Certainly Fed comments from yesterday’s FOMC meeting made it abundantly clear to even its most optimistic cheerleaders that it is more concerned about the economy than it has previously conveyed. In spite of its employment and inflation targets for tightening having been reached, it failed to budge on rates and sounded less inclined to raise them. That further diminished its credibility.  We guess they doubt the employment data as much as we do.    

Having pushed the boundaries of politically acceptable monetary options, and then some, the Fed has been forced to stick with its tightening rhetoric simply to lend credence to the notion that all is well and to give it room to ease when future market volatility erupts.  The Fed has also been sounding reticent to employ the negative rate policies used by other central banks, mostly adhering doggedly to its bizarre propagandizing about raising rates in the U.S. because of “strong job growth,” while occasionally mentioning the possibility of going negative if the situation required it.    

The U.S. is supposedly in the middle of a hiring frenzy of waiters, bartenders, and store clerks according to the very employment data that is strangely held out as proof positive of QE success.  It is little wonder that wage growth remains poor when most of the new jobs being created pay so little.  However, even the employment data seems out of sync with comments from retailers and restaurant managements who are describing the current environment as tough.   Many major retailers are closing stores and recent earnings reports were mostly disappointing to say the least. 

Economic growth is still stuck in the 0-2% range at best and has now hit a weaker stretch at the low end with inventories too high and new job quality too low.  Central bank credibility continues to decline as the sense of “how much more can they do” and “we are still not out of the woods yet” is leading to the realization that asset prices are in many cases way out of line with what a rational business person should pay. 

What appears to be a typical bear market rally with questionable breadth has done nothing to alter our view on the investment world as massive corporate stock buybacks and short covering appear to be the major sources of demand for equities.  The Treasury bond market is not a believer in the economic rebound implied by the rally in riskier assets given how it is behaving.  That only adds to our skepticism.

At the same time, our favorite valuation barometer of market cap to GDP remains in clear bubble territory and would imply serious risk to high net equity exposures.  Those thinking that low interest rates justify exorbitantly priced stocks are simply ignoring data from prior low rate environments that suggest otherwise.   The S&P 500 could be cut in half if we were to return to historical averages, let alone reach cheap levels. 

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 relation.

Most of the market and economic news of late continues to fit into the longer term themes we have been discussing for quite a while and that is surprising to many investors.  The Fed is already backtracking from its hawkish tone.  Even some of the most ardent defenders of extreme monetary meddling have become exasperated with the economic and market dysfunction that it has produced.

That is an interesting turn of events.

Central bankers across the globe tried enormous quantitative easing measures and zero rate policies for a few years to avoid facing the problems they created in the last cycle.  Because high debt levels across global economies are choking off growth, GDP is much lower than that which was achieved for many decades in spite of these efforts.  Monetary policies led to the buildup of additional problems like massive overproduction in China, too much crude capacity in the U.S., and bubbly prices for real estate in many cities across the planet.  Slowly but surely, these issues are surfacing.

Importantly, it seems that, for now, additional attempts at “goosing” markets with new policies or dovish rhetoric are not having the bullish effects they once did.  For instance, market rallies after Japan announced a move to negative rates and the ECB mentioned even more QE only led to short-term euphoria that quickly faded.

Many financial assets and real estate globally reflect valuations that are still much too high relative to the earnings streams that ultimately support them in a “greater fool theory” with blind faith in the magic of QE. The declining credibility of the bankers should be troublesome to those who hold these assets and trusted investment decisions to the notion that no price is too high when monetary policy is profligate and money is free.  Our greatest concern over the last few years has been the day of reckoning that would come when investors realized they had duped themselves into believing that any of this monetary craziness would really work or justify their reckless investment activity.

We may be near that point.

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 relation.

