Always Be Easing

When will more stock investors figure out that what they thought to be Fed omnipotence over the last ten years was largely a function of several factors that it did not control?  This is an important question because central bankers across the globe have moved into overdrive to try to keep stock index levitation in place as economic fundamentals deteriorate and the U.S. trade battle with China escalates.  Meanwhile, more stocks are in bear markets with each passing day.

The inversion in the yield curve with collapsing Treasury rates is a harbinger of weaker growth.  The curve has failed to steepen in response to Fed easing.  It seems that just about everything from bonds to commodities is pointing to trouble ahead, but U.S. indices refuse to acknowledge increasing risks.  We have seen this near the ends of past cycles including 2000 and 2007 with U.S. equities at similarly stretched multiples of GDP.

U.S. treasuries are flirting with record low yields on growth worries and $16 trillion of global debt trades with negative yields.  This speaks to how miserably central banks have performed in recent years. Riots in Hong Kong and renewed Brexit fears are not helping matters.  Argentina’s markets collapsed once again this week in an historic plunge. 

We reiterate the point that much of the negative-yielding debt involves the masking of credit risk as the ECB bought the sovereign issues of the weakest nations in Europe to keep the system there afloat.  Capitalism is not supposed to involve lending at rates below zero, but that’s what it takes to maintain the status quo these days.  We have to laugh at those who say negative rates are no big deal.  Being paid to borrow money shows how convoluted the “solutions” have become. YEAH.

While we were once taught that the key to sales is to Always Be Closing (ABC), Always Be Easing or ABE has become the central bank rallying cry over the last decade.  The PhD’s have no game plan other than doing more of the same.  As keeper of the world’s critical reserve currency, the Fed led the charge into this tragedy because it never normalized and declared victory without reversing policy.  You don’t typically win games in the fifth inning. 

We live in a world where many investors feel compelled to remain invested on an unhedged basis in securities that offer low expected returns only because they have been taught to believe risks can be contained by monetary policy or they decide they have no other choice.  Were it not for a shrinking group of still favored mega-cap stocks mostly in tech land, market sentiment would be much worse with investors irate at the Fed for having crafted such a distorted landscape.  In a sign of the deteriorating backdrop, each day we find more stocks in numerous sectors becoming interesting on the long side as they fall completely out of favor.

Nothing the central bankers did worked in the way it was predicted, but the propaganda is designed to keep that fact hidden because monetary policy is the only thing that can be controlled. It’s mostly a charade designed to encourage risk-taking.

The Fed has completely wedged itself into the tightest corner we can recall in thirty years of following the PhD’s in the Eccles Building.  It simply can’t “not ease” or markets will rebel in a big way.  At the same time, all they have at their disposal is what was once thought to be powerful medicine, but it has demonstrably proven to fail in producing additional growth.

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.

Fed Left With the Really Weird Stuff

The Fed would be perceived much differently without the corporate stock buybacks that have driven this cycle.  We bet that “Have you hugged a CFO today?” is now a common refrain around the Eccles Building.  The staff at the Fed also likely praises the powers that be in China for going into an incredible $30 trillion in debt over the last decade.  That overseas madness helped the global economy move forward more than anything the Fed did.  Now China is growing at the slowest pace in decades.  U.S. corporations have broadly exhausted debt capacity in pursuing buybacks.  The central bankers find themselves with little conventional firepower left as growth stalls.  All that’s left is the really weird stuff.

When will stock indices figure out that central bank stimulus isn’t a stimulant?  Money flows suggest the Fed may be running out of tricks and/or investors may be changing course.  Over the last several months, stocks are broadly losing momentum even as the U.S. indices are able to muster rallies but with important divergences in lagging small caps, banks, and transports.  Meanwhile, bonds and gold are breaking out to new highs.  All of this could be interpreted as signs that the markets think the Fed will be unable to deliver as promised after a ten-year debt binge that has led to weak growth and unflattering long-term consequences like trillion-dollar federal deficits that no one seems to worry about anymore. 

