Record High Debt and Slowing Incomes

Record High Debt and Slowing Incomes

With the holiday season upon us and the markets eager to see just how much Americans are will to spend this year, let’s take a look at just how much they can spend. Increases in spending are made possible by just two things:

  • An increase in income
  • An increase in borrowing

Today’s employment report gives us some insight into the direction in income levels as the 3-month moving average for hourly earnings for the 80% of the population included in the production and non-supervisory data shows that earnings continue to be on the decline, despite an unemployment rate that is the lowest we’ve seen since 2000.

Taking a step back and looking at the bigger picture it is easy to see why so many in America feel the American Dream is no longer attainable. The year-over-year increase in average hourly earnings for the 80% of the workforce included in the production and non-supervisory category have declined from an average of 7.0% in the 1970s, to 4.5% in the 1980s, to 3.2% from 1990 to 2007 to 2.1% from 2010 to today.

As for borrowing more to pay for purchases, Total Consumer Credit (excluding borrowings for real estate purchases) as a percent of Disposable Income has reached a new high.


We’ve also seen Consumer Confidence back near multi-year highs.


However, the savings rate has been falling and is near 10-year lows.

Historically, when the spread between these two peaks, the year-over-year rate of growth in spending declines.

The bottom line is the soft data, such as Consumer Confidence levels, are not what allows for increased spending. With revolving credit levels as a percent of disposable income reaching record levels and the trend in earnings on the decline, sustained increases in spending are simply not possible.

Consumer Confidence & LEI’s Flash Warning

Consumer Confidence & LEI’s Flash Warning

Consumer Confidence for September declined a bit more than expected, falling to 119.8 from 120.4, versus expectations for a decline to 120. While that doesn’t sound all that meaningful as it is still well above the long-term average of 93.9, we see something occurring beneath the headlines that warrants further attention and is particularly concerning – relative confidence levels by age group.


As one would expect, confidence among younger consumers is almost always better than amongst older consumers, (less time alive means less time for regrets and a perception of more time to accomplish one’s goals) which is why this month’s Consumer Confidence report is so remarkable. This month middle-aged consumers, those 35-54 years of age, have a higher level of confidence at 128.2 than younger consumers, those under 35 years of age, who have dropped to 120.9 from 126.6. This divergence is quite rare, but even more concerning is the magnitude of the reversal. Going all the way back to 1980, the negative 7.1 spread in confidence between those middle-aged and those in the younger cohort has never been greater. The low rates of household formation coupled with the well above average rates of college grads living with mom and dad put the Millenial generation deep in our Cash Strapped Consumer investing theme.


We also saw something with respect to confidence levels by income that could be a concern for the current administration. While confidence levels for consumers with incomes over $50,000 and those with incomes under $35,000 rose, confidence for consumers with incomes between $35,000 and $50,000 dropped to the lowest level since last October. Given that a large portion of President Trump’s base is in that cohort, don’t expect to see an improvement is his approval ratings anytime soon.

For investors, this means that President Trump may have an even more difficult time passing the legislation he promised on the campaign trail. Low approval ratings make it less appealing for legislators to reach across the aisle and increase the perceived potential risk versus reward for those in his own party to be staunch supporters of any Trump-led legislation. Repeal/replace of Obamacare and tax reform, let alone that much-promised infrastructure spending is more challenging when fewer and fewer support the current administration.


The Consumer Confidence report also revealed weaker plans to spend, with autos falling to a 14-month low and housing dropping to 6.9 from 7.3. On the other hand, the trend to remodel versus trade up continues as plans to buy a major appliance jumped to 54.0 from 50.5, the highest level since May 2009. This bodes well for shares of Home Depot (HD) and Lowe’s (LOW).


The Chicago Fed National Activity Index (CFNAI) gave us ample cause for concern as 50 of the 85 variables it measures across the national economy were in contraction mode for August with the 3-month moving average dropping to -0.04 in August from +0.15 in June. Personal Consumption & Housing was in the red at -0.06 and has now been negative for 123 consecutive months – more evidence of our Cash Strapped Consumer.


Finally, the ECRI leading index smoothed growth rate has fallen for seven consecutive weeks, stalling last week after having growth at nearly a 12% pace at the beginning of 2017. We haven’t seen growth this weak since March of 2016.