The consensus on the “big picture” economic and market views have rapidly moved more in line with our base case over the past couple months.  Worries over weak global growth and high equity valuations are being expressed frequently by many who seem surprised that extreme monetary policy since 2009 did not lead to sustainable growth.  Faith in the central bankers is waning.  U.S. GDP likely grew at less than 1% to end 2015. A lot of economists on Wall Street are completely baffled about the fact that they were so wrong about consumer spending in the U.S.

It sure looks like the Fed tightened policy into a manufacturing recession and commodity depression and global trade remains very weak.  At the same time, based on what we are hearing about office furniture sales from the managements of our short positions in the sector, a softening in the “white collar” world is likely at hand.  Even subprime lending boosted auto sales lost some luster into year end.  CSX management indicated they have not seen such weak rail traffic outside of a recession.  Energy lending exposure at the banks has become a big issue and it appears as though credit provisions will have to rise by a lot.

While many pundits seem to want to say the current market tumult is just a China growth adjustment issue, as we have been saying for a couple years, we are confident that it is much more than that.  China’s unraveling is simply additional evidence that central banks created an unstable global economy that is now facing inevitable corrective forces.  While there were once too many U.S. dollars during the Fed’s fascination with QE, now there are too few as QE ended. Trouble spots have been emerging for well over a year as debts became quite burdensome for the heavily leveraged without the economic growth the PhD’s assured us would come.

It was not just a crude oil or junk bond problem in the U.S. last year.  One can “connect a lot of dots” to make the current situation quite easy to understand if one simply is at least willing to entertain the notion that extreme quantitative easing since 2009 was going to have market and economic downsides. QE never helped the real economy in ways that would drive organic growth and led to enormous malinvestment globally.  It seems that the major stock indices are simply the last to recognize this. With earnings estimates still coming down, holders of equities have continued to become less willing to stomach further pain.

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 relation.

The Fed, after frustrating and teasing markets for many months, picked a point when it would normally be talking about being more accommodative to drain market liquidity with its first rate increase in years.  We have been talking about this dynamic all year and feel free to read any of our past posts if so inclined.

We will only emphasize that corporate earnings, equity market breadth, the industrial economy, emerging market debt, and the corporate bond market have deteriorated further since we last wrote.  We are sure you likely have better things to do than to go into further detail because it has all been said before.

As for the actual significance of the change in monetary policy, suffice it to say that the drain in market liquidity is much more meaningful than what might be implied by a paltry 25 basis point hike in rates because the Fed was once again too easy for too long and dominated market functioning to a degree we all hoped would never take place. 

As investors, we take no joy in sounding like Scrooge…but the Fed leaves little choice.

On a personal note – Merry Christmas one and all!

On most days, stocks are still driven by currency movements, markets for volatility products, and options expirations.  The “tail wags the dog” as long-term investor activity has given way to computer algorithmic trading schemes that “paint a pretty tape” in a low volume environment.  Mid-afternoon trading in the U.S. is like a ghost town, leaving the HFT crowd free to their own devices. However, the percentage of stocks above key moving averages is way out of line with indices flirting with their highs.  The recent stock rally is marked by a lack of broad participation and is likely the result of shorts being covered by those who do not want to be on the wrong side of central banker market-supporting bloviations that have become an almost “24-7” routine.  Believe it or not, the computers are programmed to buy when the bankers pontificate.

Problems are mounting and we have to laugh at the length of the list of things we are not supposed to worry about.  We have been talking about corporate bonds as a primary source of trouble for some time and lately the issue has become too obvious for even Fed supporters to ignore.  Lower quality credit spreads have blown out to multi-year wide levels.  Leveraged loans and junk bond prices remain near four-year lows, sitting out the stock index rally.  Goldman Sachs recently wrote:

“Companies in the United States have taken advantage of low interest rates to issue record levels of debt over the past few years to fund buybacks and M&A.  This has driven the total amount of debt on balance sheets to more than double pre-crisis levels.” 