We would remind the Fed’s faithful acolytes that the ultra-nutty policies like negative rates, corporate bond buying, and even stock buying tried by foreign central banks has not been met with enduring success or lasting enthusiasm.  One might think the Fed would be gun-shy about attempting more dramatic intervention after ushering socialism into this country with its coddling of the elite since the last crisis, but we’ve learned it knows no shame.  Its latest practice of hiding behind small wiggles in inflation data to argue for rate cuts when we all know it’s only trying to prop the stock market shows that.

We are left wondering if the data will allow the Fed to act as recklessly as it might like to defend stocks in coming quarters.  The perfect construct for future stock manipulation rests on the official inflation data and/or growth remaining softer. Those may not happen.   Of course, the clear weak spots in the entire Fed-led levitation are deteriorating corporate credit metrics after years of runaway debt issuance with incredibly little covenant protection in the high yield domain.  The corporate bond market will decide the fate of the Fed narrative and it looks like a bubble waiting for a pin.  Cracks are emerging.

After Chairman Powell’s recent dovish Congressional testimony, even some of the usual cheerleaders seem to be losing faith.  They ask why it needs to ease now with such loose financial conditions already in place and stock indices at the highs.  However, even with many credit friendly measures like spreads and rates, the inversion of the Treasury curve is making it clear that monetary policy is too tight given the landscape. The curve needs to steepen like yesterday.

Stocks are staging a narrow rally on the notion that the news is so bad, the central banks will have to ease policies in a counterintuitive, but typical late-cycle fashion. Most of the bad news relates to surveys of industrial activity along with generally slower domestic activity in places like retail, autos and housing. Slowdowns are more pronounced overseas.  Job growth in the U.S. is at a recessionary 1.5% year-over-year growth level and the labor force is shrinking despite all the narratives about a strong economy.  Rail traffic was down 6% in June.  Factory production is declining at a 2% annual pace, but inventories continue to rise.  Something is afoot.

We have been concerned about the Fed losing credibility for years because markets rest on that faith, not on valuations.  The Fed is now quite concerned as Treasuries have forced its hand into easing mode because most market participants see little room for even slightly tighter monetary policy.  Importantly, although financial conditions in the U.S. are already at record levels of easiness, borrowing is failing to respond to lower rates. 

What can the Fed really do from here other than encourage asset speculation which has become its primary function?  The practice of analyzing and investing in discounted future corporate cash flows at attractive levels has taken a backseat in U.S. equities. Basing decisions on future central bank activity has become the major endeavor for many. 

With investors expecting three rate cuts by the Fed, the big assumption out there is that inflation will remain tame, paving the way for central bank largesse.  However, it’s entirely possible that inflation picks up because of Chinese supply chain disruptions or cycle dynamics.  We already think low growth will be a problem, but it’s entirely possible that GDP does not sink to levels that fit with the Fed becoming as ultra-dovish as stock investors seem to demand.  We don’t think the China trade issues will go away soon, but perhaps the most acute pain is over for now.The slow demise of Deutsche Bank is coming to a head.  It is amazing how little notice is taken of this banking giant’s troubles over recent quarters.  Because it is so heavily involved in the global derivatives markets, the implications are negative but unclear.  It also demonstrates how the ECB is crushing the banks in Europe.  What kind of monetary policy is that?

With growth slowing, bonds have outperformed stocks over the last year.  Assets that did not inflate in recent years like precious metals, non-U.S. stocks, value stocks, and commodities offer more attractive investment profiles.  Maybe money will flow to them one day because they are all cheap relative to major U.S. stock indices. 

Easier than normal monetary policy took place during the up part of this cycle, but what happens when the central bankers face the down part without as much room to ease. Those celebrating the levitation of the S&P 500 are ignoring the fact that the narrowness of the move is concerning much like it was at prior instances of misplaced confidence. 

