As the equity markets continue to hover in the stratosphere, we think it’s important to highlight some key facts and figures that we are not sure you will hear them anywhere else.   Consumer confidence fell in January to a 14-month low and is probably a partial reflection of the payroll tax hikes that hit during the month, which will be difficult for stretched consumers to overcome. This tax increase amounts to about $2,000 annually for many and obviously even more for those in higher brackets.  Prices at the gas pump have begun to get more painful again and are the highest for this time of year ever.

Obamacare taxes will be hitting too and marginal tax rates were just raised for many so that the spending circus in DC can continue.  Unemployment just ticked up to 7.9% and we know that many small businesses will be looking to shrink below the 50-employee level to avoid entanglement in the morass we call healthcare reform.  In general, transferring wealth from the private to public sector will continue until “we the people” say stop.

Many localities again lowered tax assessed values for residential real estate in 2012 in spite of the Wall Street proclamations that housing is strong.  We do not argue the fact that major homebuilders have seen a big pickup in activity, but this bounce off of the bottom for them does not alleviate the pressure of so many underwater mortgages.  Also, the mortgage underwriting is much more stringent today than it was a few years ago in the sense that there actually is one now, so gains in the sector will be slowed by that process.

Europe, particularly Spain and Italy at the moment, continues to represent an enormous risk due to credit issues in spite of the declarations that all is well overseas.  Spanish unemployment has recently hit 26% and housing remains in a depressed state as their GDP contracts and bank loan losses mount. German retail sales fell 1.7% in December versus November in another sign the economy there is struggling.  Most of the continent is in recession.  EU unemployment rose to 11.7% in December.  Bear in mind that the only reason bonds of the most troubled nations have rallied in the last six months is that the ECB has provided a backstop, but there has been no fundamental reform or credit improvement, just an enormous buildup of risk on central bank balance sheets.

To counter the global malaise, Japan has fired another round in the currency war as its government debt overwhelms its economy.  We fear that recent Japanese efforts to devalue through QE may have taken the “beggar-thy-neighbor” mentality to a more dangerous threshold as many nations race to cheapen their currencies versus that of trading partners in order to attempt to meet future obligations with debased monetary units and boost exports.  Japan has no choice because its debt-to-GDP stands at a frightening number of over 200%! The aging of its population has caused it to cross the Rubicon…not enough workers paying taxes to cover all of the government’s obligations. Our Congress and the Fed should pay close attention.  After the Nikkei 225 equity index hit 39,000 in 1989 during an asset bubble it now stands near 11,000, despite numerous QE efforts and too much government spending for twenty years.

Whether one thinks the global economy is ready to boom or crater, so much good news is reflected in equity valuations that there is no room for error.  It is difficult to find voices recommending caution towards markets even as indices flirt with new highs.  We find this “throwing in the towel” to be irrational based on historical metrics, but we have witnessed similar lemming episodes in prior cycles.  We know we can’t remember a time when it was so difficult to find cheap stocks to purchase.  Even during the crazy days of the tech bubble in the late 1990’s it was possible to find quite inexpensively valued equities in the small cap and mid-cap sector.

In a replay of the last few years, pundits, prognosticators, and Wall Street universally proclaimed that all was right with the world as a new year commenced.  Congress allayed “fiscal cliff” concerns for the time being by postponing discussions of spending cuts in spite of the unsustainability of current deficits, igniting a big equity rally during the year’s first week.  Earnings reports were not bad enough to stop the frenzy, especially as Japan began jawboning about its latest and greatest quantitative easing effort.

I am not sure the “talking heads” need much of anything to justify spouting positive views on all matters and ignore or minimalize anything even remotely negative.  That disdain for facts and objective reality has been going on for a few years.  The commentary (cheerleading) as the fourth quarter played out would have led one to believe we were in a real recovery, not one that even recent St. Louis Fed data depicted as the worst ever.  Just look at their graph below to see why.

