If things were going as well as the Fed tells us, would it really be so concerned about even a slight increase in rates from levels that were once considered an “emergency” response?  Last week’s release of the minutes from their January meeting indicates the Fed is aware of the obvious downturn in the data.  We have to laugh when the “talking heads” depict the U.S. as a pillar of strength.

We just don’t see how numbers that in years past would have been discussed as quasi-recessionary are often ignored or even celebrated.  For instance, manufacturing production is struggling to grow in recent months.  Retail sales fell 0.8% in January after declining 0.9% in December.   The dollars being saved at the pump are clearly not showing up elsewhere.  The average consumer in the U.S. is pressured just to pay the bills because we have begun to see consumer-based lenders increasing bad debt provisions.  Credit card companies noticed a credit turn as 2014 progressed and delinquencies in sub-prime auto debt are rising as well. 

It is not hard to understand why it is tough out there for so many.  The January employment report looked good in many ways, but the labor force participation rate remains stuck near multi-decade lows, so true unemployment remains atrocious.  We seem to be adding high numbers of lower paying jobs in the last few months, but it is just not enough to grow the national income in the aggregate at the rates of yesteryear.

We also suspect the Bureau of Labor Statistics model may be assuming too many jobs are being added from new business formation in their so called birth-death calculation because their data is inconsistent with other sources on this key element of employment.  Besides, employment is a lagging indicator which reflects the state of affairs a few months prior.  How long will it take for layoffs in the oil sector to show up in the employment numbers?  It seems like just a matter of time when the drilling rig count has fallen by about 30% over the last few months.    

Our GDP slowed to back near that 2% level that we have been stuck at for years according to the first look at 4^th quarter GDP.  We know the pundits act as if it was the “best 2% growth ever” and they forecast that this year will be the one when we emerge from our funk, but they have been doing that since 2010 to no avail.  The report also contained a big inventory build and a lot of healthcare spending, so we have a hard time getting too convinced that economic liftoff velocity is here.  It is the second quarter in a row in which Obamacare spending seemed to dominate on the consumer side.  It sure looks to us like maybe some serious income is being sucked into that program.  No wonder the savings at the gas pump did not end up at the mall like the deciders told us it would.   

Having watched us debase the greenback, our major trading partners are cheapening their currencies and cutting rates to escape intensifying deflationary forces as well.  This is clearly impacting our competitive advantages.  U.S. corporate revenues and earnings estimates are being trimmed substantially to account for the strength in the dollar and lower growth. The currency hit to sales of U.S. companies with meaningful foreign exposures in just released 4^th quarter reports was large at 5-10% in many cases.

At this point, given the added pressure caused by the crash in oil prices, it is beginning to look like 2015 earnings may be below those for 2014, making it quite difficult to justify P-E multiple expansion from already bubbly levels.  A year ago analysts were predicting about $122 in operating earnings (profits without all the expenses they don’t like to mention) for the S&P 500 for 2014 and now it looks like actual operating earnings are going to come in near only $113, 7% lower.  Since early 2014 operating earnings estimates for the S&P 500 for 2015 have fallen from about $137 to roughly $119 for a total collapse of 13%.  Of course, those are not GAAP estimates, which typically are about $7-10 lower than the non-GAAP operating measure.   We just do not see the wisdom in paying a record valuation for a diminishing earnings stream. Did someone say something about a put contract with the Fed if anyone loses even one dime owning stocks?  We missed that memo!

We are not sure how the Fed will be able to stomach raising short rates while many other central banks across the globe have been cutting them as growth concerns become more acute.  Of course, that thought energizes the equity index chasers.  Also, QE anticipation in Europe seems to have the “animal spirits” flowing again. Nonetheless, we can and will only depend on buying securities at prices that make sense to us, not “winks and nods”.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

Speaking of a “wink and a nod,” the Swiss National Bank stunned many market participants last month by deciding it would no longer peg the franc to the euro as it had done for years.  It had promised to continue this peg not that long prior to stopping it, but they had signed no contract, of course.  The initial 30% move higher for the franc wiped out some market participants and bruised others who had relied on the words of the central bankers.

We suspect that the Swiss had become a bit concerned about having to continue to accumulate euros at a fast clip because risks of holding that currency have once again become more difficult to ignore.  Also, the people of Switzerland voted last year on an initiative to require their central bank to hold more gold.  While it did not pass, maybe such a display of enough dissatisfaction with monetary chicanery to create the referendum in the first place caused some rethinking about priorities.  We don’t really know.  However, the reason does not matter to those who sustained losses.  They lost because they based investment decisions on an informal agreement, a sort of promise, not relative valuations.   