Investing is ultimately about buying future cash flows at attractive yields.  Over the investment horizon, U.S. stocks are priced for returns near zero.  As it stands, the celebration of new highs for the S&P 500 in the face of a lot of deteriorating data and earnings reductions seems like a New Orleans jazz funeral to us.

Meanwhile, few are asking if the globe’s central banks and government spenders will be able to keep behaving so recklessly without bonds or currencies staging a rebellion.  Even if they can, will this make absurdly priced assets more absurdly priced when the cyclical tailwinds become headwinds, exposing the limits of monetary accommodation.  Of course, a no-deal Brexit, a Chinese currency devaluation, or some other shock may provide an excuse for profit-taking, but the ascent of risk aversion seems inevitable regardless of what unforeseen events may unfold.

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.

Undiscounted, Fed-Induced Slow Growth

Today the Fed chose to leave rates unchanged for now, but it did its usual hand-holding routine to assuage investors’ concerns by promising to be there for them if they were to even get so much as a tummy ache, sunburn, or a hangnail at the pool this summer.  The Fed knows there is no room to error on the side of being too tight because equity investors would rebel.  Though the reliance is repugnant, it has become quite clear again in recent months that global stock markets need what is termed monetary “stimulus” to keep from collapsing.  However, this “stimulus” is an economic depressant in so many ways.

Markets are in the process of slowly figuring out that the downside of overactive central bankers is that stocks and other risky assets have once again become divorced from economic reality.  This has not historically gone on forever.  Assets tend to revert back to GDP over time.

The bond market has become enormously concerned about growth prospects.  It seems to have a view that is more in line with a lot of bank stocks, some cyclicals, and other value stocks.  There is likely a message for the broader stock market in this, especially as most rallies are still being led by a narrow group of market favorites with fading growth profiles.  A large portion of stocks remain below key moving averages and small caps are lagging.

Numerous coincident and leading indicators suggest the cycle has peaked and meaningful softness is ahead.  A few pundits now think we are already in a recession, though the jury is still out on that.  Overseas the growth slowdown is more pronounced than in the U.S.  China is of particular concern to us. 

While central bankers think they are riding to the rescue, you can almost see the eyes rolling in recent weeks when the ECB and BOJ promised more of the same tired monetary policies that were once portrayed as the equivalent of monetary bazookas.  This bears watching because it could mark the onset of investors becoming entirely disenchanted with central bankers.     

The bond market is conveying the thought that current efforts to stoke animal spirits with monetary jawboning are falling far short of targets with the 10-year Treasury near a 2% yield from over 3% a few months ago.  Interest rates have broadly collapsed in recent weeks as a giant safe-haven bid has hit the Treasury market on recession fears.  Commodities generally remain depressed versus stocks. 

Some measures of global trade and industrial production are hitting the weakest levels of the last ten years.  Rail carloads in the U.S. have turned decidedly negative.  Job growth is weakening.  Homebuilding and auto sales still look to have peaked for the cycle.  Most retailers’ earnings reports for their most recent quarters were dismal.  It’s not just China tariffs that are at fault because the softness is too widespread across numerous sectors. 

It’s concerning to us how participants are willing to assign much of the blame for current economic weakness on trade issues without respecting cycle dynamics.  In the end, it may not matter, especially if Trump takes a hard line with China.  However, we do expect him to back off with a face-saving “deal” if U.S. stocks turn chaotic.

Based on history, the currently inverted Treasury curve usually means risk should be avoided.  The front end of the curve is pricing in a lot of Fed easing, so it will have a tough time getting ahead of investors’ expectations.  The 2-year is trading about 60 bps below fed funds.  That’s a problem. 