I admit it was entertaining to listen to the convoluted logic as the mainstream media explained how the just released real GDP number for the fourth quarter (not in above graph) which came in at -0.1% is a good thing….just like the multi-decade high level of long-term unemployment or the near 40% decline in Apple’s stock (we have been short that one).  Real GDP would have been even lower had the U.S. Bureau of Economic Analysis (BEA) not monkeyed with the deflator.   Of course, the Fed will just do more money printing, which is everyone’s favorite reason why one should buy anything and everything.  Therein lies the bulls’ hopes, but additional QE will probably not provide much to change the current doldrums based on past results.

January was replete with fourth quarter earnings reports.  Based on how markets reacted, we think we must be looking at different financial statements than the crowd.  Revenue and profit growth is very hard to find among the plethora of companies that reported.  Numerous cyclical companies are experiencing significant revenue declines and cloudy futures.  Overall, the graph below depicts how fourth quarter earnings estimates have moved significantly lower as more companies report.

We were around in 2008 when mantras like “housing prices will never go down” and “this time is different” were used to justify an expensive equity market.  If we hadn’t had this experience, we might start to doubt our current beliefs about stock prices which are much less rosy than most pundits.  Despite this recent history, the so called “experts” are once again quite confident in their prognostications.  Their never cloudy crystal balls see nothing but sunshine and blue skies ahead.

Consider some recent statistics…

• Long-only mutual funds just recorded $8.9 billion of inflows, the largest weekly increase since March 2000.
• According to Bloomberg, hedge funds have taken their leverage up meaningfully to increase bullish wagers on stocks.
• In December, the 20 most heavily shorted stocks in the S&P 500 returned 5.1% versus 0.7% for the rest of the index. That massive short covering is just another indication that many players have tilted strongly towards increasing equity exposure.
• Finally, margin debt on the NYSE is at five-year highs.

The momentum is fierce.  Most major stock indices are near multi-year highs.  No one wants to get stampeded by the thundering herd.  The bell hasn’t rung yet!

But wait a second!

Let’s not let emotion and rampant punditry get in the way of reality.  We see a large number of major reasons stocks shouldn’t keep moving unabatedly higher.  Let’s look at 10…

1. Wall Street just recently reduced GDP growth estimates for the 4^th quarter to around 1% from roughly 2%.  Just imagine what real GDP growth would be if the federal government wasn’t spending $100 billion more each month than it is taking in in tax revenues and if realistic inflation numbers were used as the adjustment factor.
2. Profits margins are about 30-40% above normal and will likely return to earth given obviously slow economic growth.
3. High frequency traders dominate market activity with their rapid-fire quotes and provide a false sense of security, driving complacency to historic highs.  However, if real money investors ever decide to hit the sell button, those same traders will likely just unplug their computers, leaving bids hard to find.
4. Markets act as if Europe has been fixed, but the German economy contracted by 0.5% in the final months of 2012.  France will likely need more budget cutting or tax increases as it just announced it will not hit its deficit targets….and these two nations are supposed to be the backbone of the continent!
5. Monetary policy remains unsustainable across the globe with dangerously bloated central bank balance sheets commonplace. Even the Fed, after the election of course, is suddenly wondering if maybe it may have to refrain from QE sooner rather than later.
6. Market darling Apple is about 30% off of its highs.  We find it quite unusual to see this market leader pounded into submission without the indices reflecting any pain.
7. Germany is in the process of removing its gold from the custody of the Fed after decades of placing its trust in our central bank.  Even the central bankers do not trust each other as much as the markets trust the central bankers.
8. The media’s cry that “China is the answer to all of our growth problems” has to be called into question when one looks at the facts.  “Very shockingly, most of our bankers say less than 20% of their (China’s) lending goes to new loans,” says the Beige Book’s Leland Miller. “Most of it is going to debt rollovers or increases – they are not funding expansion. This calls into question just how sustainable this expansion is.”
9. The Russell 2000 sits near record levels, yet long-term unemployment in the U.S. sadly resides at levels not seen since WWII.  Holy bubble, Batman!  Massive fiscal and monetary stimuli are creating false hope.
10. The steel inventory-to-shipment ratio for December just hit levels last seen during the bust of  2008 according to BofA Merrill Lynch, adding to our conviction that 2013 is not coming out of the gate with a bang.

