Bull markets tend to bring out movies about the world of finance.  However, like the bullish Time magazine cover we have mentioned in recent months, they can be powerful contra-indicators.  For instance, Wall Street came out in 1987 and Boiler Room arrived in 2000, marking critical turning points after significant market surges.  This cycle has brought us a remake of The Great Gatsby (eery timing given our view that we are re-living the 1920’s in many ways) and more recently The Wolf of Wall Street.  We have seen neither, but they reminds us how tightly scripted markets have become, as if the writers, directors, and producers somewhere have a story to tell us each trading day, and boy do they stick to the plot.  Markets in cycles past have had a similar feel, but nothing like today.  Perhaps it is because computer algorithms dominate trading completely and are quite adept at managing prices around the story line 24/7.

We call the current market movie “Mirage.” The script goes like this: the Fed is the heroic protagonist, dropping cash on Wall Street.  The prime beneficiary of QE is the S&P 500.  The Fed creates an illusion of well-being.  Central bankers and policy makers in Europe and Japan wear the white hats too as they play up any signs of growth and promise to do anything they can to support markets.  The private sector and the real economy do not even play “bit” parts.  According to the script, the FOMC, in its infinite brilliance, will stop printing money at the exact perfect time in the distant future and equities will to continue to thrive as rates remain ultra-low.  Villain bonds and precious metals are to be feared because QE might end today and the Fed might actually tighten policy tomorrow.   Please pardon the disconnect between our last two statements because that’s what the markets do every day. It’s a gaping hole in the plot, we know.

The storyline includes no mention of the massive overbuilding in China, which helped corporate profitability in the U.S immensely, or any other factor that was outside of Fed control, like FASB easing mark-to-market rules for banks. The computers relentlessly trade all asset classes in a tight band around this storyline, as if the movie was completely nonfiction.  Huge sums of money are placing identical bets as the herd grows larger, drawn into the engrossing plot.  The intrinsic value of securities is not important, just listen to Bernanke.  How the computers treat asset classes most days is the only thing that matters in this flick. Momentum rules the roost.

By our best measures, this “movie” has pushed equities to all-time high valuations.  Yet apparently many participants feel compelled to buy stocks.  Although some are skeptical of this year’s price move in equities and other risky assets like EU bonds, few seem willing to leave the party just yet.  What strikes us as astounding is that just about every professional believes they can get out the door at just the right time and are even advising investors to do the same.  That doorway will get mighty crowded at some point.

We think we know how the sequel goes.  Tepid growth fades to recession because massive global debts simply cannot be overcome in spite of central banks’ liquidity binge.  Consumers, businesses, and governments are already overly indebted in the U.S. and many other nations, but the powers-that-be attempt to create ever more debt to grow our way out of the chasm.  However, both the desire to borrow and the desire to lend have passed their peaks and additional debt would be quite difficult to service.  It is a “Catch 22” that central bank balance sheet expansion cannot defeat; the critical limit has been reached. According to this script, after a few painful years, only debt restructuring can clear the path for future growth.  To avoid this pain, every country will continue debasing its currency in a “beggar thy neighbor” strategy to repay obligations with cheaper money, but this just leads to more asset bubbles and future crashes.  The sequel will likely include an earnings collapse because of the slowing economy and the unsustainability of current record profit margins.  Stocks should correct, but may just go mostly sideways for years.  High quality bonds should do well in a flight to quality.  Precious metals should rise in a flight to safety, as well as their relative scarcity versus the ever increasing supply of fiat currencies backed by nothing.

If we ever wondered about the long-term impact of QE, we think the cratering of mortgage applications to the lowest levels in twelve year answers the question.  Inman News reported that Trulia’s Chief Economist recently tweeted that “increased mortgage rates — which jumped in the spring over worries that the Fed would dial back its stimulus program — have ‘whacked’ refinance applications, and the housing recovery has been too weak to fill the gap with purchase loans.”  How real was any supposed housing recovery anyway?  It was facilitated by a bunch of hedge funds buying properties and artificially driving up prices in major markets.  For instance, the New York Times quoted a local broker who said “maybe 70 percent of the sales we were seeing were to hedge funds, investors and others taking advantage of what was happening in Brooklyn. Only about 30 percent were actual end users or first-time buyers.”  This is going on all over the country to various degrees and that’s a problem.  What a mirage! Have we learned nothing from the bubble of 2006-2007?

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.

Listening to the leaders at the Fed these days is like hearing the best students in the class arguing with the teacher over a grade.  Much of the media seems like parents arguing on their child’s behalf.  For the guys at the Fed, who mostly know academia and nothing else, low grades would be crushing if they were not delusional.   The class in this case is Real Economy 101 in which the Fed has helped guide the labor participation rate to thirty-year lows.  Too many twenty-something’s reside in their parents’ basements for lack of a good job and older workers have given up looking for work in droves.