At 21 times trailing GAAP earnings for the S&P 500 are stock investors paying any attention to worries expressed in the bond market?  Based on how many cyclical stocks in sectors like auto parts, retailing, and energy are hitting the new 52-week low list the answer is yes to a degree.  Often the broader market follows suit when this happens.  We find it meaningful, but no one seems to talk much about the fact that many non-U.S. banks trade at depressed valuations below book values despite monetary policies that are supposed to boost lending and growth.  The ECB and BOJ have clearly hurt banks’ profitability with their extreme policies.  In the U.S., banks have sat out much of the rally in recent years as if investors worry about more extreme policies coming here.  We just don’t understand how central bankers can expect to stimulate growth when they are causing bank stocks so much pain. 

One untold story of this cycle is how value stocks have failed to rally with fervor in response to central bank policy.  It’s not told because it does not fit the omnipotent Fed narrative.  We think value stocks’ underperformance speaks to how central bank policies don’t drive the economy in a traditional way.  At the same time, we think it calls into question how much longer investors will react positively to monetary madness because the growth stocks that have been the leaders of this cycle have been stretched to historic levels versus value stocks while their business momentum is ebbing. 

The Fed’s problem is that over the last year it became too tight only relative to ten years of ludicrous policies that have left it with much less future flexibility. If you had a crystal ball and told investors in 2009 how poor economic growth would be for ten years given how recklessly and shamelessly central bankers were about to behave, most would not have believed you.  That has yet to be discounted by equity holders.  

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 Almost Everything Bubble

As earnings reports roll in, it is getting more difficult for analysts to figure out the future direction of profits for many industries and individual companies.  But still, complacency reigns supreme.  Chip stocks are fascinating because although sales are down 15-20% for the group, the stocks rallied to all-time highs not long ago.  No one seems worried.

Numerous cyclical stocks refuse to acknowledge any real concerns, though it is getting harder to avoid seeing slowing revenues in more places.  According to Bank of America, downward EPS guidance were recently outpacing positive guidance by two to one.  

Major technology stocks continue to drive the indices, but the breadth of the market is unconvincing.  Cracks in the stories of the high-fliers continue to get tougher to ignore.  Apple is selling fewer phones.  The ad growth trend at Google is looking suspiciously softer.  Amazon has ridden the boom in cloud computing to the land of positive earners, but growth in that sector looks to have seen its best days. Competition is ramping up in a big way as Microsoft and Oracle fight it for customers. 

3M painted an unpleasant picture of the global manufacturing scene on its last quarterly conference call.  Now, some “thoughtful” analysts and commentators are pointing out that buybacks drove a lot of its earnings growth in recent years as revenue growth was never exciting.  As we have said before, there is a lot of EPS magic going around.  Our short book includes numerous similar stories that remain buried in an ETF somewhere like Jimmy Hoffa’s corpse.  One day they might actually be discovered.      

It was the explosion in corporate debt and stock buybacks that drove this cycle in the U.S. just like the mortgage boom did in the last.  A more cautious Corporate America because of a less certain economy and stretched credit metrics will likely be the source of its demise. 

China is showing much less ability to drive growth with debt.  This is key.  The 10-year, $30 trillion borrowing binge there saved the globe’s central bankers from being discovered as inept more quickly.  However, despite an incredible borrowing spree early this year to foster growth, it looks like the economic data is already rolling over again there.  The April retail sales and industrial production numbers continued a softer trend.  Globally, trade is collapsing at a fast rate that cannot be blamed on tariffs alone.

Unless one chooses to invest without any deference to historic valuation metrics, caution is in order.  We are not willing to accept the prospect of low projected returns with a greater than minimal chance of a big drawdown.  If history does not matter anymore, which we strongly doubt, we are still willing to avoid risk because the likely returns from betting with the crowd appear low.

Six stocks have been responsible for about 40% of the increase in the S&P 500 over the last five years and that has been hard on any investor who focuses on the value end of the equation.  We have been doing this long enough to remember the last time value investors went through a similar long stretch of underperformance in the 1990’s. The pundits were quite sure value strategies were outdated then as well. 

The “everything bubble” simply left out value stocks to a large degree.  Now, it appears the six market darlings and many other favorites have lost momentum as they remain well off their highs during this year’s rally.  The environment has a very late cycle feel to it especially when one considers that U.S. stock indices have made little, if any, progress in over a year with a lot of volatility to boot.  Perhaps value investors will one day look smart again.