Call us stubborn, but we find it hard to reconcile these points with the fact that speculative positions in the historically volatile Russell 2000 small-cap index stand at extreme levels.

Maybe they do ring bells at tops, maybe not.  But we do know that our primary job is to manage risk, and we see alot more than those who may simply be wearing earplugs.

Scott Brown

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.

Perhaps some of the resilience is U.S. equities is the result of a perceived safe haven status.  The U.S. does remain the best house in a bad neighborhood in spite of what is clearly an unsustainable fiscal situation here.  But it is a really bad neighborhood! The “fiscal cliff” will likely be papered over with a non-solution solution that gets us through yearend, but we cannot continue down this road of annual deficits of over one trillion dollars. Our equity market should discount a return to some normalcy.

I spent ten years of my life as a credit analyst and I remember an important lesson: once government debt approaches 100% of GDP, which we are near now, it becomes virtually impossible to exit the downward spiral in a painless way.  I am not even counting the $60 trillion or so in unfunded federal mandates known as Social Security and Medicare.  This is not a political statement.  It is just credit analysis and math.  Every one percent increase in interest rates adds over $100 billion to our yearly deficit and rates sit at Fed-mandated historical lows now. The federal government has been ballooning in size since the turn of the century as our leaders have continued to spend with reckless abandon because it is the easiest thing to do.  Both major parties are to blame here because there is no real leadership.  We need to reduce spending at all levels of government.  We are flirting with a European economic model just as the EU is showing the world it just does not work.  We may be a relative haven for now, but our equities should not be valued near the richest valuations in our history given the stresses on our economic system.

In the end, the economic and market environments of the U.S. and across the globe are in a precarious spot because of a lack of leaders willing to pursue real solutions. Art Cashin of UBS, as usual ,cut right to the chase recently: “one sentence perfectly describes the quandary on three continents – the ultimate award for candor and honesty must go to Jean-Claude Junker (Prime Minister of Luxembourg) who apparently said ‘We all know what to do, we just don’t know how to get re-elected after we have done it.’  That says it all.”

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.

Gone are the days when specialists and exchanges with live traders dominated stock and commodity trading.  These days, real people are largely out of the picture.  Instead, computers in the hands of high frequency trading firms (HFTs) that run algorithms all day long have taken over the market-making function.  They account for about 70% of the volume in stocks.  In many cases, these firms are allowed to place thousands of orders that they soon cancel in just fractions of seconds after placing them.  In fact, they locate their powerful machines very close to the exchanges in order to increase the speed at which they can place orders.  At times they jump ahead of real investors because they are able to act in milliseconds.  Often, these computers will not even execute a trade; they just place quotes, thousands of quotes, with no apparent intent of taking the other side of a trade.

For the last several months you have heard us discuss the fundamentals of the European debt crisis and the bursting bubble in China, but we would be remiss if we did not take time to highlight this even more basic element of the market.  We find it just as troubling.  And it’s compounded by market regulators who are turning a blind eye to this blatant chicanery.  For the last couple years, we have marveled at the way the equity market catches a bid at about the same times on almost every trading day.  This should not occur in rational markets; regular pattern should be arbitraged away very quickly as participants learn to take advantage of anomalies.  But the pattern persists.

In the old days investors and traders would have blackballed firms guilty of perpetrating such shenanigans, but in most cases the HFTs operate in anonymity.  To top it off, the HFTs just turn off their machines when markets get nasty, leaving real money players with nowhere to go for liquidity.  The May 2010 Flash Crash and the recent calamity at Knight Capital were perfect examples of what can happen when the current market systems go haywire.  It’s bad enough that one of the richest equity markets in history (based on normalized earnings) is being held aloft by fiscal frenzy and monetary mania.  When you add high-frequency hysteria to the list, there is more than enough support for caution.