Glad you noticed.  That’s a lot of debt and corporations do not have much to show for it. For instance, trailing twelve-month S&P 500 GAAP earnings have collapsed by about 14% to $91 versus the peak of roughly $106 a year ago. This measure averaged about $87 during 2012 before QE3 got ramped up and levered stock buybacks went into full force to try to craft earnings growth out of stagnant revenues.  Forgetting the QE hype and ignoring the pundits, $4 of incremental earnings is not a lot to get excited about and certainly does not justify index levels.

When we go below the surface and look at individual names, it seems like many stocks that have fallen in price by a lot are still quite rich.  We can’t figure out how revenues can be maintained near recent peaks given the sea change in demand.  Cheaper industrials mostly make us wonder what normalized revenues will be without China spending another $20 trillion in the next few years after “overdoing” it in a big way for the prior five.  Many countries in the emerging markets were riding that nation’s coattails, as a flood of cheap dollars encouraged an amazing amount of borrowing and speculative activity to feed the China bubble. 

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.

If we were asked what has happened in recent weeks we would say that “it’s like deja vu all over again.”  Yogi Berra was often mistaken for a fool because of numerous funny but insightful quotes like that.  However, even lifelong Indians fans like us know the beloved Yankee catcher was far from that.    His façade belied his wisdom.  The Fed seems like the polar opposite of Yogi right now.  It is perceived as wise by many because of some PhDs and political skills, but it is really proving quite inept and confused as it repeatedly pushes markets to the brink of a tightening and then backs off.

Because the Fed would desperately like to “turn the page” on its policy blunders, FOMC members are still trying to stick to the script of QE success by highlighting anything it can find that is going right and ignoring the rest.  The media and the pundits seem to be mostly on board, dutifully marching in line.  The Fed would like to tighten for no other reason than it is feeling enormous pressure for taking a “command and control” approach to supposedly free markets for seven years without anything sustainable to show for it other than enormous amounts of inflated assets and overcapacity layered atop the unresolved problems of the prior cycle.  It wants to be done and it realizes that the political tide is turning against it.  Nonetheless, the minutes from the latest Fed meeting convey that doubts remain about the path of future growth among the members even as it once again prepares markets for a tightening of policy that it hopes will be confidence boosting.  Confusion reigns.

The news and data is not helping the Fed’s case.  It looks like the retail sector is joining the energy and industrial sectors in a pronounced collapse in demand.   The Fed’s delusional script is encouraging investors to cling to false hope in equity indices, while fearing the relative safety of U.S. treasuries, which are quite inexpensive relative to the sovereign debt of other developed markets.  At the same time, the Fed’s script is causing the dollar to soar to multi-year highs and that is a big drag on global growth in a world craving cheap greenbacks. 

Owners of individual stocks and high yield debt are bearing much pain for believing the Fed has any idea what it is doing. Other asset prices, commodities, and economic activity are clearly still mostly rolling over even as the rest of the central banks print major amounts of currencies. Key industrial metals, copper and silver, fall every day it seems.  Crude is back near $40 as inventories remain gigantic.  Meanwhile, ridiculously bubbly private equity market values are falling hard and it is becoming more difficult to finance LBO’s in the debt markets. Story stocks like SunEdison and Valeant are coming apart at the seams.  The only thing left to hold out as “proof” of monetary successes is some heavily manipulated stock indices, Wall Street-enabled auto sales, and a contrived unemployment rate.

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.

Many more investors seem to be coming around to the idea that economic growth is quite slow and that central banks have been completely ineffective in their efforts.  Risk premiums have mostly gravitated higher this year to compensate for the increased economic uncertainty.  However, stock indices (in contrast to many stocks) continue to levitate on the idea that monetary policy will come to the rescue, while most everything else reflects quite the opposite.  Importantly, bad news will cease to be risk asset supportive when credit market participants become much more selective or completely reluctant to buy corporate bonds.  We think we might be near that point just as Dell and Anheuser-Busch Inbev look to raise enormous sums to finance acquisitions.