Remember, you can be confident that the sky is not falling, but that does not mean that you must bet the house that the highest median stock valuations ever will make for profitable investments.  There is a difference between the two that rarely gets much airtime in a very short-term, surface analysis world where the dialogue is led by those with the loudest voices that often don’t do what they recommend you do. 

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.

Jawboning Inflation

When the administration and some on Wall Street ask for Fed rate cuts with stocks near the highs while boldly proclaiming how wonderful the economy is, you know something is up.  We think that underlying it all is the knowledge that the Fed has left us with nowhere to go after having blown the biggest bubble of them all.  We can’t remember a time when so much stock-supportive jawboning took place on an almost hourly basis by so many different parts of the establishment including pols, central bankers, the media, and the Street. 

The odd juxtaposition of patting oneself on the back about the economy (which ain’t that great in reality) and blaming the Fed for growth not being better might have cost Trump in pushing for a quick end to trade negotiations.  The Chinese figured out that he must be  worried, or he would not sound so urgent about needing the Fed to cut rates and do more QE. 

The President’s intense focus on the stock market makes it easy for China to figure out how to cause the man some pain.  Trade tensions hurt stocks.  Why not play hardball and wait for the next U.S. election after voters get hit with his tariffs?  Does Trump really think China pays them?  U.S. businesses and consumers do.

It’s gotten even more bizarre in the last few weeks on the Fed’s war against low prices front.  If “Whip Inflation Now” or WIN buttons were popular in 1974 as the cost of living skyrocketed, we’d guess a new rallying cry is in order now like “Let Them Eat Cake.” 

The new enemy of “low inflation” allows the central bankers to ease policy if they want and that’s a big reason for its creation, pure and simple.  In addition, the Fed wants to help inflate government liabilities away by paying them off in debased future dollars.    

Hiding true inflation in carefully concocted government data has been a constant theme for decades.  Twenty years ago, the deciders changed the way that housing costs are reflected by not looking at actual home prices.  They “derive” a number based on rents.  We kid you not. 

A recent cover of Bloomberg Businessweek asked, “Is Inflation Dead?”  Are you kidding me?  The headline “Weaker Inflation Views Stir Fed Fears” appeared in the WSJ this week.  Spin that narrative, baby!  The bottom line is that the Fed would desperately like to steepen the Treasury curve and it can’t do that if higher inflation is seen as a problem.  Never mind that according to their preferred measures inflation has been stuck close to its goal of 2% for years.  We do give credit to Kansas City Fed President Esther George for countering the low inflation problem narrative, but we wonder how long it is before she is brought in line. 

One thing about tariffs, they should help the Fed with its current inflation focus.  It should be tickled to death. While Trump may have solved the Fed’s problem, he simultaneously backed it into an even tighter corner.  The Fed can’t cut rates if inflation is heading higher because of tariffs.  The real problem is that the cycle is showing strains that will only be resolved with a recession and a normal cleansing of weaker businesses and credits.  The Fed will fight this gravitational pull any way that it can to no avail. 

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 Patient Never Left the Hospital

Let’s get this straight.  Real rates never became positive in the U.S. in this cycle and overall financial conditions indicate policies are quite easy while the federal deficit skyrockets in a supposed boom, yet somehow the Fed needs to become more dovish after behaving incredibly irresponsibly for a decade.  If participants refuse to see the problem with that, we can’t help them. 

The Fed’s dovish turn this year went too far, too fast.  It panicked after the late-year equity swoon highlighted that the financial system suffers from a lack of liquidity when real selling begins.  Translation: The Street does not take the other side of trades like it used to in down markets and contrarian investors are a rare breed these days. 