The bottom line is we see a continued disconnect between sentiment, the hard data and the market’s enthusiasm coupled with a profound “meh” when it comes to political and geopolitical risks. However, as we noted earlier, expensive stocks can get more expensive and the market isn’t giving us any signs of an imminent reversal, particularly as we see an increasing number of stocks moving above their 50-day moving averages.

Falling Dollar as Trump Trade Tumbles into Investor “Meh”

Falling Dollar as Trump Trade Tumbles into Investor “Meh”

The U.S. dollar got hit hard again today as the Trump Trade continues to reverse and investor sentiment becomes more neutral – a big “Meh.”

The U.S. dollar is continuing its steep decline today as the AMEX U.S. Dollar Index makes new lows for 2017 and is nearing the lowest point over the past year, pushing down towards 94.

^DXY Chart

This represents not only an unwinding of the so-called Trump Trade, but speaks to how weak economic data has been coming in relative to expectations, (we’ve talked about this extensively which you can read about most recently here and here) AND relative to what we are seeing outside of the country. This decline has been driven primarily by the euro, the Mexican peso and the Japanese yen.

The dollar fell as the European Central Bank President, Mario Draghi, delivered a talk conveying more optimism for the European Union, citing growing political tailwinds, and the emergence of reflationary pressures. This came as Monday’s Durable Goods report showed the American economy is treading water, with Shipments and New Orders both dropping 0.2 percent month-over-month versus expectations for 0.4 percent gains. Core Capex has basically stagnated since February and despite all the euphoria in tech stocks, booking for new computers and electronics also declined 0.2 percent month-over-month and has now declined in 3 out of the past 4 months, which translates into a 6.5% decline on an annual basis: a long way from the 10 percent annual growth rate we saw at the start of 2017.

The Chicago Fed National Activity Index declined in May, the second decline in the past 3 months with the 3-month moving average essentially flatlining.

Looking over at France, with the recent win by Macron the economy there is looking much more upbeat as single-family housing permits rose 17 percent year-over-year versus 6 percent in the U.S. Single-family housing starts rose 19.4 percent in France and 8.5 percent in the U.S. In addition, mortgage purchase applications in the U.S. have fallen in 6 out of the past 7 weeks.

In Germany, the lfo business sentiment index recently hit a record high and across the Eurozone a collective sigh of relief can be heard as Italy is addressing its NPL (non-performing loan) problems. The latest was with a mix of state bailout, to the tune of €17b, on Banca Popolare di Vicenza and Veneto Banca that has equity and junior bondholders wiped out, protecting only senior note holders and depositors. More is likely to follow.

Looking at yesterday’s Consumer Confidence Survey, while the overall index rose from 117.9 to 118.9, it didn’t make up for the decline of 7.3 during April and May. That’s not terribly concerning, but this other bit in the details is. While the index for the Present Situation rose from 140.6 to 146.3 and is at the highest level since June 2001, Expectations fell again for the third consecutive month and are now at the lowest level since January. This type of divergence typically precedes a recession and if we look at these moves over the years, a recession typically hits 9 months after Expectations peak. That peak, so far, looks to have been in March.

Yes, but those Fed guys sound oh so confident despite tightening into an economy with slowing growth, declining inflation, weakening credit growth and a flattening yield curve.

  • Since World War II, the Fed has engaged in 13 tightening cycles
  • During 10 of those cycles, the economy slid into a recession
  • In the 3 where a recession did not occur, GDP growth fell by 2 to 4 percent. With current GDP growth struggling to get above 2 percent, that’s worth noting.

Meanwhile, the equity market is mostly yawning.

The VIX has now dropped below 10 eight times in 2017. To put that into perspective, in the 22 years from 1994 through the end of 2016, the VIX saw that level all of 7 times!

VIX Chart

In the past month, short position contracts on the VIX have doubled to now sit at a record level.

Over in the bond market, the view of the economy isn’t all that rosy. As of June 20th, the net longs on the 10-year Treasury hit a level we haven’t seen since December 2007.

Today’s AAII Investor Sentiment report showed that neutral sentiment is at its highest level since last August at 43.4 percent while bullish sentiment declined from 32.7 percent to 29.7 percent. This market is seriously astounding with a record 130 consecutive weeks where half the investors surveyed were not bullish, while we’ve had such a smooth melt up in the first half of 2017. Only one other year have we seen even less of a pullback during the first half! Meanwhile, the Bears are also scratching their heads with bearish sentiment falling from 28.9 percent to 26.9 percent, the lowest level since the first week of the year.