The high yield bond market has become quite inexpensive relative to the S&P 500 in 2015.  This cheapening process began with the collapse in the prices of oil and other commodities last year, which has taken place, in no small part, due to the rising dollar and slowing economies.  This obviously hit the revenue of commodity producers. More broadly, the strong dollar is commonly hitting the revenues of many multi-nationals to the tune of 5-10% and that is adding to concerns and impacting earnings.  Of course, few noted the positive effect of the weaker dollar on revenues earlier in the cycle during our QE phase, but now that other nations are conducting the same policy in obscene amounts, making the dollar richer, investors are either up in arms or dismissing the reversal of fortune as insignificant.  Debt coverage measures look quite stretched in the resources sectors and their suppliers and problem credits are growing in number.  Over time, credit spreads have widened across the board in many industries as downgrades have increased dramatically to the point that makes bond buyers skittish. 

As we have said in prior letters, because of the gargantuan pace of issuance in recent years, the corporate bond market will be the center of the storm, much like mortgages were in the last cycle.  It makes no sense that one can buy high yield corporate bonds at the more attractive spreads of 2010-11, while the large cap equity barometers are much richer than they were back then.    After all, the corporate debt market has been even more important to equities in this cycle than in prior ones because many of the bonds issued have been used to fund the stock buybacks, which were much more impactful than anything the Fed has done. 

We have not witnessed cathartic selling in stocks yet in spite of how uncomfortable many felt in recent months. The S&P 500 is still valued at about twice the normal price to revenue ratio or market cap to GDP metric.  All judgements on equity exposure must reconcile with the tendency for these measures to mean revert and then some.  That could prove quite unsettling for those who decide to bet that somehow, some way that index will become more extremely overvalued.  It can happen quickly or slowly, but for analysts like us who use historical valuations as a guide, assuming that a return to rational valuations will not happen is a mathematically uninformed approach and thus quite risky. 

Credit markets do lead stock markets.  When those with the first claims on corporate cash flows begin to worry as expressed by wider bond credit spreads, even in the face of the perception that the Fed may remain easy, then stockholders must also discount greater risk by lowering share prices. We expect corporate debt to continue to follow the normal cyclical script and cheapen in 2016.  We also expect the S&P 500 to cheapen versus credit markets.  It is important to remember that the list of stocks down over 20% from their highs is quite high, so the foundation of the equity market is not exactly rock solid.  If events follow the familiar pattern of past cycles, those maintaining equity exposures through index-oriented vehicles will lose conviction as the idea that a Fed less likely to raise rates also brings with it the reality that growth must be quite slow and risks increasing. 

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 employment report for September seemed to corroborate the economic weakness we have seen everywhere else.  As we suggested would be the case some time ago, even the strongest supporters of the Fed are starting to wonder why sustainable growth is nowhere to be found after all of the supposedly stimulative effects of QE. If Wall Street was not busy pumping out auto loans to anyone who wants a new set of “wheels” at stunningly long loan terms and without much regard for credit scores, auto sales would be much lower than the current run rate.  We remember quite well from our bond days that once the delinquencies on those loans turn clearly up, that game will be over. Nonetheless, even with auto making running at unsustainable levels, industrial production for manufacturing fell for the third time in the past four months in September.  Ford and GM equities seem to see through the charade by remaining un-bubbly.

The Fed and its former chairman, Mr. Bernanke, can brag all that they want to about the “official” unemployment rate being at 5.1%, but we all know that number is statistically owed to the reality that the labor force participation rate is at 40-year lows.  The job market looks great if you stop counting large numbers of people who have given up looking for work.  The “rose-colored glasses” seem to enable many on the Street to focus on only the number of jobs created in a given month without factoring in that not all jobs are of equal quality.  We enjoyed our time in the restaurant industry back in the day, but we do not think that waiter and bartender jobs are of the same caliber as factory jobs.  Most economists don’t care to admit that foodservice is the source of a lot of jobs in recent quarters.  It took the slower payroll growth of the last few months to wake up some slumbering analysts to the idea that all is not well.  Jobless claims are always low at the late stages of cycles and speak little or nothing about the pace of actual hiring.