Nonetheless, our brave students at the Fed are just certain as can be that money velocity will rise sooner or later, as their printed money finally gets put to productive use in the real world.  Doubters like us must prove the “counterfactual” (a popular word among the FOMC acolytes these days) that things would be worse without the heroes at the Fed who have rescued us every five years or so from the popping of the bubbles they helped blow.

The FOMC swears it deserves an “A+” because stock prices are so elevated and speculation is rampant again.  Numerous pundits praise the wisdom of Chairman Bernanke.  However, for the first time we can recall, a number of significant money managers and captains of industry have voiced concerns that a bubble has formed in many asset classes. But the Fed supposedly knows better!  Though there is so little real world experience within its ranks, somehow the central bankers’ good grades in school and fancy research papers replete with indecipherable squiggly lines trumps the wisdom of people who really do not have a vested interest in sounding cautious.

We will give them their coveted A+ in one subject: Bubble Formation 101.  They have been receiving that grade for over twenty years.  Equity bulls are now running over 3.5 to 1 versus bears according to sentiment surveys.  Margin debt and mutual funds flows are at euphoric extremes.  Tech companies with no earnings are priced into the stratosphere.  A++!  We also give them an A+ in Capital Misallocation Strategies 101.  The FOMC is causing money to flow into markets and not into productive capital.  They openly sell the “sizzle” of their magic trick.  However, does the Fed think that business decision makers are so naïve as to believe anything in the current environment is real or sustainable?  Will higher stock prices lead to job growth?

Why you may ask are we so hard on the Fed.  It is because their policies at these extremes help so few and penalize so many, especially savers.  Even some from the inside the Fed are beginning to recognize the shortcomings and unintended consequences of current policies.  In a recent piece in the Wall Street Journal Andrew Huszar, the man put in charge of the Fed’s mortgage purchase program wrote:

“I can only say: I’m sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed’s first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I’ve come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.”

Better late than never we suppose.

By the most important measures, U.S. stocks are the most richly valued that they have ever been in about 100 years of history, in spite of the underlying economy needing life support and pain killers for five years now.  We predominantly use normalized earnings to value equities in an effort to adjust for cyclical earnings variability and typical profit margin behavior, but a more direct and less “geeky” way to get to largely the same answer is to compare stocks to annual revenue figures.  On that front, data-centric fund manager John Hussman recently wrote:

“While the valuation of the S&P 500 Index itself was higher in 2000, it’s notable that the overvaluation of the S&P 500 was skewed in 2000 by extreme overvaluation in very large-capitalization stocks, while smaller capitalization stocks were much more reasonably valued. In contrast, we have never in history observed the median stock as overvalued as we observe presently. Indeed, the median price/revenue ratio of stocks in the S&P 500 now exceeds the 2000 peak. Likewise, as Damien Cleusix has observed, if we examine valuations by quartiles (25% of stocks in each bin), the average price/revenue ratio of the two middle quartiles also exceeds the 2000 extreme.”

Yet comically, former Chairman Greenspan had the audacity to recently argue stocks are cheap.

The next Fed Chair, Janet Yellen, just told us today during her confirmation hearing that there is no “over leveraging in the markets” and no “misalignment in asset prices.”  Why worry?

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.

Wrangling over the debt ceiling in the U.S. took center stage for weeks and we look at the whole episode as a sad sign of the times.  It will likely become ever more commonplace.  Governments across the globe are fighting to continue deficit spending and politics has forced central banks to take huge gambles by buying up enormous sums of debt.  It is a global Ponzi scheme and a game of currency debasement.  Those who recognize the recklessness of these policies push back and are castigated by the many in the media and various pundits as if being upset about handing the next generation a horrific set of fiscal circumstances makes one a pariah or worse.

Our best guess is that those who favor these policies should expect more frequent pushback as it becomes obvious to most that they are not working and have unintended consequences.  Common sense dictates that various vested interests will continue to argue over priorities because real money (as opposed to the printed variety) is scarce.  Many will continue to argue that putting our heads in the sand is just fine and that our debt binge is not an issue. Nonetheless, government involvement in markets and the economy is just about all there is these days.  Five years into a supposed recovery the Fed seems too fearful to even slightly diminish its QE program.  Before QE began even one $85 billion asset purchase program would have been a huge deal, but now a monthly purchase of that sum is the norm!

It seems as though everything that the powers-that-be do is a contrived effort to keep stock markets from collapsing.  We think the Fed pays lip service to employment and inflation, but determines its success by where the S&P 500 closes on a given day.   We do not say that lightly! Someone needs to tell them that QE is simply creating more free reserves because banks are not lending.  We point to recent dismal reports from retailers, restaurants, and trucking companies as proof of policy ineffectiveness.  At the same time, we know we have never could have imagined that so many stocks could trade at levels that reflect a robust business environment, yet the reality of their revenues and earnings paints a starkly different picture.  This reality gap is a hallmark of monetary policy and one that must be resolved.  Perhaps that will happen with a flat equity market for years without a major correction, but expecting that scenario would be betting against about a hundred years of market history.