With economic data coming in well below expectations while the market has continued its melt up (today notwithstanding) despite bonds telling a worrisome tale with falling long-term rates and a flattening yield curve, it is no wonder investor sentiment is increasingly a neutral “meh..” or perhaps more of an “Eh…?”


Economic Data Continues to Paint Peaking Picture

Economic Data Continues to Paint Peaking Picture

This view never gets old.

This view never gets old.While this was a shortened week with the Memorial Day holiday, it was certainly packed with economic data. Yours truly fell a bit behind coupled with the short week and another one of my trips from Southern California back to my other home base in Italy, so this is a longer than usual post. No matter how many times I do that trip, and my frequent flier miles balance can attest to the level of insanity, I am endlessly amazed at how I can get into a steel tube in one part of the world and end up, after just one tube change in London, roughly 7,000 miles away without much fuss. Hat tip to British Airways for a lovely trip despite the pain felt by tens thousands over the holiday weekend – our thoughts on that calamity were shared on last week’s Cocktail Investing Podcast. The view from 30,000 this week was quite useful given the onslaught of data!

The week started with the Bureau of Economic Analysis inflation report which was in-line with expectations, showing the Personal Consumption Expenditures, price index was up just 1.7 percent on a year-over-year basis.

The Core PCE Price Index, which excludes food and energy, was also lower from prior periods, up just 1.5 percent year-over-year versus an increase of 1.8 percent at the beginning of the year. As we expected and called out a few times, the base effects are wearing off.

Real Personal Consumption Expenditures, which is a measure of consumer spending, weakened on a year-over-year basis, down from 3.1 percent in March to 2.6 percent in April. The peak for these expenditures during the current business cycle was back in January 2015 at 4 percent, which was below the prior business cycle peak of 4.7 percent in February 2004. We see this as confirming our Cash-Strapped Consumer theme remains solidly in the forefront of the economy.

Yes spending has been muted, but more concerning for the longer-term growth potential of the country is the ever-weakening population growth rate. The Bureau of Economic Analysis’ most recent data showed yet another drop in the growth rate to the lowest level on record with the BEA, at 0.7 percent, reinforcing our Aging of the Population theme. Over 600,000 people dropped out of the labor force just last year.

Keep in mind when you hear talk about expanding GDP growth rates that,

There are only two core factors that impact the potential growth of an economy, growth of labor and improvements in productivity.

Shipping looks to be strengthening, which is a good gauge of growth in the overall economy, but remains below longer-term normal levels and is still within the muted growth rate we’ve seen during this business cycle.


The Conference Board measure of Consumer Confidence fell more than expected in May, after having declined in April as well, although overall optimism is still relatively high. The index dropped to 117.9 in May versus expectations for 119.8, down from its peak of 125.6 in March, the highest level since December 2000.

The exceptionally large spread between “soft” sentiment data and the actual hard data has been narrowing, but that has been primarily driven by declining sentiment data.



Housing prices remain strong with the S&P/Case-Shiller Home price index coming in with 5.9 percent annual growth rate versus expectations for 5.7 percent, driven in part by exceptionally low inventories. We’d argue that this is consistent with our Asset-Light investing theme, as Millenials, in particular, show a great affinity for renting homes and using ride-sharing services than owning such assets, particularly those like cars that have inherently low utilization levels.



The US Pending Home Sales number disappointed in April, falling below last year’s levels with a 1.3 percent decline. The National Association of Realtors Existing Home Sales index was 3.3 percent lower this April than in April 2017.


The rate of price increases in homes is well above the annual rate of wage growth, which makes the current pace unsustainable unless we see wages start to catch up. We may just start to see that with the improvement in job creation we saw this week from ADP, with Private Nonfarm payrolls rising 253,000 versus expectations for 180,000. The report saw jobs in construction and professional/business services rise notably, with the later experiencing is the largest one-month increase in around three years.

So things were looking pretty good on the jobs front until Friday’s payroll report from the Bureau of Labor Statistics which came in well below expectations at 138,000 new jobs versus expectations for 185,000. The Labor Force Participation rate dropped from 62.9 percent to 62.7 percent and to add insult to injury, the BLS revised the April job creation numbers down from 211,000 to 174,000.