The Fed is finally realizing that normalization is not possible and that must be concerning to it. Because it became too dovish, too soon given the landscape, it risks having to move to the hawkish side if economy bounces like stocks have.  Regardless, the current M.O. is talking about not tightening while still shrinking its balance sheet for a few more months. That is not easing, though participants act like QE is back already. 

It is late cycle, not mid-cycle, so the challenges are immense.  Many professional investors feel trapped by the monetary shenanigans.  Play along with stocks broadly trading at 2-3 times normal valuations or risk losing clients.  Long-only managers mostly refuse to go to cash, feeling compelled to chase an expensive market even when the downside risk is high. Remember most of the gains of a cycle are usually erased by the end of the cycle, but that is ignored in every cycle.

Treasury bonds and stocks can’t both be right after each rallied strongly in the first quarter.  The recent unusual inversion of the curve between bills and the 10-year Treasury that typically marks a cycle that is long in the tooth would suggest that stocks may have it wrong.  We have always put a lot of credence in this measure as an important sign that risk needs to be reduced, especially when economic indicators are softening like they are now. For instance, the current annual rate of employment growth of 1.4% is usually only seen near recessions, but you’d never know that listening to the pundits who mostly still sound ebullient.

The legacy of the Fed is that it taught the masses to ignore risk and short volatility (VIX), betting that rain will never come after so many sunny days.  Hedging equity exposure is supposedly for suckers even with stocks at expensive levels late in a cycle.

So, here we are again at levels of complacency that have proven troublesome in recent years.  At the same time, the push towards the highs is again being led by a somewhat narrow group of stocks like last fall before the correction.

We got here because of the Fed pivot and a big jump in Chinese lending in recent months. China regularly manages its economy with bursts of lending when growth softens.  All it took was a decent equity selloff late last year to force the Fed to fire almost every bit of ammunition that it could, at this point, just shy of more QE.  It’s kind of an unflattering policy reversal even for an institution that has failed so miserably for thirty years. 

Suddenly, the Fed wants to stop normalizing its ridiculously large balance sheet, one well beyond what was needed for decades when GDP growth was a lot stronger.  While we expected this reversal, it does not make it any less noteworthy and historic that what were once termed emergency measures must now remain in place according to those in the Eccles Building.  It’s like the patient never left the hospital.  

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.

Misleading Math

Newsflash: Nobody in the real world wants to pay higher prices for things.  The economists tell us inflation is 2%.  We all know that’s silly.  It’s much higher.  Most consumers are being squeezed.  Everyone buying groceries, a house or a car and paying medical bills and tuition knows that.  The new focus on inflation targeting is cover to allow the central banks to do whatever the heck they want without making people worry that the economy is soft. They just want control of the narrative. 

Economic growth is the real problem and the Fed is unable to fix that.  Add together workforce growth and productivity in the U.S. and it’s not hard to see why real GDP of 2% is tough to surpass, especially late in the cycle when the additional boost from bringing workers off the sidelines is diminishing. If the deciders want wage inflation, stop making capital so cheap. Why create asset bubbles that just make houses unaffordable and future returns on equity investments low?   

Those buying stocks now because the “Fed has their backs” aren’t exactly making a contrarian call.  They are expecting euphorically priced securities to become more euphorically priced even as earnings uncertainty rises.  Profits are expected to be down about 4% for the first quarter and this quarter looks soft as well.  Remember, some of the worst returns in the stock market occur when the Fed is easing, but investors become risk-averse as earnings deteriorate. 

A recent article by Mark Hulbert re-visited an issue we have mentioned more than a few times. It discussed how misleading it is to say that the Russell 2000 trades at 17 times earnings as many pundits and participants do when it really trades at a P-E of 75.  Yes, 75. The 17 figure is “derived” when the roughly one-third of companies that lose money are excluded from the calculation. 