The current business inventory-to-sales ratio is at a recessionary 1.37, so the road ahead looks bumpy to say the least as those unsold goods are worked down.  When the CEO of a major industrial supplier, Fastenal, says that we are in an industrial recession, we listen.  We will not bore you much further, but we could add quite a few more names to the list of companies that are having a much tougher go of it this year in the industrial sector and the trouble is not confined to the depression in energy.  For instance, Caterpillar is enduring the worst run of sales for its heavy equipment in quite a number of years.  As we have said all year, it is a mighty strange environment for the Fed to be talking about raising rates because growth is so good.

The Fed has already taken short rates to zero and held them there for years and other central banks also tried numerous money printing efforts which did not ultimately lead to sustainable growth.  Both Europe and Japan have been printing money with abandon this year.  With China no longer able to provide the engine of global growth because its $20 trillion debt binge has become a drag, many are wondering what to make of the current environment.

We have to laugh at all of the talking heads whose main thesis for an investment idea for years was predicated on a company’s exposure to China as that nation boomed.  Many of the same ones are suddenly touting that China does not matter even as it faces a stunning amount of overcapacity in more sectors than we can count from steel to housing.  It reminds us of the last cycle when we were told that the blowup in subprime mortgages was trivial because it was a small segment of the overall market.  We know where that went.

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.

As we strongly suspected would be the case, the Fed decided to do nothing last week after months of guiding markets to a September rate hike.  Collapsing growth in China is likely not the only dissuading factor, though it garners much focus.

The leadership in China now regularly and openly props up their stock market after trillions have been lost.  We see no choice for China but to devalue its currency some more and try to export its deflation.  That prospect does not give the Fed much room to normalize policy.  The central planners are starting to realize that money printing has not worked and the markets are figuring that out too.  Importantly, because emergency monetary policy has been in place for seven years, it leaves the deciders with very few market-manipulating strategies from which to choose, but they will try.   

As we have been discussing, a lot of things elsewhere have been pointing to a global slowdown and disinflation all year and now it is tough to find things that do not.  The collapse in emerging market currencies and bonds is likely the clearest indicator that the current equity market volatility is more than a garden variety correction.  It once seemed to many debt issuers outside the U.S. that the flow of U.S. currency from QE would lead to a boom that would never end and they borrowed trillions of dollars accordingly.  Now the current relative scarcity of dollars since our Fed stopped printing is a major contractionary force on global growth.  The collective debt service on bonds issued in dollars grows much more expensive with the stronger greenback and credit issues are surfacing in a significant way.   

At the same time, lower oil prices are causing serious drama for energy producers whose cash flows are shrinking rapidly.  We have no idea where oil prices are going, but we do know that defaults in the energy sector will be a major global drag.  In the U.S., the shale boom drove a lot of industrial demand and now that is rolling over in a big way. 

The U.S. has a major inventory problem that must be resolved and the negative print for industrial production for August may be the start of the unwind.  That inventory accumulation has kept manufacturing from rolling over harder, but now those unsold goods must be worked off and that will be a problem for the rest of the year.   Jobs in the manufacturing sector already were not growing in spite of all the hoopla from pundits raving about the U.S. decoupling from global woes.     

Corporate earnings are becoming more of a question mark as 2015 estimates have been revised about 20% lower over the last year, so it is quite difficult for even the top-down equity exposure grabbers to persist because they must willing to stomach that they are purchasing a shrinking cash flow stream.  Cyclical stocks sold off after the dovish Fed meeting last week and that is yet another sign that earnings worries have become a pronounced market impediment. 

Of course, the problem with the massive QE efforts in the U.S. and elsewhere is the fact that they will likely prove impossible to stop for long until true sustainable growth emerges. This is not because these policies helped, but because they created distortions in both the real economy via currencies and debt creation and in markets via unrealistic valuations.  We are not big fans of QE (to say the least) except as a last resort in a severe crisis and for a brief period of time. Nonetheless, we doubt the Fed can muster the intestinal fortitude to normalize policy when both the markets and real world data will cause many to scream for more money printing though it has done nothing to help here or in Europe and Japan. 