In addition, last month the electorate in Greece voted in new leadership that was much less wedded to maintaining the status quo regarding that nation’s membership in the EU.  After years of depressionary economic conditions brought about by the bankers’ demands that Greeks pay the price to forestall the inevitable collapse of the euro, the people voted to try something new. 

Who can blame them?

Unable to devalue a local currency because they are part of the EU, the writing has been on the wall for a long time.  Further debt write-downs near $100 billion are likely as is the return to the drachma at some point.  In spite of the ECB assuring us things are “fixed,” markets are dealing with the same credit issues that first became apparent about five years ago and at some point volatility will likely rise meaningfully again as the story unfolds.  Holders of Greek securities are feeling that pain.  Though this problem may be left to be dealt with at a later date, it looks like another “wink and a nod” gone bad.  Obviously, Spain and Italy may be not be too far behind Greece in looking to restructure debt, so European leadership is setting precedent in current negotiations, making it enormously challenging to say the least.

Everything that has been done so far has not improved the balance sheets that needed repaired in Europe, it has only provided liquidity so that the big global banks can “extend and pretend,” i.e. change loan terms to avoid taking losses.  Europe’s recently divulged QE program appears massive in size, but the limited risk-sharing of potential losses from holding sovereign debt at the ECB-level makes us think that this scheme may be even less effective than QE efforts elsewhere.  The Germans do not want to underwrite more of the risk of holding Spanish and Italian debt let alone Greek.  It indicates that this EU is not the unified body that its leadership tries to project.  We also wonder whether the ECB will actually be able to find enough bonds to buy to meet its target.

The dotted line is not signed here either.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

It is clear to us that holding a long-only, broad-based equity portfolio is nothing more than some sort of “wink and a nod” understanding between the holder of those securities and the central bankers. Given that valuations are twice normal levels and GDP growth is half of what it used to be, many investors are making a bet that they likely do not understand and with an amount of inherent risk that would have made many informed analysts over the last hundred years or so cringe.

True, for now they can still apparently depend on the methods of some hedge funds and high frequency traders whose computers seem to be programmed to bid stocks at regular points throughout the day in a fashion that makes the market appear as manipulated as any we have seen. However, with earnings estimates coming down substantially, many seem in need of reminding that the bankers and central planners will not cover losses and have conveniently not put their names on any “line that is dotted” suggesting so.  If they had signed, they would likely disavow having done so when things got tough anyway.

After all, as the current President of the European Commission, Jean-Claude Juncker, once said in an unusual bout of truthfulness about being a decider, “when it becomes serious, you have to lie.”  We are guessing a lot of lying is going on now as the muckety-mucks decide Greece’s fate. 

As we have said before, based on the signals of the powerful Treasury bond rally, narrowing equity market strength, wider credit spreads, and falling commodity prices, the planners are losing some control with everyone but the stock index chasers.  The cracks in the foundation of the financial system remain wide because all that has happened since the darker days of 2009 is the equivalent of “painting over the problem.” Debt has grown by enormous amounts to try to make us believe things are fixed, but debt growth is not income growth and the two should never be confused.

According to recent research from the consulting firm McKinsey and Company, since 2007 global debt has grown by about $57 trillion, bringing the total to about $200 trillion with a “T.”    Roughly $25 trillion of that new debt was of the government variety.  All that we got for it is a global economy lucky to hit 2% growth when we used to aim for 4%. 

Nice recovery folks!

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

The Swiss National Bank abruptly decided to abandon the franc’s peg to the euro.  The people of Greece told the EU to “take a hike” in their election.  And earnings estimates are rolling over in quick fashion.  All of these factors put pressure on most commodities (except the precious metals) and equities.  As currencies gyrated, high quality bonds were sent to record low yields.

The inevitable loss of faith in the myths of the central planners appears to be percolating.

We continue to believe in investment math.  This discipline may be tested by the ECB’s commencement of QE in coming months.  Plus, there will almost certainly be some more myth telling to accompany these efforts.

However, the lack of success that has come from excessive money printing in recent times should serve as a warning to herd followers.  This EU money printing Ponzi scheme is simply like trying to push a boulder uphill.  And there’s no reason to get crushed when gravity takes over.

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

Surging high quality bonds and sinking commodities are still expressing quite clearly that the central bankers have thus far failed to ignite a sustainable recovery and, in fact, global growth expectations are heading south.  Copper and iron ore markets reflect the same pessimism as that for crude.  Because so much of the economic activity of the last few years was commodity-intensive, pricing in these markets serves as even more of a barometer than it has historically.  The U.S. currency is displaying enormous strength as “the best house in a bad neighborhood,” causing significant pain for issuers of dollar debt outside the U.S.

