he was following on the hard work and success that Clinton left behind in getting the US out of its chronic deficit by strengthening the US balance sheet. In other words, the US was in good and improving fiscal condition in 2000. By the election of 2008, however, the solvency ratio of the US had fallen to .289, or what we term the brink of ‘scientific bankruptcy’. Obama did nothing at all to repair the damage that Bush Jr. left behind him. And so President Trump is starting his tax cutting exercise with the US in the worst fiscal condition that it has ever been in. The US balance sheet plunged dismally during the tax-cutting tenures of Reagan/Bush and Bush /Obama but there is simply no room for another such decline in the US solvency measure, without crossing the Black Hole event horizon. As a result, we are entering a totally new era with unforeseeable consequences on the horizon.

One can, of course, adopt a completely clinical attitude towards this event and simply wait and see. Indeed, given the unwillingness of the president and the Republican-controlled Congress to mitigate – or even understand – the potential outcome of such an event, that is probably all that any person of any political/economic persuasion can do. However, it couldn’t hurt if readers passed on this information to others.

I certainly do not detect any political willingness in the US, Europe or Japan to embrace a modern Clinton-style solution to the debt problem. Right now, most central banks are at least paying lip service to the concept of ending Quantitative Easing and moving towards some level of Quantitative Tightening, as – believe it or not – all central banks are acutely aware of the Weimar experience. However, it would be my guess that as the current “expansion” phase of the US and global economy slows and heads into something that looks like a recession, especially if this is accompanied by prolonged stock market weakness, the political pressure on central banks to reverse course and stimulate again will be tremendous. Unfortunately, with no tools left to them and certainly no political support for a Clinton-style solution, then for the central banks, monetary (debt) expansion is likely to be the solution of choice.

What could be a real concern would be a significant recession coupled with a stock market meltdown – or perhaps I should put that the other way around given the extreme valuation of the US stock markets – a significant bear market in common stocks which triggers a strong slowdown in the economy as it did in 2001-2 and 2008-9. A decline in the US GDP accompanied by a large increase in stimulus (debt issuance) could push the US through the .289 mark with unknown and unforeseen consequences. The offset to public debt increases could, of course, be the rapid paydown of private sector debt in this circumstance, with the ending balance being more or less still at that point of stasis, as Japan experienced. What we cannot know as of yet is, is there a point of central bank frustration coupled with the lack of response of the private sector which pushes one or more central banks to pile on stimulus much more urgently, á la Germany in the 1920s and Zimbabwe (among others) in later years?

I would be very watchful to see whether and when my thesis proves out. A strong leader of the US Federal Reserve Board could emerge with good political support from Congress, with a mandate to actually resolve the US debt problem (and, of course, by definition, the rest of the insolvent world which will take their cue from the Americans). I am cynical enough to doubt that this will occur, but cautious enough not to bet the farm that it won’t. However, Jerome Powell, the new Fed chairman, has been labelled the GOP version of Janet Yellen (the outgoing chair person), and so I would expect nothing imaginative or innovative during his tenure.

Despite the general consensus that interest rates will rise, I would not look for much of an increase in overall interest rates unless one of two things happen. First, if the US debt/GDP ratio does plunge much below .289, then interest rates are very likely to soar. Second, if, on the other hand, structural change occurs which resolves the current malaise and the debt/GDP ratio returns to the average of most of the 20th century of roughly 0.70, interest rates will return (that is rise) to normalcy as well. But until there really is a true debt resolution movement underway, then things cannot change much from the conditions which I have outlined above. Demand for money will continue to be very weak, the US economy will continue to sputter along, and the rich will continue to get richer as the centrifugal forces of debt expansion continue, driving the poor and middle classes further into debt or at least genteel poverty. As depressing as this may seem, this is actually not a bad outcome, given one alternative, a plunge into the Atrill Black Hole.

What’s Should be Your Principal Take-away?