We think we are caught in this paradigm that requires the Fed to buy up Treasury debt largely because it creates a ripple in the market pond that causes investors to keep doing foolish things like buy equities at some of the richest valuations in market history.  We have no way of knowing how long this powerful belief in magic can continue.  We know a lot of money has been lost in years past during prior Fed easing cycles because sooner or later fundamentals take over.  Many are relying on one year’s worth of expected earnings to make investment decisions.  That often does not end well, particularly when profit margins are dramatically above long-term averages and revenue growth is hard to come by.  We really do believe that the Fed has lost all credibility and simply targets the S&P 500, but many know this now and believe they can exit before the party stops.  We have no way of guaranteeing that with our capital and cannot take the risk.

Janet Yellen has gotten the nod to head the Fed, so don’t look for any changes in monetary policy.  She may talk about shrinking the enormous $85 billion monthly purchase plan.  She may even try it for a period of time….until stocks correct 10% or so.  In fact, if it’s possible, we suspect that she will be even more accommodative given her public comments and demeanor.  She, like Bernanke, really believes the Fed can create employment in the face of structural issues that are beyond her control. Many of the unemployed remain so because there are not enough of the types of jobs created by the Fed’s last bubble in housing. Given the cruel nature of markets, it is likely that money printing will continue until QE becomes the two most loathed letters on the planet in coming years.  Based on history, it is the expected result given the tremendous accolades now being piled upon the academicians at the Fed.  Greenspan was a celebrated legend before the tech bubble burst in 2001.  Of course, Bernanke has been given recent credit for saving the world after the housing insanity which he helped create, but he was far from rock star status right after the 2008-09 crash.

The equity market is a market of individual stocks.  In the end, the dynamic has become one in which faith in the magic of QE is pitted against the reality of individual company earnings reports.  We strongly suspect that over the coming quarters too many companies will disappoint investors, causing their stocks to swoon and ultimately taking indices with them.  We invest based on valuations, so we worry ourselves with what we can control.  The Fed is either going to keep pumping dollars into the world or it is not.  Investors are either going to persist in their belief that QE will magically boost stocks or they will become worried that QE is not helping the real economy as free reserves build and money velocity continues to crater.  We do know that earnings have begun the process of rolling over and it is inordinately difficult to find equities to purchase.

We also know that QE punishes savers who would without a doubt have more disposable income if the Fed were not guiding all into riskier assets at rich prices.  We suspect that Fed policy makes capital cheap for businesses and labor expensive, yet the FOMC wonders why employment is stagnant.  We also know that it must be impossible for many businesses to conduct long-term planning because everyone knows that just about nothing in the current economic environment is organic or sustainable.

We are not paid to be optimists.  We are paid to be realists.

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 did not reduce its monthly asset purchase amounts today at the conclusion of the FOMC meeting.  While we had hoped to see a beginning to the end of QE and are surprised in some ways, it obviously fits with our theme that the economy is not doing nearly as well as the deciders were telling us.  We wonder how much longer equity investors can hold out irrational hope in this crew to justify valuations, but we suspect that Mr. Bernanke has not helped his credibility.

We find it perverse that the Fed drives markets so completely.

In looking at the equity market on a price-to-sales or normalized earnings basis or other metrics, low single-digit future annual returns are currently priced into the market over the long haul.  These are among the lowest historical projected return numbers going back a long time, QE or no QE.

While stocks are often considered the world of unlimited upside in bull markets, few discuss that long-term returns are determined by the initial price one pays for each dollar of earnings.  Thanks to QE, 2013 has witnessed investors paying more and more for a flattening earnings stream in an economy that has disappointed to the downside and appears to be quasi-recessionary.  At the same time, low quality stocks have been the big winner.

Bond bullish anecdotal comments and negative news from a plethora of sources are routinely and totally ignored…for now. The jobs report for August once again disappointed in a big way, but taper fear has held sway.  Real final sales and consumer credit card usage have rolled over to the point that has signaled major trouble in the past. While auto sales for August were a perceived bright spot, some calendar quirks made comparisons a bit difficult.  Plus, we know that an auto loan growth binge is driving this segment because incomes are going nowhere.

Retailers and restaurants remain in the doldrums based on an enormous number of company comments, but you would not know it by looking at most equities in the sector.  FedEx just told us today that revenues grew a paltry 2% for its latest quarter and missed some estimates, but the stock is at all-time highs!  Wall Street trading machines choose to focus instead on nebulous data like the numerous ISM surveys, which seem to move in the opposite direction from more dour management commentaries and actual revenue figures.  The “Europe and China are turning up” story has received a lot of press of late mostly based on ISM surveys, but EU industrial production is reported to have fallen 1.5% for August, while Chinese export numbers are better only in comparison to very weak figures from prior months.