Equity markets are banking on their next QE “fix” from Europe, while worrying that Greece may leave the Euro community.  At the same time, certainty over the Fed raising short rates sometime this year is waning due to growth worries.  Equity bulls attempt to spin discussions around this topic into the thought that if the Fed tightens, then growth must be strong.  If the Fed does not raise rates, then the free money environment continues.  Both are a win for stocks according to those camps and bullish sentiment is at historic extremes along with valuations as a result.  In spite of equity indices residing near record highs, the average stock is down about 20% from its high, so even the world of stocks is not as euphoric as many pundits seem to indicate.  Credit spreads are moving wider in another indication that all is not well.

The employment report for December was just more of the same.  Strong headline job gains masked weak wage growth and an alarming number of people leaving the labor force.  It seems that part-time and lower quality jobs are continuing to be the driving factor.  The headline 5% GDP number for the third quarter contained an inordinate amount of spending on Obamacare and national defense but provided very little reason to raise future growth expectations, particularly when spending on goods actually slowed.  A slump in imports was another major element of the revision higher.  Moving onto the fourth quarter, based on what we have heard so far from retailers themselves, Christmas sales look to be in line with the soft performance we have seen in recent years with no clear impact from lower gas prices.  December retail sales were just reported at -0.9% in an apparent surprise to those that seemed to think that printing money helped the average person spend a ton this holiday season. 

As we have discussed previously, the two biggest sources of growth in the U.S. have been shale fracking and auto production.  However, because crude prices have cratered, energy production and employment will be a drag on growth this year with some offset from the beneficial effect of lower gas prices.  We have been surprised by the speed of the historic collapse in energy markets, and though we need no reminding, it is a testament to just how quickly a belief system can come apart at the seams.  In addition, a recent big spike in auto loan delinquencies centered on the major growth engine of sub-prime debt creation will likely weigh as the year progresses.  That leaves us with new attempts to crank up sub-prime lending in housing in 2015 as the latest growth gimmick in spite of all the drama such past efforts have already caused. Memories are indeed short!  Clearly the powers that be want to continue to hope that high debt growth will lead to high economic growth despite the fact that the trillions of new debt created since 2009 has not produced escape velocity. 

At some point, the disconnect between equity indices and reality will have to be resolved. With more participants having come to the conclusion that U.S. equities are at historic extreme valuations, we wonder who will be the next “greater fools” to do the buying when the exit doors become crowded.   Corporations buying back their own equity in huge amounts while the insiders sell in their personal accounts will only go on for so long because the marginal ability to improve EPS per dollar spent decreases as the stock price moves higher. 

The collapse in commodity prices to multi-year lows, wider credit spreads, and the huge rally in global high quality bonds indicate that many markets do not agree with the central banker assurances that sustainable growth is here to stay.  Is it really such a huge leap of faith to go from realizing that QE has not helped the real economy based on these renewed growth concerns to worrying that if that is the case then stock prices at bubble extremes are quite risky?  Perhaps stock investors should have a chat with a group of oil traders who have learned the hard way that fact and fiction eventually converge in markets. 

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

 

The Fed supposedly tried to change its language to a somewhat less friendly tone in its official statement yesterday by suggesting a rate hike may come sooner than never.

The attempt failed.

Based on the ensuing rally, it simply seemed to be whispering “sweet nothings” into the ears of equity investors.  Nonetheless, the reality is that the global markets and economic matters are moving beyond the Fed’s ability to even pretend to control despite the stubborn refusal of stock investors to see beyond the computer-generated fantasy land created during most trading days.

The Bank for International Settlements had this to say about the global equity bounce off of the October lows:

“It is, of course, possible to draw comfort from recent events. Those who do so stress the speed of the rebound. At the same time, a more sobering interpretation is also possible. To my mind, these events underline the fragility – dare I say growing fragility? – hidden beneath the markets’ buoyancy. Small pieces of news can generate outsize effects. This, in turn, can amplify mood swings. And it would be imprudent to ignore that markets did not fully stabilise by themselves. Once again, on the heels of the turbulence, major central banks made soothing statements, suggesting that they might delay normalisation in light of evolving macroeconomic conditions. Recent events, if anything, have highlighted once more the degree to which markets are relying on central banks: the markets’ buoyancy hinges on central banks’ every word and deed.”

When the central bank for central banks comes to the conclusion above, maybe there is a problem.