I want to leave any readers who have managed to hang on to the bitter end with a very clear message. The Marginal Productivity of Debt Curve visually and clearly shows that if the US (and Japan and Europe) were closer to the peak of the curve, the additional GDP which would result would be enormous – we calculate from the table of values, somewhere in the order of +18-20% greater than today. I should observe that while this calculation follows from our math, Bill Clinton has already ‘proved’ that the math is essentially correct when it suggests a strong and favourable outcome. The MPD Curve does not portend merely a modest improvement, but a game-altering change in the growth outlook resulting in a powerful improvement in the US economy and its annual growth rate – at least until their respective economies get to their usual peak level, if not for some time afterwards.

Afterthoughts

The Divine Right of Kings has long ago been supplanted by the Divine Right of Government. It is this problem in the past 100 years or so, and up until now, that allows and has allowed money-printing governments to spend and borrow, and run economically amok, to the massive detriment of employment, resource allocation and utilization, and the general well-being of their citizens. This “divine right” needs to be supplanted by a constitutional requirement for the government of every country to be solvent as measured, and be as close to peak efficiency as possible, reporting to their citizens on a regular and timely basis.

Finally, I do not think for a moment that the solvency problems that we are faced with today are the result of political malfeasance, ill will, greed, or even stupidity. In general, politicians and financial leaders act in what they consider to be the best interests of the greatest number of people. Their intentions are good. Unfortunately, as Michael Bloomberg has observed, you cannot manage what you don’t measure, to which I must add, you cannot manage if you don’t know what to measure. My (late) colleague, Dr. Atrill has shown us what to measure and why: it is now up to us to do something about it.

  1. Ross Healy
  • Chairman, Strategic Analysis Corporation
  • Associate Portfolio Manager, MacNicol and Associates Asset Management

[1].289 is the numerical value of Wein’s Constant of Radiation in physics. It is one of 11 constants from the realm of physics that show up in the book How ALL Economies Work, by my late guru, friend, and partner, Dr. V.H. Atrill.

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Could This Market “Die of Old Age”?

I was struck the other day by an article by Byron Wien, vice chairman of Blackstone Advisory Partners. He recently wrote that in his view, the market could keep going for some time – perhaps into 2019 – because the usual factors that warn of impending bear markets are simply not in evidence at this time, and that markets do not die of old age. There is no inverted yield curve, he observes that retail investors are not euphoric about equities as they were in 2000 and 2007 for instance, hedge fund net exposure shows a mood of caution, the leading indicator index has been climbing steadily since 2016, corporate earnings have been increasing, and he asserts that strong business activity exists in the US, Europe, Japan, China and India. There is a lot of investor complacency, as evidenced by the very low VIX index readings, but as long as the economy continues to grow, he thinks that maybe that is not all that negative. Under those circumstances, a major crash-and-burn kind of stock market outcome seems to be unlikely in the near or even intermediate future. Since I myself have been cautious about the markets, and continue to be so, it struck me that I am either too pessimistic or Wein is too optimistic – and which is the more likely outcome? I do agree with Wein that the usual indications of a bull market peak are not present. That does not mean that strong bear market indications are absent, however, nor that this market is not very long in the tooth.

At the top of that list of bear market indicators is the lack of intrinsic value as we at my company, Strategic Analysis Corporation, measure it, notably in the S&P 500 and the NASDAQ 100. I recall that early in the year 2000, the S&P reached a valuation in which our Fair Market Value (FMV – our intrinsic value upside/downside determination) fell to zero. It actually bumped against that zero value level three times early in that year before the market finally slipped into the bear market mode that prevailed for the next 2 years into mid-2002. While the clear signs of rampant speculation in the dot-coms may be what most investors and commentators remember about 2000, for me it was the zero FMV potential which is what I recalled most vividly, and which – in my view – was what caused the market to run out of gas. Speculative excess, yes! But I said then and I would say again, I do not think that markets can run on negative energy – which is what they are trying to do now. Wein, of course, has no measure that matches our FMV and is therefore entitled to ignore it (at his peril, perhaps).