While payrolls in construction rose in the ADP report, the Census Bureau was more in line with the weaker BLS report when it reported a month-over-month decline in US Construction Spending, falling 1.4 percent versus expectations for an increase of 0.5 percent. On a year-over-year basis, spending is up 6.7 percent, with that increase coming from residential, which rose 15.6 percent in April on a year-over-year basis while total public construction spending was down 4.4 percent in April on a year-over-year basis. Residential construction is rising on a year-over-year percent basis, but the overall level is still subdued compared to what we’ve seen in prior business cycles.


Despite weaker inflation data and the weaker jobs report, the CME fed fund futures market is still predicting, with over 90 percent probability, that the Fed will raise rates at the June meeting to a target of between 100 and 125 basis points. The probably of an additional September hike is now below 25 percent. YOU SHOULD SAY WHY YOU AGREE THE FED WILL HIKE EVEN THOUGH THE EMPLOYMENT REPORT WASN’T “GOOD ENOUGH” (OR WAS IT?)

The manufacturing PMI from the Institute for Supply Management (ISM) came in slightly better than expectations, at 54.9 from 54.8 in April versus expectations for 54.5 with New Orders, Employment and Inventories rising versus weaker Production.


However, the Markit survey presents a slightly different picture, with US Manufacturing PMI down to 52.7 in May from 52.8 in April, sitting at the lowest level in 8 months with a moderate improvement in New Business.


Both surveys agreed on falling input prices for manufacturers as inflation looks to be easing across the board. That sound you hear is falling prices, not us patting ourselves on the back for seeing this ahead of the herd.

Auto sales continue to decline in May with sales coming in at the second weakest in the past 26 months, surpassed only by March’s weaker read. Unit volumes are at a roughly 11 percent decline versus Q1, which experienced a 17.5 percent decline.


Bottom Line on the economy is that the data is still mixed, but when we distil it all down, we see an economy that is highly unlikely to accelerate to the upside from here with distinct indications that we are nearing the end of this business cycle. This view is further reinforced when we see President Trump’s approval rating at 40 percent with a disapproval rate at 54 percent. Much hope was based on campaign promises that will be difficult to pass through Congress without support from the other side of the isle, support that is less likely with those kinds of approval ratings given the number of Democrats up for reelection at the mid-term.

Consumer Spending – it isn’t all about Confidence

Consumer Spending – it isn’t all about Confidence

There was a time, in a life long, long ago, when my view of shoes was purely functional. I mostly had black ones, with no interest in wasteful spending on frivolity. What doesn’t go with black? Sandles, flats, pumps, all black, I kept it simple. Then I started to work for extended periods in Italy and after a few months, my colleagues here agreed with me that yes, California girls don’t do the whole shoe, purse, put together ensemble bit at the level that Italian women do so effortlessly. Oh really? Game on! And that is how I met two of my great loves Jimmy (Choo) and Christian (Louboutin) and found just what kind of confidence a great pair of stilettos can provide, even when all else is going to hell.

I pondered this phenomenon of stiletto-induced confidence in the face of a perilous Italian cobblestone street or a sleep-deprived workweek over my morning cup of coffee as I reviewed this week’s Michigan Consumer Confidence report and its impact on spending.

With roughly 70 percent of GDP attributed to consumer spending, expectations for more robust growth rely on expectations of increased spending. The catch is that spending is simply a function of income and credit, not confidence. If you want to spend more, you must either earn more or borrow more – pretty simple.

Earlier this week Consumer Confidence for March blew away expectations, with the index reaching 125.6, its highest level since December 2000, versus expectations for 114. Confidence levels have now surpassed those seen in the last expansion period which ended in the financial crisis.


Interestingly we are seeing the difference in the confidence levels by income grow increasingly wider, with those at higher income levels rising much faster and higher than those at lower income levels. Confidence is typically higher the higher one’s income level, but the spread has been growing.

Income expectations have also been rising rapidly and are reaching levels last seen during the peak of the prior expansion, which has those in mainstream financial media giddy over spending expectations. Those of us at Tematica find this fascinating given the actual trends in income over the past two years. The following chart shows the year-over-year change in real person income, seasonally adjusted, as reported by the BEA (Bureau of Economic Analysis) which defines such as,

Personal income is the income received by, or on behalf of, all persons from all sources: from participation as laborers in production, from owning a home or business, from the ownership of financial assets, and from government and business in the form of transfers. It includes income from domestic sources as well as the rest of world. It does not include realized or unrealized capital gains or losses.