 

We have heard so many earnings warnings in the last few weeks that we have lost count, but FedEx, Intel, Nike, and Norfolk Southern are representative of the sorts of bellwethers that have been indicating trouble ahead.  Chinese equities continue to sit near 2009 lows, suggesting that that nation will not likely be the engine of growth it has been for the last few years.  The more we read, the more clear it becomes that China has a tremendous bad loan problem as well.  In Europe, the world awaits a decision by Spain to accept a bailout package which would require it to give up a good deal of its sovereignty.  Rioting in Madrid and Athens has reared its ugly head again over austerity measures put in place to stem the fiscal bleeding. Global manufacturing indicators continue to point to recession.

In our view, markets rally in the face of already rich valuations and in the face of this bad news simply because the Fed has embarked on additional quantitative easing (QE), creating a sugar high for short-term traders with some indices up in the neighborhood of fifteen percent.  In contrast, transportation stocks have gone nowhere this year; an anomaly that seems to suggest that QE hype does not treat all stocks equally.  Transportation stocks are often an important leading indicator of future growth prospects, so either industrial America is headed for a major slowdown or an unusual decoupling will occur.

We cannot emphasize enough how much distortion has been created by the Fed which has knowingly tried to force investors into one of the riskiest market scenarios we have witnessed.  Zero rate policy has caused investors to take more risk when they should be taking less; pushing volatility to low levels in spite of the most uncertain market environment we can imagine.

Yesterday’s comments from Chairman Bernanke have clarified the view that the Fed knows it is taking money from savers for its grand experiment, but few on Wall Street mention the negative effect of that on consumer spending.  Also, gas prices in the U.S. reside at record levels partly because of speculative commodity activity directly resulting from QE3 and its predecessors.  Obviously, that is another enormous burden on consumer spending and business cost structures.  Again, we do not see that jiving with the conventional wisdom that QE is good for equities espoused by the same pundits who led many to slaughter in past Fed easing cycles.

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 is holding out hope that the third time will be a charm as it unleashed a much anticipated third round of quantitative easing last week, this time pledging to buy $40 billion worth of mortgages per month until the labor market improves.   The fact that this announcement came the same week that the IMF apparently suggested that Greece may need a third round of bailout funds is quite ironic.  The powers that be have shown themselves to be incapable of solving problems, but are willing to do more of the same just to be doing something.  We think the Fed hit the panic button because it sees the important ECRI indicator flashing recession in spite of QE1 and QE2 and operation twist.

Retail sales and industrial production in the U.S. just printed at horrible levels and just about every global manufacturing survey suggests contraction.  The Fed appears to be having a hissy fit over the criticism it is receiving for holding deposit rates near zero for years and raising prices at the gas pump and grocery store by encouraging commodity speculation, while the banks get access to free money that they are not lending.  We doubt this third round will make much difference to the real economy because we already have an enormous level of free reserves in the system as cash is hoarded and money velocity sits at multi-decade lows.  More free reserves from QE3 won’t help!

The economic theory of “pushing on a string” means nothing to Chairman Bernanke. We suppose we can forgive it for its dogged reliance on failed policies because the Fed is dominated by academic theorists, not nuts and bolts practitioners.  We have structural unemployment issues remaining from the last Fed bubble and a lot of those jobs are just not coming back.  It is quite interesting that the Fed’s new employment or bust mandate is occurring even as the labor department continues to contort employment data in ways to make the unemployment rate look better than reality.  The DOL simply moves participants out of the labor force in different ways either through increasing the disability tally or classifying more people as no longer looking for work.  Needless to say, sadly, the true unemployment rate is much higher as the labor force participation rate sits at early 1980’s levels.