A second enormous issue is the massive and continuous efforts by the central banks to prop up markets through Quantitative Easing (QE) which they have been hard at work in executing since the horrific lows of 2008-9. Investors now expect that the central banks will maintain their programmes of stimulation – even if, for a moment or two in time, they falter at this task, or decide to end their current QE programme and replace it with some Quantitative Tightening (“Tapering” or QT) in order to wean the markets and the economy off all of that stimulus. That is thought to be a ‘temporary measure’ at worst, to be repealed at the first sign of serious market weakness. QE, in all of known market history, has never been tried before, and the comforting notion that the Fed will always be protecting the backs of investors is certainly a driving force behind steadily rising market values. I do not know what will happen when the Fed actually tries QT instead, and, as reassuring as their words may be that QT carries ‘no adverse consequences’, “tapering” definitely can not have the same positive effects as “easing” has had (although this proposition has yet to be tested).

Chief among those who claim that they cannot see any market tops in sight are those who observe that there does not seem to be any visibly obvious valuation excesses such as the Nifty-Fifty stocks of the early 1970s, the dot-com stocks in 2000, and the housing bubble which peaked in 2007-8. In some ways, this is the easiest claim to refute because the valuations (in price/book terms) of today of some of the very largest of stock market capitalizations easily match the extremes of the dot-com stocks in 2000. The measured downside risk of most of the FANGS are enough – if they were experienced (again!) – to cause massive losses of investment capital, and the investor pain that goes with it. Facebook carries a forward PE Ratio of a mere 28, while Invidia has a 50x PE Ratio for 2018, Netflix has a 106x PE Ratio, with Amazon being the champion at 138. Amazon, Invidia, and Netflix have all had histories of stunning percentage price declines in weak markets. Apple, another market favourite, is also not immune to huge price declines. The problem with such massively capitalized stocks suffering price declines in line with their own historical magnitude is that they drag down more stocks with them the further that they fall.

picture 1
Observing the popular crypto-currency movement as well as the willingness of investors to blindly put their money into vehicles that they don’t understand and can’t measure in any case is to harken back to the Mississippi Bubble era of three centuries ago. As well, with more than 1000 bitcoin issues public right now (and rising steadily), it is looking almost worse than the dot.com market of 2000. Does the world really need all those cryptos and what – if anything – is their intrinsic value in any case? My guess – based on long and sometimes bitter experience – is that most will die in the coming period, the survivors will be seriously tarnished, and the speculators who own them will be severely mauled.

In the meantime, investor expectations appear to be very powerfully optimistic. Merrill Lynch finds that their clients are holding the lowest allocation to cash in the last 13 years. The Market Vane poll show that 71% are bullish and 65% of respondents expect stock market prices to be higher in the next 12 months. There are also a record number of speculator futures contracts which are short the VIX. Technically, at any rate, those numbers are concerning. It is really difficult to assert that investors are anything but rampantly bullish!

Further, I are intrigued by the extremely low VIX levels averaging about 0.3% a day (the measure of volatility of the markets which historically has served to measure the comfort of investors with the valuations in evidence). I vividly recall, for instance, the one-day market crash of 1987 which was preceded by a long period in which the daily fluctuations of the market averaged close to 2%. One day, that 2% change just kept on going – down 28% before finding a bottom (in price/book terms, from about 2 times down to about 1.5 times book in a single day). In other words, that crash was clearly signalled – or perhaps “clearly in retrospect” would be a much more accurate way to put it. Our advice to our clients at the time was “the market is levitating”, although we hardly expected a one-day termination of that condition. Today, there is no obvious parallel between October 1987 and October 2017 in VIX terms, save to observe that an extremely low VIX may be a sign of extreme investor comfort and complacency – for all the reasons that I noted above, especially the promise of Fed intervention should anything untoward occur. Do keep in mind that in 1987 Fed intervention also occurred – vigorously – but not until the day after that market crash. Curiously, the same set of conditions applied then as do now, namely all of those market algorithms that kicked in to sell out investors as the market plunged are alive and well today as trading robots (“bots”), resetting stock allocations on the go, as it were. I am hoping that the automatic stabilizer mechanisms remain in place that were put in place after 1987 – but I doubt it as none have been tested in a real-life meltdown. Simulations, maybe, but reality? Recent one-day “mini-crashes” do not give me confidence that a serious setback will not be exacerbated by all of those bots. And how is one to know when the next “mini-crash” occurs that it is merely an error in someone’s programme or the start of something much more serious? Not that I am expecting anything like another 1987, but current valuations are a sleeping tiger best left unmolested. I do note, however: the market is levitating again.