Nonetheless, a belief that the global economy must be strong because stocks are higher cannot be shaken. Last week we finally got a Time magazine cover (a powerful contra-indicator in market history) celebrating how wonderful life has been for investors (if you have been willing to tolerate the risk of a major loss of capital in an environment containing even more macro risk than that of 2008).  The reality is that problem assets have been papered over (thank you FASB) and ignored for now as the Fed steers many to the edge of the cliff in a nauseating adherence to strategies which have resulted in three equity market bubbles and a housing bubble since the turn of the century.

While many point to the Fed-supported treasury market as manipulated, we posit that price discovery activity in equities is as phony as a three-dollar bill.  We would not have believed five years ago that such high levels of illusory quoting would be considered legitimate behavior in any way, shape or form.  Who needs the fabled but largely unproven “plunge protection team” when regulators have created a strange brew of exchanges, high frequency traders, and market makers that dominate activity, making true investment activity but a sideshow.  Maybe our instincts are incorrect, but we cannot help but strongly believe that this chicanery will take center stage at some point when real selling happens.  The late August three-hour trading halt brought to us by NASDAQ and other glitches like Monday’s snafu in options elevate this to “elephant in the room” status.

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.

Longer-term treasury rates might be too high and bonds could be cheap.

There, I said it!

With everyone calling for rates to go much higher after the Fed begins to reduce QE in September, we think they may go lower. We believe the growing herd of bond bear calls may be shortsighted.

Leaving aside the discussion about the Fed tapering process, history has demonstrated that rates have sunk to much lower levels in countries that have sustained slow growth due to structural issues such as too much debt.  Look at the Japanese experience.  We share their problem, as does Europe, so we would not be surprised to see bonds stabilizing and rising in coming quarters.

We find it comical when we hear talk of a strong economy.  We will stick to one fact, and one fact alone: over 70% of the jobs created this year have been part-time.  Who in their right mind can take the Fed and pundits seriously when they hold out strength in the labor market as a reason to reduce the pace of QE?  A preponderance of part-time jobs is not a sign of job market strength.

Of course, we would still love to see the Fed stop because QE it is a “bad drug” that has become an addiction for the markets. Corporate earnings are plateauing, yet equity markets race to put a higher multiple on those earnings because of QE, leading to a dangerous environment.

The broad equity markets remain priced at levels that typically have marked major tops, but we are not naïve enough to think we know when a meaningful correction might occur.  Such a downturn will likely not be pleasant because margin debt remains at historic extremes.

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.

We long for the days when markets were not nearly so centrally managed, when the repetition of the same shallow promises by the “deciders” at the Fed and the ECB held little sway.    The U.S. deciders seem to care mostly about where the S&P 500 trades and that shows as it stands out as one of the few global indices in bull mode.  With that in mind, hedge funds ramp the U.S. equity futures higher during thin markets when most people in the U.S. are still sleeping and bid at regular times throughout the trading day to keep the party going.

We reiterate that high frequency traders’ shenanigans are given way too little credit for the euphoria.  Just last week we learned of a major brokerage that was penalized for permitting all kinds of manipulative behaviors.  We would prefer an end of the behavior as opposed to a slap on the wrist, but at least it was a start.  Fundamentals matter quite little and we deplore that.

Our favorite bit of chicanery is “Tuesday bid day,” when markets are goosed higher by a confluence of buying on that day of the week for no apparent reason other than it’s the day after Monday.  Many times it all starts with a plethora of fake quotes that are never intended to be executed, but create the perception that the sky is the limit.

Central bankers and policy makers across the globe trip over themselves discussing the next market propping measure or they downplay the likelihood of less QE if stocks so much as sneeze.  It didn’t used to be the only game in town!  Ultimately, fundamentals will assert themselves, but the deciders are doing their best to prevent that.

Most participants move in unison more than in times past with differing opinions hard to find.  The June employment report was almost universally painted as robust.  Nonetheless, the household side of the U.S. employment report showed a massive increase in part-time jobs and a giant decrease in full-time jobs.  That’s not good!   What’s more, not too long ago we would have thought the rise in the U-6 unemployment by 0.5% to 14.3% to be bond bullish.

From a big picture perspective, the percentage of people who have a job remains near a thirty-year low as shown below!

Bonds were crushed yet again as the report was proclaimed as quite strong, leading to speculation that the Fed will definitely start buying fewer treasuries and mortgages in the near future.  Clearly an untethering from objective reality is at work as every bit of bad news is ignored and every “as-expected” number is portrayed as a “barn burner.”