While confidence in income gains is rising, income growth has been slowing for years. As of December 2016, personal income was growing at less than half the rate it had been growing two years earlier in December 2014. This Friday we’ll get the latest numbers and will be quite keen to see if this trend has continued.

Recall that a few weeks ago we pointed out that

From February 2016 to February 2017, real average hourly earnings decreased 0.3 percent, seasonally adjusted. The decrease in real average hourly earnings combined with no change in the average workweek resulted in a 0.4-percent decrease in real average weekly earnings over this period.

So the income story is not one that is improving, but how about credit?

Credit card standards? Tightening. Our Cash-Strapped Consumer is going to have a tougher time putting anything more than those Affordable Luxuries on plastic.


Auto Loan standards? Tightening.


Ok, forget credit cards and auto loans, what about everything else? Tightening.


How about banks’ willingness to extend credit? Argh, not looking so rosy either.


This isn’t exactly bullish for financials, and we’ve seen the Financial Select Sector SPDR ETF (XLF) go from being one of the stronger sector performers to sitting in the bottom three recently. On the other hand, a slowing economy is bullish for the iShares 20+ Year Treasury Bond ETF (TLT), which was hit when post-election inflation expectations spiked.

With income growth slowing, work-weeks shrinking and credit tightening, yours truly is rather skeptical that we will see this boom in spending, no matter how confident consumers may be feeling, even if I’ve got my mojo overflowing thanks to a pair of strappy Jimmy’s.


Retail Sales a Warning?

Retail Sales a Warning?

Retail sales flashing a warning?  Sales have recently taken a serious pounding, which many claim is due primarily to the awful winter weather in much of the US.  While the tough winter undoubtedly did have an impact, the chart below (which shows the month-over-month percentage change in retail sales and the quarter-over-quarter percentage change in US GDP) indicates to at least to yours truly that there is a bit more to the story.

Retail Sales


Since November 2014, sales have dropped over 3%.  The only time the drop has been larger was from June 2008 to December 2008 when sales fell by 13%.   Retails sales have declined in 4 of the past 6 months and 8 of the past 12 months.

If we look at the broader picture of the consumer we see that:

  • Consumer Confidence has fallen in 3 of the past 4 months and  7 of the past 12 months (trend is worsening)
  • Personal Income has fallen in 6 of the past 12 months
  • Personal Spending has fallen in 4 of the past 7 months and 5 of the past 12 (trend is worsening)
  • Jobless claims have risen in 4 of the past 6 months and 7 of the past 12 (trend is worsening)
  • Average hourly earnings have declined in 5 of the past 6 months and 8 of the past 12 (trend is worsening)
  • Challenger job cuts have increased every month over the past 4 months (Not good!)

For the economy as a whole, Bespoke Investment Group’s summary of economic indicators is currently at its worst reading in a year and has only improved in one of the past 6 months!

It certainly does not look to us like this is an economy about to overheat, needing the Fed to tightening the monetary belt!  While it is foolish to believe one can accurately predict the behavior of bureaucrats, it certainly doesn’t look like the Fed has a compelling reason to tighten rates in June.  We believe it likely they will hold off raising rates until the data coming in looks stronger than it does today.

February MarketWatch

February MarketWatch

This month’s MarketWatch is a bit more positive than last month’s.  From Dec 31st, 2013 to the lows for the year to date on Feb 3, the S&P 500 pulled back 5.8%, while the Dow Jones 30 gave back 7.3% in the same time frame.  Both indexes rebounded in February, with the S&P 500 now about flat for the year as of Feb 24, while the Dow has rallied back to being down about 2.2%. Only the NASDAQ is in positive territory, up 2.28% year-to-date. In contrast, natural gas is up 37% year-to-date, gold up 9.8% and silver up 11.5%. By February 3rd, the volatility index (VIX) closed up as much as 51% from the first day of trading for the year, but has since fallen back to close on February 24th at the same level as it closed on the first of the year.

On February 25th, we learned that the previously robust Conference Board Consumer Confidence index dropped by the most in 4 months, missing expectations by the most since October. The Chart below, hat tip to ZeroHedge, shows the trend from 1995. Some good news within the Consumer Confidence readings were seen in the Jobs Plentiful Index, which rose to 13.9%, its highest reading since June 2008, and the Jobs Hard to Get Index fell to 32.5%, its lowest reading since September 2008. Both readings indicate continued gradual improvement of the US employment picture.