Despite the equity rally, about 40% of small cap stocks in the U.S. are down 20% or more from their highs.  Clearly the average stock does not share the euphoria of the S&P 500 or the magic tale its devotees spin. Other markets see trouble too.  In addition to crude oil tanking, other commodities are at multi-year lows. Copper, iron ore, precious metals, and coal markets remain depressed. Global yields are sinking to record lows with German bunds near a 0.60% yield.  Oil-dependent Russia is in full meltdown mode with its currency and stock market getting crushed.  The U.S. treasury yield curve has flattened to levels which have indicated major economic concerns in the past.  Junk bonds are struggling mightily with worries suddenly concentrated on the energy sector. 

One can only marvel at the confidence of those brave souls still mostly enthralled about large cap equities given this backdrop when dollar strength alone should make robust earnings estimates for 2015 suspect. 

U.S. profit margins appear to be rolling over or topping near record levels and earnings estimates for 2015 have moved lower as 2014 has progressed.  Corporations have been buying back stock at a high rate to manage EPS damage, while many executives are selling large chunks of personal holdings.  IBM has been a prime example for years of a company with sluggish revenue growth coupled with a big shrinkage in its shares outstanding, boosting EPS.  That combination worked well until it finally became quite apparent last quarter that that it can only mask its difficulties for so long.  The Fed will not be making IBM shareholders whole and QE did not prevent losses.  We will be seeing more stories like IBM’s because many corporations have relied on the same strategy.

Markets away from stocks do not paint a rosy picture.  Longer-term bond yields and commodity prices are still pretty clear in their expressions of growth doubts.  Copper and iron ore prices point to the still weakening Chinese real estate market.  Credit spreads indicate much more caution in corporate bond land.  Most economic data is not at all inspiring.  Our third quarter GDP growth owed its surface strength to a major increase in defense spending and slowing imports.  We may be adding jobs at a nice clip, but the quality is poor and labor force participation is still alarmingly low especially when one considers that this was supposedly what the Fed was trying to ameliorate.  Once again, in spite of robust soft surveys like the ISM, actual U.S. industrial production printed at -0.1% for October as auto production is now slowing after the sub-prime lending induced binge earlier in the year.

After all of the money printing, real final demand at the consumer level is still so demonstrably weak if one listens to any major retailer’s quarterly conference call.  Macy’s, Dillards, Kohl’s, Sears, J.C. Penney, and TJX are all telling the same basic story if one bothers to listen: a lot of people are living paycheck to paycheck.  Even Amazon, the retail growth darling (with a hugely overvalued stock), saw weaker performance than its investors had expected.  However, in a clear sign of the speculative nature of the current environment, a number of retailers’ stocks rallied strongly after guiding lower for coming quarters.  You gotta love the Fed! 

The U.S. has obviously been riding an energy production boom in recent years thanks to hydraulic fracturing (fracking). We encourage you to think of energy production as the housing construction industry of this cycle.  Like the home building bubble created by the central planners and the Fed from 2003-2008, fracking is another endeavor granted favor by the deciders who also crushed the coal market to give it a boost.  An enormous amount of debt has been raised to fund the undertaking including a major portion in the junk bond market.  Wall Street profited handsomely in the capital raising process, of course.  Sound familiar?

In recent months, oil prices have been crushed to four-year lows because demand is just not able to match the massive increase in domestic supply.  Too much cheap money was thrown at the energy sector and predictable imbalances have occurred.  In recent weeks, the equities of many producers have been decimated.  Capital spending budgets for next year are being trimmed as a result.  These capacity gluts will hit suppliers and other sectors as well.  When many capital expenditures decisions in energy were based on the unnaturally low hurdle rates derived from a zero-bound monetary policy and printed dollars, you got entirely too much capacity.  Because the energy industry was a significant contributor to our GDP in recent years, oil below $80/barrel will have a meaningful dampening effect on the industrial production side here in coming quarters, which will likely not be overcome by any relief for consumers at the pump.    

The oil industry is likely just the first crack to become apparent.  We go back to what we discussed last month.  Six years into an ill-advised effort at escaping the crash from the bursting of the last bubble it created, the Fed has gotten the world even more totally addicted to cheap dollars.  Now, by supplying a world that is short dollars even fewer of them by ending QE, the Fed is creating a gigantic margin call.  Current dollar strength is a crushing blow to many global borrowers.  Trillions of dollars have been borrowed across the globe for all kinds of purposes.  Businesses in emerging economies that were drowning in dollars and spending like mad are being forced into a more scarce dollar environment. Sustainable growth has not arrived and it is difficult to know what has been organic economic activity and what has not.  We think that the pricing of treasury bonds, oil, many commodities, and precious metals markets are reflecting the end of the QE sugar high, while stock indices have yet to discount reality.   