As always, we feel compelled to mention what is going on away from the chatter of the talking heads.  Behind the scenes Portuguese bonds have been blasted on renewed credit worries in recent weeks.  Europe is in a major world of economic hurt that just gets worse with most new data points.  Unemployment in Italy just hit 12.2%, a 35-year high, and European industrial production fell 1.6% over the prior year.  Auto sales are at a two-decade low.  Growth in China looks increasingly suspect as bad loans and overcapacity weigh on growth.  Exports there are softening and economists are reducing GDP expectations yet again.  Japanese growth has picked up for now after the onset of their enormous QE, but their sovereign debt situation remains among the most perilous.

Pre-announcements of negative earnings surprises are running quite high at about 7-to-1 here in the U.S.  Revenues will likely shrink for another quarter for corporate America.  The damage in the mortgage market is one for the record books, but few pundits really mention it or discuss just how devastating a 30% move higher in rates is to a potential homebuyer.  We were only growing either side of 1% prior to the rate spike, which J.P. Morgan and Wells Fargo both admit will have big impacts on their mortgage businesses.  Of course, the talking heads act as if growth is 4% or more, even as retail sales come in at levels normally witnessed around recessions!  Finally, it does look like the regulators will be doing the right thing by requiring banks to significantly increase their equity capital, but that is not exactly a positive from a growth perspective.

From what we have been reading, it is quite tough in the hedge fund universe.  According to Bloomberg, “hedge funds lost 1.4 percent in June, the most since May 2012, paring the gain in the first six months of 2013 to 1.4 percent, according to data compiled by Bloomberg. Hedge funds that use computer models to decide when to buy and sell securities slumped 6.3 percent last month, extending losses for the year to 7.1%.”  With the S&P 500 up in the mid-teens for the year, many investors are asking themselves “why hedge at all?”  We are in an environment much like 2007 when hedging risk is penalized and participants pay up for the privilege of taking risk.  Hedge funds are now routinely derided and “buy and hold” is celebrated.

We have read the book and seen the movie.  We find many seasoned practitioners seeming to forget that 10-15% equity corrections are quite common throughout history and 30-40% drawdowns occur around recessions…the current cycle is long in the tooth.

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 year began like the prior few with Wall Street pronouncing that the economy could finally stand on its own two feet.  Riskier assets have rallied strongly once again.  But a funny thing has happened on the way to this self-sustaining recovery.  Much like the prior years, it has not arrived.  Real final sales as reported in the recently released first quarter GDP report came in at avery weak 1.5% rate. We have endured the longest stretched of low growth since the 1920’s.  To counter this fact, the government will soon be issuing a newly minted calculation of the GDP report to artificially concoct more growth.

We could not make this up if we tried.

The savings rate for consumers hit 2.6%, the lowest since 2007.  Business investment in equipment slowed to 3% growth from 11.8% in the 4th quarter.  Once again the talking heads had touted the strong growth of early 2013, but these numbers are troublesome in themselves because the inventory build within the GDP report suggests that second quarter growth is going to be hard to achieve.  April’s just released ISM softened and many regional manufacturing surveys paint a picture of weakness.  Last week, in a sign of frustration, the Fed blamed the pols in D.C. for the lack of monetary policy effectiveness.

April’s employment report was taken by the market as strong.  Here is the take of Briefing.com:

“The underlying details point toward weaker consumption levels. The average workweek dropped to 34.4 hours in April from 34.6 and average hourly earnings increased 0.2%. The decline in workweek more than offset the increase in payrolls and earnings. Altogether, aggregate wages declined 0.3% in April.  That would be the first decline in wages since January. We are working under the assumption that consumers will gradually raise their savings rate back toward the 3.5% that it averaged during most of 2012. If households increase their savings amid declining wages, there is no chance that consumption levels can remain positive. It would not be surprising, given these figures, if retail sales decline for a second consecutive month in April.”

In the first place, the total number of jobs added is not what we would have considered strong in the past.  Secondly, aggregate wages do not shrink in a healthy economy.  Thirdly, the big jump in part-time workers of 278,000 is another red flag.  Finally, the broader measure known as U-6 total unemployment was up 0.1% to 13.9%.

Revenue growth has become a major concern in looking at earnings reports from a large list of companies like IBM, 3M, Procter and Gamble, Nestle, Apple, Amazon, and Caterpillar to name a handful. Bank lending rolled over in the first quarter as well and has been stuck at paltry growth rates since 2008, in essence explaining why Fed policies here are not helping the real economy (“you can lead a horse to water…”).  The Fed’s new money just sits idle in bankreserves as money velocity craters.  The S&P may be at record highs but most decision makers do not have the confidence this would typically reflect.

Just wait for the full impact of Obamacare later in the year!