Investor sentiment continues to rise, up now 53% from the 10-year low in November 2012 and up 28% from December 2013.  Corporate earnings continue to be a source of concern however, with 82% of the S&P500 companies that have shared forward guidance issuing negative outlooks.  This past earnings season was a repeat of what we’ve come to expect in recent years, as bottom line performance generally meets expectations, but top line revenue continues to be relatively weak, often missing expectations.  The bottom line is being met more through cost cutting that through increasing sales.  Since cost-cutting measures are a more limited source of bottom line growth that increasing sales, this warrants attention.

Last year the utility sector was the 2nd worst performing sector, up 10.7% versus the sector leader, consumer discretionary, which was up 37.4%.  So far this year the defensives that underperformed last year are in the lead this year with utilities leading the pack, up 6.9% while last year’s leader, consumer discretionary down 2.5%.

Meanwhile fears of a hard landing for China are resurfacing, with the Shanghai Composite falling nearly 10% in the past week and down another 2% overnight as of February 25th. In addition, China’s yuan dropped the most in over a year and the Shanghai Composite declined the most in five months on speculation that the People’s Bank of China will act to end the yuan’s steady appreciation. Given the pressure that emerging markets have been under, this is one area where conservative managers such as Mr. Brooker and the First Eagle funds are searching for stocks that are cheap enough to buy.

Bottom Line: Market volatility has returned as the Fed slows QEInfinity and economic news continues to surprise to the downside, coupled with increased fears over China and emerging markets, keeping markets mostly sideways so far this year.

Comparative History: 2012 vs. 1998

Comparative History:  2012 vs. 1998

The first quarter of 2012 was a stunner in the equity markets, giving us the best first quarter since 1998, which begs the question, what did 1998 look like relative to 2012?



Sector trends Beginnings of an enormously impactful internet revolution Banking sector still struggling, corporation cash at record levels in response to continued economic uncertainty coupled with political volatility.
Federal Government Spending Relatively controlled with a 0.7% of GDP surplus Federal spending is at the highest percent of GDP in history outside of a world war with a projected budget deficit for 2012 nearing 9% of GDP
Federal politics Stable Political infighting of Montague and Capulet quality
Economic growth Sustained 4+% GDP growth rate Sub 2%, weak and slowing
Industry capacity utilization 82.8% 78.4% (Significant excess capacity)
Housing Strong and growing 23% of homeowners are underwater with prices still falling with a mortgage process more invasive than a colonoscopy
Labor markets Unemployment 4.5%Percent of the population employed 67.1% Unemployment 8.3%Percent of the population employed 63.8%
Consumer confidence Conference Board measure 131.7 Conference Board measure 70.2
Central Bank Stable and predictable with a balance sheet of $500 billion rising at 5% annual rate with 4+% GDP growth rate Unpredictable and in unchartered territory with a balance sheet of over $3 trillion rising at a 20% annual rate with sub 2% GDP growth
Inflation as measured by CPI 1.6%  (Significantly less than GDP growth) 3.0%  (Above GDP growth)
Risk-free rate 4.9%  (Positive real returns with CPI) 0.09% (Negative real returns with CPI)


We must also take into consideration the weather, which has given us not only an exceptionally warm January and February, but this past March was reportedly the warmest on record!  The Easter bunny will arrive two weeks earlier than last year as well, which makes the third-biggest buying holiday in the U.S., (behind Christmas and Valentine’s Day) likely to help support economic data in the coming weeks.

If we look a little deeper at the markets, Apple rose 48% in the recent rally and is responsible for nearly 20% of the appreciation in the S&P500.  It represents 4% of the S&P 500’s market capitalization and 11% of the Nasdaq!  Divergence is everywhere, meaning there is no clear, consistent trend despite the headlines.  Small and mid cap stocks, the broader NYSC composite, transports, the Baltic Dry Index and Treasury yields have not made new highs, contrary to what would be expected in a true bull run.

With Q1 earnings season barely a month away, the stock market will need to see $108 on operating EPS (earnings per share) to justify the market at its current price to earnings level (P/E).  Current consensus is for $105 and my calculations tell me that is overly optimistic.