We have five final points.  Similar monetary stimulus did not work in Japan in the 1990’s after their bubble years.  Secondly, one only has to look at the continued flight of deposits out of the Spanish banking system to see that huge deflationary forces remain at work in the world as the ECB takes over private banking functions in Europe.  Thirdly, that most important source of global money supply growth for the last few years known as the Chinese currency system is now collapsing as exports shrink there and capital heads elsewhere.  Fourth, while a major “fiscal cliff” may be avoided in the U.S. in 2013, we will still likely experience a fiscal contraction of at least $100 billion next year.  Finally, and perhaps the most direct counter to QE3 is the fact that Fannie Mae and Freddie Mac have recently been ordered to shrink their portfolios of mortgages more quickly to the point where their balance sheets must contract by roughly $700 billion over the next few years.  Perhaps the central planners conveniently decided the Fed was the perfect entity to take up that slack…but we do not want to ruin a good reflation story conjured up by Chairman Bernanke, his cronies, and Wall Street.

In August, equities had a strong month in spite of an especially weak earnings season.  They seemed to respond to the plethora of comments from central bankers and politicians who act confidently that their words and strategies can forever enable investors to avoid losses.  Good luck with that.  Without a doubt, we are at a critical historical juncture because of the credit drama in Europe, profound Chinese economic weakness, and soft growth in a U.S still mired in the aftermath of the housing bubble.

As we see it, corporate earnings have clearly begun to roll over and recent global manufacturing indicators demonstrate we are at or near a recession.   Because the economic cycle has now rolled over globally, central bankers must fight both the downside of the business cycle and the downside of the secular debt growth story discussed above.  Again, good luck with that!  Maybe they will be hugely successful, maybe they will not.

The talking heads and pundits espouse that U.S. equities are cheap based on current (likely) peak earnings or relative to treasury yields.  Well, the first measure ignores the fact that earnings for the market typically fall about 30% from the peak during a recession.  The second measure ignores the fact that measuring stock valuations relative to treasuries has not been reliable over much of market history; it’s comparing apples to oranges.

What’s more, reality has a funny way of intervening in central planning.  For instance, money velocity in the U.S. just hit a multi-decade low in the face of enormous quantitative easing by the Fed as consumers and businesses hoard cash.  In other words, the Fed can throw a lot of money at the economy, but it can’t force its use.  In Spain, a major European trouble spot, capital flight out of the country has reached alarming levels even as the ECB is supposedly set to start a new round of Spanish debt purchases.  Consumers and businesses are voting with their feet, confounding stabilization efforts.  Inventory levels in China are skyrocketing according to numerous sources in spite of efforts by leadership there to make the economy more consumer-spending oriented after years of a centrally planned infrastructure binge.  Things do not always work as (centrally) planned.

To say the least…these are interesting times.

The market’s initial reaction to yesterdays’ comments from Chairman Bernanke was mildly negative.  I guess he did not give the impression that additional quantitative easing (QE) is in the cards for now.  However, a rally soon followed in a continuation of a strange trading pattern that has dominated the year. 

What strikes us as strange is the belief that has been in place these last few years over the effectiveness of QE efforts.  QE has been viewed as a magic bullet. In reality, looking at the way cyclical stocks have corrected in recent weeks, we would expect major US indices to be 15-20% lower in price already.

We get the clear impression at this point that these divergences are largely the result of the US investors placing all hope that the Fed can prevent our market from acting like those abroad, if only it were to pull the trigger and decide to buy hundreds of billions of dollars of additional treasury bonds.  This belief seems strongest at present, just when it appears that we are quite close to a recession.  Retail sales have been negative for three months.    

We find the market’s faith in the Fed misplaced.  We would argue that the hundreds of billions of dollars spent by the Chinese government to prop up growth since 2009 have had more to do with the ebullience of U.S. markets than anything the Fed has done. That stimulus helped keep the earnings picture strong for many U.S. companies that do business there and in other emerging nations that sell to the Chinese.  The Chinese built roads, rails, office buildings, and homes under the “build it and they will come” school of thought.  Many cities and industries now suffer from massive overcapacity as a result.   

Now China is in the midst of a major slowdown.  Anecdotal evidence abounds and is more telling than the Chinese government’s economic releases, which cannot be trusted.  Christie’s, the auction house, reported that sales in Asia were off 24% for the first six months of the year.  Jewelry sales have also slowed dramatically according to retailers both on the mainland and in Hong Kong. Earnings warnings from Chinese companies are abundant and severe as the Shanghai Composite sits at a three-year low. 