We have seen some improvements in housing particularly in the cities that were the hardest hit, but much of that is the result of hedge funds rushing in to buy distressed properties.  This is just the sort of speculative activity that currently reckless Fed policy evokes and it should be unsettling to us all because hedge funds are not natural owners.  Look out below when they can’t rent their houses at the levels in their models.

Outside of the U.S., unemployment in Spain just hit 27.2% and incomes across the rest of Europe are imploding at an alarming rate.  Slovenia appears to be the nation most likely to follow Cyprus into a bailout.  France’s economy is a “basket case.”  Perhaps most importantly, the Bundesbank just issued a scathing denunciation of the ECB’s bond rescue program as the German court reviews these policies.  That court decision alone could derail efforts put in place to conceal the debt problems in the EU, which are only growing.  Industrial profits in Chinaslowed to 5.3% for March from 17.2% growth earlier in the year and broader growth has been a negative surprise.

We could go on forever, but suffice it to say that the news has continued to worsen, emboldening those whose entire investment thesis is buy equities because the central bankers will magically levitate markets no matter what the news.  Suddenly, discussion has changed from the Fed will ease up on QE because things are so good (let’s buy stocks) to the Fed will do more QE because things are so bad (let’s buy stocks).  The common thread is “let’s buy stocks.” Japan is conducting QE and the ECB has mentioned giving a negative deposit rate a try after just lowering rates.

It matters not that valuations sit near the richest 15% or so of historical observations based on normalized earnings.  Would you buy a business at a high multiples of peak earnings at peak profit margins when the economy is being sustained by extraordinary fiscal and monetary intervention and turning softer?

Me neither!

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.

China is a dream world that’s symbolic of current investor psychology. Because real economic growth was so hard to achieve in the U.S. as consumers became overly indebted late in the 20th century, Wall Street and the powers-that-be looked to China as the next engine of global economic activity. For many years companies here have benefited enormously from trade with that nation.  Nonetheless, we suspect China’s growth story over the last decade will go down as the biggest financial fantasy of all time in the sense that so little of it was truly organic or based on competitive markets.  It was mostly the result of central government planning and reckless infrastructure spending.

Massive debt growth fueled their bubble just like it did about everywhere else on the planet.  In fact, according to a recent Wall Street Journal article, “analysts at Standard Chartered PLC estimate that Chinese corporate debt was equivalent to 128% of gross domestic product by the end of 2012, up from 101% at the end of 2009.”  That absolute level of debt is a major red flag and their growth rate is another.   The article goes on to say that “according to a 2011 report by the Unirule Institute of Economics, an independent think tank in Beijing, once government support such as cheap loans, rent-free land and direct subsidies—cash injections—are stripped away, China’s industrial state-owned enterprises were unprofitable between 2001 and 2009.” We simply continue to wonder how much longer this can continue if this is even close to the truth.

The Wall Street Journal also recently contained a piece on China by a Morgan Stanley analyst who wrote that “since 2007, the amount of new credit generated annually has more than quadrupled to $2.75 trillion in the 12 months through January this year. Last year, roughly half of the new loans came from the ‘shadow banking system,’ private lenders and credit suppliers outside formal lending channels. These outfits lend to borrowers—often local governments pushing increasingly low-quality infrastructure projects—who have run into trouble paying their bank loans.  Since 2008, China’s total public and private debt has exploded to more than 200% of GDP—an unprecedented level for any developing country. Yet the overwhelming consensus still sees little risk to the financial system or to economic growth in China.”

The Chinese central bank (PBOC) has been tightening monetary policy, though few have mentioned it.  This occurred even though copper inventories in China remain very elevated versus this time last year and economic growth seems spotty.  It also appears that the leadership there wants to contain housing growth with renewed vigor.  They are raising down payment requirements and limiting purchases.  Given the historic growth-at-all-costs mentality, one would expect pro-growth policies.  We have to wonder why they are pursuing a renewed effort to contain economic activity. We also wonder why tremendous credit growth is having so little incremental impact on GDP, which is growing closer to 3-4%, not the “official” 7-8%, according to outside observers. We suspect that troubles with bad loans are finally starting to weigh on policymakers desires to continue to do business as usual.

Chinese banks are very tight-lipped about losses, of course.  However a recent article from Quartz reported that: “Shang Fulin, the chairman of the Chinese Banking Regulatory Commission, raised concerns at a mid-January meeting that over half of the 67 trillion Yuan of loans held by Chinese financing institutions have been made to risky borrowers such as local government financing vehicles, property developers and industries with overcapacity. Shang added that such loans need to be ‘heavily fortified’ and require ‘classified policies.’” Who knows how long it might last, but it looks like China may for now be more interested in dealing with past problems loans as opposed to continuing to create them.  In essence, it looks like maybe bad loans have reached a level that clogs the financial system to such a degree that rapid growth might compound the problem.  Call us crazy, but maybe China’s leaders are losing control of that economy.