The S&P 500 has its own set of problems.  Trailing twelve-month GAAP EPS is $132. The gap between GAAP earnings and Wall street’s contrived “operating earnings” number has now gapped to $20 from about $10 not that long ago.  What happens when record profit margins that are already being squeezed fall from currently lofty levels?  How much longer can wages be suppressed in favor of management and stockholders?  Higher short rates should pressure interest expense figures and the strong dollar hurts as well.  It’s not hard to get to a $100 EPS number and a market that would be trading near a 30 PE at current levels.  A normal multiple of that $100 puts us at 1100-1500 not 2900. 

It is the same every cycle.  At market peaks, investors are routinely encouraged to use peak earnings and not worry about a negative inflection point.  However, valuations should be based on more than just one year’s profit number.    Also, if one wants to put a higher multiple on stocks because interest rates are lower than recent cycles, one must also reduce the earnings growth rate implied by those lower interest rates.  The two basically offset each other.  Remember, GDP used to run at 3-4% real rate, now we run at 1-2%. Interest rates are lower to reflect that fact.

From our vantage point, it comes down to whether equities return to anywhere near normalized valuations, let alone become cheap.  Not only have indices become priced at 2-3 times normal, they have done so with value stocks being left behind as the most expensive growth stocks led the charge.  The biggest reason they are ignored is not because sharp pencils were put to work regarding valuations.  Blind buying of index funds has created its own momentum in the direction of growth stocks, creating a bear market in the value arena.

It’s likely that fading domestic factors including the passive investing mania, the tech narratives of this cycle, unsustainable profit margins, incredible corporate debt growth, and massive stock buybacks played more of a role in markets over the last ten years than many central bankers and investors would like to admit now that it looks like the Fed is becoming the only game in town.  Regardless, U.S. equities are priced for perfection and the world is, if anything, less than perfect.

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.

Modern Monetary Madness

What happens when “shock and awe” becomes more of the same?  Central bankers everywhere must be wondering about that as mainstream money managers are now openly talking about the “Japanification” of the global financial system.  That implies doubts about central bankers’ omnipotence are surfacing since Japan has been stuck in a funk for decades even as the BOJ became increasingly aggressive.

The fact that the Fed has never been able to meaningfully reverse the emergency financial measures it began a decade ago is leaving its credibility in tatters.  Chairman Powell’s unusual interview on “60 Minutes” this week spoke volumes about how desperate the Fed is to maintain control of the narrative.  Similarly, in a recent press conference, the head of the ECB, Mario Draghi, lacked his usual swagger, seemingly weighed down by the failure of the Euro economy to respond as promised to years of radical easing measures.  China and Japan are also grasping at straws as their respective centrally planned charades unravel.

Recent calls to conduct even wackier monetary and fiscal policies are coming from once reasonable people both inside and outside the central banks because they are out of new solutions and can’t stomach less manipulated markets that might allow for real price discovery.  Letting market forces take over with much less government intervention is off the table because the deciders think the pain would be too great.  Capitalism is being tossed aside in the process and that is ultimately horrible for equity valuations as we have seen throughout history.

With economic growth downshifting in recent months, across the globe pols, commentators, and market participants are now trying to form a consensus that solving the world’s growth problems is easy.  Borrow even more heavily at the sovereign level and let the central banks buy the debt.  Strangely, some people who have been around a long time and used to know better are warming up to this “solution.”  Count us out!

Supporters call the next step into madness Modern Monetary Theory (MMT), but it’s really socialism under another name.  Central banks paved the way for it when they rescued big banks and investors starting in 2009.  Capitalism when markets were rising gave way to socialized risk-sharing when they fell and that has rightfully angered a large segment of the population.  After all, if the Fed can support stock prices for the wealthy by printing money, why not just print some income for those who don’t own stocks?  It’s nutty, but so is what the Fed has been doing for ten years.

Everyone conveniently forgets that Japan has been moving further into the realm of such monetary experimentation for thirty years to no avail.  Europe, China, and the U.S. followed suit in the last decade to no avail.  Last week, in an abrupt reversal of its plans to tighten, the ECB announced another in a long line of supposedly stimulative lending programs.  Markets were mostly unimpressed.  Promises of more negative interest rates policies were unveiled as well and that was supposed to be a good thing according to the PhD economists.   However, holding rates below zero has proven quite detrimental to bank profitability and bank stock prices in Europe, leaving one wondering why they should be expected to boost lending this time around.