We find it instructive to look at the world from the perspective that over-levered economies across the planet are fighting massive deflationary forces as they attempt to de-lever.  The powers that be use all means available to counter this deflation, but in the end, they just end up forestalling the inevitable debt restructuring that must occur.  China is no exception.

Even the news from the muni bond market is troubling. Three California cities have filed for bankruptcy protection, which heretofore has been a rare occurrence.  Typically cities would just cut employment or services, but continue to make bond payments.  However, these cities, like government entities in Europe and elsewhere, are operating in a new environment in which slow economic growth exposes past spendthrift habits, forcing difficult responses.  There are no quick, easy, or painless solutions in spite of investors’ desires at times to believe otherwise. 

We expect that markets will learn a difficult lesson as slowing growth in China causes earnings expectations to be revised dramatically lower in the U.S.  Perhaps it will be the point when some participants realize that “Emperor” Bernanke has no clothes. Sooner or later many investors will have to return to real work like discounting future cash flows, not gaming central bank activity.

Scott Brown, July 18, 2012

We live in a financial world swayed and dominated by the sound bites of pundits who do not fully grasp the depth of the issues and by the remarks of leaders who promise actions that might cure symptoms, but not the underlying disease.  Many times the leaders simply need to agree to meet in the future to discuss a framework for solving a problem and markets react like a final resolution is a fait accompli.  In reality, it’s really just a head fake.

As I mentioned last week, in late June EU leadership grandly pronounced a new solution without substance or a means to enact it.  For instance, the powers-that-be espoused the creation of a central European bank regulator without any real ideas as to how to put it into place.  Never mind the fact that Spanish banks have already made an enormous amount of bad loans or that European banks are already replete with the debt of weak sovereigns.  Talk about a day late and a dollar short!

Markets have routinely responded to these proclamations as if the leadership can somehow work magic and “poof” all of the problems would disappear.  These are not generally the markets of yesteryear that would have been much more skeptical of these announcements and forced leadership to make real reforms.  Last week saw Italian and Spanish bonds get crushed and the euro get flushed as it became clear that, once again, EU leadership had done nothing the week prior except parade around in front of cameras pretending to be wise stewards who were diligently working on real solutions.  Spanish ten-year bond yields rose above the 7% level, which has proven to be a critical threshold for other nations which ended up asking for aid. 

After Friday’s very weak U.S.jobs report for June, markets initially sold off, but then rallied as rumors abounded about how our Fed would certainly have to embark on QE3 to save the world.  We have witnessed numerous herculean efforts both fiscally and monetarily to help the economy, yet all we are left with is another $5 trillion of federal debt and a quasi-recessionary economy.  June retail sales were the slowest in two years and ISM numbers indicate that industrial America is no longer in growth mode,  but U.S. markets act as if the next round of QE will be the dose that works.

While some equities in the U.S. are beginning to price in recession, the overall indices and the majority of the markets refuse to correct for fear of missing another QE-induced sugar high.  It is a dangerous mix.  The Russell 2000 small cap index resides near record highs in spite of a plethora of earnings warnings from numerous significant companies.  In contrast, commodity markets, which were for a long time thought to be the place to be to counter an inflating Fed, seem to have none of this giddiness.  Also, emerging equity markets including China and India remain sober by comparison.  European equities have been decimated.  Most interesting to us was the ho-hum market reaction to monetary easing in China and Europe last week.  Maybe the central bank magic is gone.

U.S. equities stick out like a sore thumb on the global investment scene.  Our concern is that a day of reckoning is coming for U.S. equity investors when they realize that we need a much “bigger boat” to fix the world’s troubles and that Europe’s problems and China’s slowdown are going to affect U.S. companies in a powerful way.  At Strategic Balance we do not want to be far from shore in a dinghy when the reality sets in that we do not just need a bigger boat; we need a battle ship and maybe an aircraft carrier.  Protecting our capital until these major risks have been contained, while also investing for the long term when the math makes sense is the only wise course we can set.

Scott Brown, July 10, 2012