The Chinese example shows that central planning has both unintended consequences and limitations.  We may be dealing with the same realization in the U.S.    Financial fantasy is not a healthy underpinning for any sound investment philosophy.

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.

Wall Street and the pundits are offering the hope that earnings will not respond to normal cyclical pressures because China’s growth has supposedly picked up and the U.S. has finally begun a sustainable recovery.  New Japanese currency debasement talk has also captured the fancy of many in recent months.  Never mind that markets are normalizing extremely high profit margins in the face of one of the most uncertain times in U.S. history.  Those who spin the “this time is different” theme continue to drift further from reality.

And these are not the only head fakes.  Given the rally in the Euro and higher risk bonds in Europe since the 2012 lows, the “consensus” seems to believe EU drama is over.  But they are ignoring Italy’s political drama arising from the recent election (it looks like the populace there may not be too happy with what the “deciders” have decreed).  Senior bank bond holders’ and depositors’ losses in Cyprus are another confidence shaker, but hardly enough to prevent the continued downward slide in volatility.  Finally, with the “fiscal cliff” scare in the rearview mirror in the minds of some, downside risk in the U.S. has been almost eliminated according to the rose-colored glasses set.  Besides the Fed “has our back!”

In our view, we are left with a less than inspiring global growth picture. Just take a look at comments from companies operating in the “real world”. Fedex just announced that it must reconfigure its Asian business because demand there is not what it expected.  Caterpillar reported dismal demand for its heavy equipment.  Steel demand remains at low levels according to numerous indstry participants.  Oracle failed to meet market expectations in the software sector.  Tiffany guided lower because sales remain punk.  Yet stocks fail to reflect much, if any, bad news.

According to the Wall Street Journal, “Companies aren’t exactly confident about the economy.  So far this quarter [referring to the first quarter], 101 companies in the S&P 500 have predicted weaker-than-expected earnings figures, compared to just 23 companies that have unveiled optimistic outlooks, according to figures compiled by Thomson Reuters. That’s the worst ratio since the third quarter of 2001. Not exactly a vote of confidence in the current economic conditions.”   Bloomberg reported that, “Sales at casual-dining establishments fell 5.4 percent last month [February], after declining 0.6 percent in January and 1.6 percent in December, according to the Knapp-Track Index of monthly restaurant sales. This was the first three months of consecutive declines in almost three years, with consumers caught in a ‘very emotional moment,’ said Malcolm Knapp, a New York-based consultant who created the index and has monitored the industry since 1970.”  We see strikingly little concern in the market for the equities of the affected companies; in fact, some sit at all-time highs.

We are well aware that the publicly traded homebuilders are seeing a big increase in demand and that car sales look good for now.  Cheap money is helping fuel those sectors and that’s good to see in some sense, but we know that giving away money at Fed-created fantasy rates of interest cannot be healthy for long-term dynamics in those industries.  In contrast, consumer sentiment as measured by the University of Michigan (see chart) paints a less than rosy picture.

As always, we like to look at the big picture to explain why many of us (call us stubborn) do not feel like the amazingly ebullient 70% bullish Market Vane for equities reading.  It’s pretty simple…despite market euphoria, real income has been sadly stagnant for a number of years. 

If job growth is as strong as some claim, why is the office building sector not reflecting it? Reuters  just reported in a piece that, “The first-quarter [office] vacancy rate stood at 17 percent compared with 17.1 percent in the fourth quarter, according to preliminary figures from Reis. The vacancy rate was down a scant 0.30 percentage point from the prior first quarter. ‘It’s really in line with our expected trends, given that hiring hasn’t accelerated,’ said Victor Calanog, Reis’ vice president of research. ‘It’s so indicative of weak demand in the office sector that quarterly construction figures are at a historic low and yet vacancies are not really cratering.’” We found ourselves triple checking this story because it stunned even us.  It points out quite clearly the sharp contrast between common perceptions and reality in the U.S.

Chairman Bernanke’s former right-hand man, Frederic Mishkin, just wrote a paper that calls into question the Fed’s ability to exit QE gracefully.  According to a recent description of this piece in The Telegraph, “officials at the US Federal Reserve may be more worried than they have let on about the treacherous task of extricating America from quantitative easing. This is an unsettling twist, with global implications. A new paper for the US Monetary Policy Forum and published by the Fed warns that the institution’s capital base could be wiped out ‘several times’ once borrowing costs start to rise in earnest.”

Such an admission certainly does not diminish our concern that the current strategies of reckless deficit spending and money printing are unsustainable and de-stabilizing in the long run. It makes us wonder why in his public comments Chairman Bernanke cheers higher equity prices without mentioning the major risks building in the system because of his policies.  QE has caused many to allocate significant sums to what we perceive to be a quite overvalued market in a speculative display of blind faith.   We just don’t think it’s a wise investment strategy to bet that one can get out the door instantly when the Chairman utters the words that the Fed is going to remove liquidity or even do less quantitative easing.  In fact, that’s no investment strategy at all, but it appears to be the operative rationale at the moment.