If we are wrong on stock valuations being historically extremely overvalued and are cautious as result, then why must a central banker somewhere open his or her mouth to jawbone equities higher every time we have the sort of correction that used to be natural until the closing level of the S&P 500 became the determinant of job performance for the Fed and other central planners?  This will work as an index prop until it does not.  Regardless, the IBM-effect will likely overtake enough stocks that investors no longer view the indices as a no-lose proposition. 

Though the chorus of QE doubters and dissenters inside and outside the central banks and governments seems to be growing louder, equity investors have renewed their faith and commitment for now.  With speculation being the dominant force driving stock markets and fundamentals pushed aside, we have mostly remained on the sidelines from a trading perspective in recent weeks.   Does anyone besides us question the pundits who advocate aggressive allocations to equities at the same time a monetary policy that would have been considered the work of the lunatic fringe is enacted in a major global economy that will likely only slow its demise?   Do many of these pundits discuss that stock valuations are twice normal price/sales and price/GDP measures and that bullish market sentiment is also off the charts? 

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.

Since our last post, one might think that based on stock prices alone, all is right with the world.  That is certainly the intention of those in charge.  After hitting the lows in mid-October, we have witnessed a historically significant (based on speed) greater than 10% bounce in commonly followed indices.  History would suggest to us that such a move at this point in the cycle is not necessarily a good thing for stocks going forward, but belief systems like the current one have also shown themselves to be more durable than logic and math would dictate.

Ultimately, the Fed announced it was ending QE3 near the end of last month because the economy is now strong enough to withstand the cessation of the program according to the script.  However, recent market drama is likely a sign that the post U.S. QE road ahead may be much tougher to navigate.  The economic data certainly is no more robust than it has been for the last few years.  Though equities may still see central bankers as miracle workers, other markets are not giving an “all clear” signal.  In particular, the collapse in oil prices is a harbinger of slower growth to come in the important energy sector.  Most significantly, Japan’s latest round of yen printing cannot be overestimated in its impact in the currency debasement wars and global trade.   

When stocks were at their lows, more QE was suggested as an antidote by one alarmed and mercurial voice from within the Fed, that of James Bullard.  That ignited the rally.  In addition, to create the robust environment illusion of surging stocks, various central bankers and deciders from Europe, China, and Japan also had to promise that more money printing or other government initiatives were on the way.  Japan actually followed through on Halloween with a more “mammother” QE program.  Their last one did not help the real economy in the ways the Bank of Japan had hoped and promised, so in its twisted logic it decided to go to an extreme that seems like pure panic to us and to many other observers.  It will be buying just about all of the debt issued by the Japanese government because it sees no other way to escape the debt deflation spiral.  Even though we had expected a “no holds barred” approach there, all we can say is…“wow!”  We have found out in recent days that Japan is officially back in recession, so one really has to wonder how long the QE belief system can be sustained.  The experience there is proof positive that QE is no elixir for a poorly functioning economy and it cannot improve corporate earnings in any predictable or sustainable way. 

In Europe, the ECB is doing everything in its power to unleash a QE program of enormous size, but it simply cannot agree on an avenue for such a scheme.  It floated the idea of buying corporate bonds in the open market (when stocks were swooning, of course) but the Germans did not like the concept one bit.  Besides, the Euro corporate bond market is just not big enough to accommodate the sort of wanton recklessness favored by ECB head, Mario Draghi.  It greatly concerns us that some European bank stocks cannot get out of their own way after the mixed results from the stress tests there.  Also, Greek bond prices are becoming volatile again.  We are getting a clear message of problems becoming more acute. The EU economy has turned for the worse and the stock charts suggest that more credit drama lies ahead. 

In the U.S., one major concern is the fact that while many companies are beating EPS estimates, they are doing so by a smaller amount and revenue growth is becoming increasingly sluggish.  Many multi-national companies received a poor response to earning reports because sales volumes softened and the stronger dollar served to compress earnings even before Japan’s latest salvo.  That dollar strength is cause for revisions to EPS estimates and one has to wonder how long U.S. and Chinese deciders will allow the deflationary effect of this to continue.  Ending QE3 in a vacuum is one thing.  Ending QE3 when the Bank of Japan is unleashing a tidal wave of deflation is another.   At some point, markets will realize that all currencies are suspect in this race to the bottom.  Gold and silver may, at that point, be perceived as being in short supply.

As time passes it becomes increasingly clear that QE has been mostly a failure for the real economy, but the powers that be have wedded themselves to the belief that it works.  Japan’s new extreme QE initiative will not be the last effort of the central bankers because cheapening fiat currencies is the end game since it makes outstanding government debts less onerous. 

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.