Evidence that the economy is actually slowing is abundant (although the IMF just raised its 2018 outlook!). Auto sales are long in the tooth and home sales plus auto sales are starting to run in negative territory (below). Like others, I am also wondering if the householder is running out of discretionary spending ability after a 9-year Fed-encouraged spree. However, consumer confidence remains quite positive, thank you very much. The ECRI’s US Weekly Leading Index growth has fallen to a 79 week low, indicating thqt economic growth is as good as it is going to get. (Is this a precursor to much slower conditions – or is this move into negative ground merely a temporary condition?)

picture 2

What about tax reform in the US, however? Surely with corporate taxes coming down, earnings per share would move strongly upwards in 2018-19. That assumes, however, that tax reform is even remotely possible and in the cards. The huge issue with tax reform is how to pay for it – that is to say, what is the offset to slashing taxes for corporations (and the wealthy by inference)? Reforming Obamacare (that is, slashing spending on Obamacare) died aborning, and other alternatives do not seem to appeal much either. Cutting corporate taxes when US corporations are buying back their stock does not really seem to make much sense, and capital spending in the US is quite tepid in any case. I have made the case, complete with the detailed mathematics, in The Limits of Debt (see my blogsite, The Occasional Contrarian) that US GDP cannot grow rapidly because of the very issue that the congressional leaders are concerned about – the size and sheer weight of the US debt on the economy. This would be exacerbated if taxes were to be cut without a balance elsewhere. And in a “lifeboat economy” (my Limits of Debt term) “I” am not prepared to reduce “my” share of the economy only to see “you” get “more”. I fully expect that tax reform will fail to get off the ground.

 

An Elderly Market, With Clear Signs of Aging

And so I come back to my question – how will this market finally reach its end and does it need the kinds of signals and indicators that in the past have been clear precursors of bear markets? I would observe that to a considerable extent, all of the usual precursors are already here. Complacency, mass speculation, and ultra high valuations are already part of the current investment condition. With the Fed trying to pull off Quantitative Tapering, at least one more rug will be removed from under the feet of investors. In medical terms, the patient has a very weak pulse (the VIX), it has no energy to keep going (zero overall intrinsic upside value potential in evidence), and the doctors are actively planning on pulling the life support plug (QT is coming). Personally, I really don’t want to bet too heavily that this sclerotic market is facing a long and healthy life ahead!
But – one last question – how would we “know” when the end finally does come? Does the stock market just lie down and refuse to get up one morning? Like General MacArthur’s ‘old soldiers’, does it just fade away? Or does it suddenly fall by 20% (or whatever)? What about a 10-20 day cascade of prices? I strongly suspect that when the VIX awakens this time, things will not be pretty. Byron Wein can’t see it and the investing public is acting as if there is no end in sight. I would be less than candid if I were to say that I am able to, either. However, the market got here by unusual measures, and its demise should be unusual, too.

What I am doing is what I have done in the past, that is to rely on our valuation measures to tell me when a break is coming. As we did at the break in the market is 1987, 2000, and 2008, I will rely on our technical signals to sound the alarm. Already, the intrinsic potential of the S&P and the NASDAQ are sounding a warning that the market is out of gas. I have not yet seen the technical break that I saw in 2008, but it is close by in percentage terms. A break below the 2400 level (2.5 times adjusted book value, and the ceiling valuation for the S&P for the 2002-8 market period) for the S&P will signal the end of the bull market for me.

For the time being, I have to say that no break has been signalled and that a bull market therefore remains in force, however poorly supported that it may be. I am, however, happy to be defensively positioned with a good cash holding.

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BNN Appearance October 5th, 2017

BNN October 5

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The “Rules” of Prediction

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favor of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

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The “Rules of Prediction

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favor of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

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The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favour of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

Posted in Uncategorized | Leave a comment