Bottom Line:  Don’t let the tail wag the dog.  The markets have become increasingly dependent on monetary stimulus while often disregarding economic and investment specific fundamentals.  On Tuesday April 3rd, the Federal Open Markets Committee (FOMC) notes revealed that the committee believes the economy is strengthening, which led the markets to believe that another round of quantitative easing is less likely.  Stock indices immediately took a turn towards the downside and volatility rose.  We work within markets in which bad news is good and good news is bad.  When the markets do not reflect the same reality as the macroeconomic fundamentals, guess which one eventually wins?

We Aren't Out of the Woods Yet

We Aren't Out of the Woods Yet

The growth of an economy is dependent primarily on just two factors, (1) the quantity and quality of the labor pool and (2) the amount of available investment capital. With the current unemployment rate, clearly the quantity of the labor pool is not a problem. The quality of that pool is a discussion for another time. So what about the amount of available investment capital? The talk in the investment world is about QE2, and unfortunately they aren’t referring to the Cunard ocean liner. QE2 refers to the second round of “Quantitative Easing” by the Federal Reserve, which is a politically savvy way of describing the Fed printing money. (Please see “U.S. Banking System” on this blog for more details.) At its November 3rd meeting, the Fed is expected to announce the launch of QE2. Expectations are for an initial level of $500 billion, with room for upward revisions. Last week Goldman Sachs opined that $4 trillion is quite possible, according to their analysis using the Taylor Rule, which is a measure of inflation, GDP and the impact of Fed rate cuts. This rule has been fairly spot on so far in tracking the Fed’s rate decisions so their analysis warrants attention.
When credit contracts, the economy is contracting, when credit expands, the economy is expanding. The Fed is hoping that by increasing banks’ ability to lend, it can jump start the economy. Mr. Bernanke is a bit like 49er and Charger fans in the 4th quarter. This time it will be different! Anyone who saw the 49er and Charger games on October 24th understands our pain. For credit to expand, borrowers need to want to borrow, and banks need to want to lend. According to an August 23, 2010 article in the Wall Street Journal, non-financial companies in the S&P 500 are sitting on a record $2 trillion in cash.  Doesn’t sound like the problem is that businesses are lacking the funds necessary to expand, now does it? So what about existing bank reserves? This chart, using data from the Federal Reserve, shows that bank reserves are at record highs, so that seems unlikely as well.

Both corporate and household lending rates are at historical lows. So the lack of borrowing can’t be because the interest rates are too high, yet the Fed is intent on lowering these already historically low rates. Be wary as history shows that excessively low interest rates inevitably lead to asset bubbles as those who have cash desperately seek some place to generate returns.

Household income is showing slight improvements, savings is trending up while spending is trending down. This doesn’t seem to indicate a desire by households to borrow. (The following chart is derived from Data from the U.S. Department of Commerce, Bureau of Labor Statistics)

What is QE2 likely to accomplish? The Fed will once again create money out of thin air and most likely use it to purchase Treasury bonds to send long-term interest rates even lower. If this works, bond yields should fall, the dollar will fall and stocks and commodities should rise. A good deal of this has already been “baked in” to the market, meaning since the markets are convinced Bernanke is going for round two, they’ve already adjusted as if it were a done deal. Shorting the dollar has become a favorite pastime of many market professionals, so we could even see a rally in the dollar if QE2 doesn’t come on as strong initially as some have predicted. In the short run, things could go in a variety of directions, all of which are becoming increasingly difficult to anticipate. In the long run, inflation and potentially high inflation is a real possibility with all this expansion of bank reserves. I recently attended a meeting of the Mont Pelerin Society, (an international organization composed of economists, Nobel Prize winners, philosophers, historians, and business leaders) in Sydney, Australia. A topic of discussion at this conference was the possible destructive consequence of the developed nations’ seeming race towards the bottom through currency debasement. The investing world is becoming a more challenging jungle to navigate as the actions of individuals in governments around the world have increasing impact on the global economy, rather than market fundamentals. This past weekend the finance ministers of the G20 countries met in Korea to discuss “re-balancing the world.” When 20 fallible human bureaucrats, with imperfect knowledge under great political pressure try to impact the world, it usually doesn’t turn out well. For investors a defensive position that does not rely on strong GDP growth or economic stability is in our opinion, a wise choice.