We end with a question: if the global landscape were as strong as many equity market participants claim, wouldn’t the Fed already be tightening?

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.

We would be quite happy if employment were to improve meaningfully in the U.S.  We know plenty of people who have been unemployed or under-employed these last few years and it goes without saying that we share their frustration, particularly when the pundits paint our current subpar economy in such glowing terms.  We always find it useful to look at the bigger picture and not respond manically to every new piece of data.  Last Friday’s employment report was no exception in its ability to bring out the usual proclamations of what great successes fiscal and monetary policies have been.  A longer term view shows just where we stand.  While not exciting enough to provide the T.V. babblers with something to fill countless hours of time, it tells the real story.  Employment may have had a slight uptick in recent months, but in the grand scheme of things the situation has been terrible for years.

Of course, the bulls want to point to improvements in the housing market, but while things may be better, actual activity is a long way from the 2005-2007 bubble.  The FHA is doing its best to make the same underwriting mistakes of the last cycle and builders are bending over backwards to qualify prospective buyers for mortgages, but overall activity remains well below the last peak.  Hedge funds are even entering the game by buying up houses in depressed areas hoping to make a buck.  We do wonder what happens when they inevitably attempt to sell these rental properties at the same time.

Housing bullishness in the equity market has reached extreme levels.  According to CNNMoney.com “struggling homeowners increasingly turned to short sales to get out from under mortgage debt last year. There were nearly three times as many short sales as there were sales of foreclosed homes in 2012, according to RealtyTrac. Foreclosures accounted for 11% of all sales, down from 13% a year before. Meanwhile, short sales rose 5% year-over-year, accounting for 32% of all home deals…. During the fourth quarter, the average discount on a foreclosure was a whopping 39%, while the average short sale sold for 23% below market, RealtyTrac found.”  That would mean that foreclosures and short sales together accounted for 43% of sales in 2012 with a weighted average price effect of almost minus 12% to average total home sales prices by our math based on this data.  We just have a hard time being too excited that housing has turned the corner because that still sounds just plain terrible to us.

Bear in mind that economic growth was low or nonexistent prior to the sequester cuts that began March 1, but the finger pointing will continue in earnest nonetheless.  The cries for even more government spending will soon be heard because many pols believe they know best how to run an economy.  We opine that even the fiscal hero of many of them, John Maynard Keynes, would likely say that these guys have taken things just a “bit” too far because we suspect that he might have the intellect to read the “tea leaves” of Europe and Japan’s fiscal woes and realize that debt-to-GDP ratios approaching 100% with no end in view tend to swallow economies whole by their very size.  Basic math tells one that each 100 basis point increase in interest rates adds about $150 billion more to our deficit in the U.S. each year and in this age of financial repression rates are more than a stone’s throw from normalcy.

We share investors’ quest for returns and income and comprehend the fact that so many feel as those their hand is forced into ever riskier investments.  The Fed has crushed incomes of the prudent in this economy by creating a bubble in bonds of all types, which has pushed interest rates to levels which punish savers.  There is obviously so little investment income to be had in fixed-income, yet life is much more expensive for us all.  The riskiest bonds are the most dangerous now because spreads are stupidly tight to treasuries that themselves trade at unnatural levels, even if one takes government inflation statistics at face value.  We do not because we go to the grocery store, buy health insurance, put gas in the car and pay tuition.  Sadly, we have not yet found a way to live our lives “ex. food and energy.”

With this in mind and because they face real world expenses, some investors have heard that dangerous “unlimited income” song and dance from Wall Street and responded by subjecting themselves to the risks of the equity market as if it is some magical land removed from the forces and bounds of the economy.   However, equity valuations over time and across the economy are subject to the same time value of money analysis as any other investment.  Profits tend to grow about 5-6% annually over time and   average about 5-6% of revenues across the economy throughout history.  P-E multiples tend to gravitate toward 15.  Long-term returns in equities do average about 8-10% depending upon how you look at it, but recessionary losses are about 30-40% from peak and it is not unusual to see 10-15% drawdowns during any calendar year.  Obviously, we have witnessed two roughly 50% disasters since the turn of the century alone, though many pundits have seemingly forgotten those.

Returns over time are “baked in the cake” so to speak just like the case with bonds-your initial purchase price determines your long-term return.  Importantly, at present, profit margins run the risk of correcting at least 30-40% and taking stocks right down with them.  We are not trying to ruin the party, but equities are not divorced from basic math over long periods.  We do not play the “greater fool” game expecting to sell positions to a sucker before reality hits because we know how quickly speculative profits can vanish.

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.