What is interesting to us is that if the Fed were to step in and conduct more QE, then it would be doing so at a time when earnings were falling and growth outside the U.S. is quite weak.  That might make the Fed reluctant to push that button in some ways.  We are of the mind that QE3 was conducted when that policy had a lot of wind at its back as earnings were going to rise with or without it and growth outside the U.S. was rising.  As a result, QE was given too much credit by many and that belief system might be lost if a new round does not unleash rampant speculation and improved sentiment.  At that point, the tool which central banks see as the panacea would become exposed as nothing but a gimmick. Regardless, we would not be surprised if the Fed begins to make easing noises in the next few months because it is what they do.  However, we cannot emphasize enough that one only need to look back to 2001-02 and 2008-09 to see that the “don’t fight the Fed” fallacy can lead to huge losses. 

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.

After weeks of highly acrimonious negotiations, Greece is being asked to effectively give up its sovereignty to Germany in order to borrow billions more after having already borrowed about $200 billion in its first two bailouts.  This money will never be repaid and most of us know that.  The needed write-down of the Greek debt held by official institutions (that even the IMF recognizes must occur) may be an important catalyst in coming months.  Europe and the euro look shakier than ever.  Germany is just not big enough or strong enough to forever backstop the currency because the debt issues across that continent are too big.  When tiny Greece can evolve into a gargantuan $300 billion problem, another loss of faith in Spain, Portugal, or Italy would prove overwhelming. 

You can’t blame a guy for trying.  Chinese leadership attempted to mimic the powers that be everywhere else by encouraging a huge stock rally even as the economy there slowed.  It worked for months until a recent sharp reversal caused about $3-4 trillion in losses in the span of a few weeks.  Trading in about 40% of stocks has been halted and short selling is banned to counter the selling.  Needless to say, those stock losses are hitting the economy there which was already the slowest the Chinese have experienced in many years.  

In the U.S., we will be lucky if first half GDP growth made it much over 1%.  We struggle to find any sector that looks poised to lead the economy demonstrably higher and it seems just about every day a new soft spot emerges.  Memory chip sales as well as construction equipment and heavy truck demand are just a few of the latest.  The major airlines look to have misjudged passenger demand in yet another cycle. Smart phone and other electronic device markets have surprised to the downside. Even sub-prime induced auto sales have slowed. Of course, the major driver of growth in this cycle, petroleum exploration and production, crashed last year and that is now a major drag impacting many companies outside of energy.    More broadly speaking, depressed prices for iron ore, coal, aluminum, and copper are signaling that all that booming industrial activity across the globe since 2009 sparked by China’s $20 trillion debt binge has resulted in a plain old-fashioned bust.

Markets are slowly coming to the realization that the cycle has likely peaked.  Credit spreads have widened and what was extremely bubbly corporate bond issuance has slowed for now as risk aversion takes over. Many of those trillions of dollars in newly minted bonds provided cash for companies to buy back their stocks. If that issuance remains softer, we do wonder what will replace the only major source of stock buying we can find.  Because of the tremendous growth in corporate bonds outstanding over the last few years and rising distress rates, we expect a continuation of widening spreads and losses in that fixed-income sector to eventually lead the downturn like mortgages did in 2008.  

Outside of bonds, transport equities and some other cyclicals are among the first in the U.S. to reflect the enormous downside pain already endured by coal and shale stocks.  Bear in mind that all of this took place without the typical tightening of Fed policy.  It all seems to be rolling over in an exhaustive admission that each additional dollar of debt creation is seemingly unable to push the rock up the hill.  These maladies that we face are a powerful secular counter that cannot be overcome by central planners who refuse to even consider the underlying causes of the issues. 

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.