Now how about those banks that Bernanke wants to nudge along with increased reserves? This past week PIMCO, Black Rock, Freddie Mac, the New York Fed, and Neuberger Berman Europe, LTD., collectively sued Countrywide for not putting back bad mortgages to its parent, Bank of America. This is surely the first in a series of suits aimed at getting control of the mortgage-backed security portfolios. Then there is the testimony from Mr. Richard Bowen, former chief underwriter with CitiMortgage given in April to the Financial Crisis Inquiry Commission Hearing on Subprime Lending and Securitization and Government Sponsored Enterprises, (why are government activities always so wordy!?). He stated that, “In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets….We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.” Does anyone really believe that Citibank was the only one up to this mischief, and we use the term mischief generously! We could see substantial level of lawsuits launched against these institutions, which would further serve to undermine an already weakened economy.

As for the banking sectors’ recent financial performance, there were mixed results with Bank of America posting a $7.3 billion loss in the third quarter and Goldman Sachs profit down 40% and Morgan Stanley’s profits fell 67%. Regional banks have shown some positive results, but smaller banks continue to close. There have been more than 300 bank failures since the recession began with 132 this year alone. There is considerable opportunity in the banking sector for mergers and acquisitions and all this tumult provides some opportunities, but again, defensive posturing is the name of the game for those investors who want to be successful in the long run.

Consumer confidence, which improved to August to 53.2, dropped to 48.5 in September. According to Lynn Franco, Directors of the Conference Board Consumer Research Center: “September’s pull-back in confidence was due to less favorable business and labor market conditions, coupled with a more pessimistic short-term outlook. Overall, consumers’ confidence in the state of the economy remains quite grim. And, with so few expecting conditions to improve in the near term, the pace of economic growth is not likely to pick up on the coming months.”

Is there any hope? I attended an investment conference in July where Niels Veldhuis of the Fraser Institute discussed the Canadian success story. Canada came through the recent financial crisis with no major bank failures, stronger GDP than the U.S. and the Canadian dollar is now selling at close to par against the USD. It has one of the lowest debt to GDP ratios among industrial nations and one of the fastest economic growth rates since adopting fiscal reforms in 1995. The Heritage Foundation/WSJ Economic Freedom Index ranks Canada No. 7, the U.S. is now at No. 11.

In 1995 Canada faced a crisis similar to the one facing the U.S. today with a downward spiraling currency, huge deficits, a tripling of the national debt since 1965, ballooning entitlements, government spending approaching 53% of GDP, and rampant inflation. The government cut spending by 10% over two years, laid off 60,000 federal workers over three years and eliminated the deficit in two years. For the next 11 years they ran a surplus, cut the national debt in half and reduced the size of government from 53% of GDP to today’s 39% all without raising taxes.

There is hope, but it will require discipline and an end to kick the can down the road solutions. We are positioning our clients to be able to take advantage of and be protected from the inevitable volatility as sovereign nations take actions that are impossible to predict in addressing their economic and financial problems. We are also cognizant of and prepared for impending inflation, that while unlikely in the short-term is highly likely in the longer-term and will be devastating for those who are not prepared.


Gross Domestic Product (GDP): GDP dropped to 1.7% annualized rate in Q2 from 3.7% in Q1 and 5.0% in Q4 of 2009. GDP is expected to remain at 1.5% in Q3 and drop to 1.2% in Q4. Traditional buy-and-hold strategies struggle with such dismal growth prospects.

Unemployment continues to be the biggest economic concern and appears to be stagnating. The Bureau of Labor Statistics reported a rate of 9.6% in September with the number of unemployed persons at 14.8 million, essentially unchanged from August. There are currently 1.2 million discouraged workers, defined as persons not currently looking for work because they believe no jobs are available for them, which has increased by a staggering 503,000 over the past year.

Housing: Mortgage rates have dropped nearly 1% in the past year to a historic low of 4.42% for the 30-year, yet existing home sales dropped a record 27% (measured month-over-month) to an all time low, since data tracking began in 1999, of 3.83 million units at an annual rate. If record low rates cannot stimulating housing, pay attention!

Market Volume: CNBC recently reported that currently 90% of all trading volume in the markets is in 5% of the stocks. This means that a very small number of stocks are moving to manipulate the indices, which calls in question the meaning of the trends. In addition, the majority of the trading that is taking place is now generated by high-frequency computers and these programs can enter more orders in one second than a whole trading room of traders can enter in a month. Just one more reason to maintain a defensive portfolio.