The QE “cure” is what is killing capitalism and global growth.  Haven’t we learned that cheap money leads to overcapacity, further concentration of the economy in the hands of large corporations, and the formation of bubbles in numerous sectors?  Wage suppression follows suit as capital is substituted for labor.  Enormous amounts of debt (which is just future spending brought forward) are created.  However, the debt must be serviced, creating a big drag on future growth. We have been living this for a decade.

The powers that be are using some of the same free market verbiage as their predecessors, but the words ring hollow because they are guiding us further into socialism and its evils.  They think they are being clever. Central banks simply can’t be allowed to play the pivotal role in a truly capitalist system because they obstruct key market forces like competition and creative destruction.

It’s clear that what the majority of mainstream central bankers, politicians, and bureaucrats care most about is maintaining stock prices at bubble levels. They believe that QE enables that outcome and keeps them in power, but we think they will be proven wrong.  They simply don’t or refuse to understand that running an economy based on stock prices does not optimize the functioning of the real productive economy. The central planners were not content with simply maintaining more orderly markets around the 2009 crash, they have “graduated” to attempting to control every tick in the S&P 500.

Importantly, these prescriptions are opening the door to a future with less market-friendly leadership that is brought to power by those who don’t own stocks and are falling further behind with these remedies in place. A growing segment of the electorate wants to end socialism for the country club set as conducted by central bankers after the 2008-09 fiasco and replace it with socialism for everybody else.  Both are wrongheaded.

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.

Confused Fed and Bubble Valuations

The Fed is very confused because it now realizes that what we have been warning about for years is taking place.  Normalizing monetary policy is impossible because the financial system has become completely dependent on its ridiculous liquidity support efforts of the last decade.

The fed funds rate on an inflation-adjusted basis is close to zero after a couple hundred basis points of tightening, yet Powell and Co. are feeling compelled to re-think plans about future policy.  It used to take 2-3% real rates to slow the economy.  However, because of the damage done by years of ultra-easy policy, GDP growth potential is not what it used to be. Enormous levels of debt have been accumulated on an aggregate basis at an unsustainable pace and now must be serviced. That is a big burden for the economy to carry.

Given the alternatives, we have no problems with a pause in further tightening if it means the Fed would just step to the background.  That is likely wishful thinking on our part.  A less active Fed would force market participants to figure things out for themselves and weigh risks with the notion that the central bank will not provide a backstop.  At the same time, if it remains too restrictive now, that might mean that it would ultimately turn to aggressive measures like more QE in response to recession fears.  Avoiding that is the other potential benefit of waiting for a while.

As it stands, the Fed over-reacted to year-end pressures in the markets as numerous players needed to shrink positions by 12/31 at a time when buyers are usually scarce.  It went too far into the dovish camp.  The arrival of 2019 alone would have caused the extremely oversold markets to rally without the Fed becoming so clearly an enabler of unstable market dynamics.  Now it is has trapped itself into a clear stock price-supporting function.

Weakness emanating from China is impacting businesses everywhere. While the U.S. economy is weaker than it had been a few months ago, it is able to stand on its own two feet.    Investors should learn to do the same.  Short-term, momentum investing has caused them to become as impatient as we can ever recall.

The major net buyers of stocks in this cycle have been companies themselves as they managed their EPS in the low growth environment and made sure executives’ stock options were in the money.  At the same time, investors gravitated in a big way away from active management to passive indexing and ETF’s, causing stocks that dominate the major indices and sector funds to become momentum names that were chased.  What this has meant is that buyers who do little or no fundamental analysis have dominated the flows.  That is why valuations have approached between two and three times normal.

A few big things get in the way of many investors understanding how overvalued stocks remain.  The first couple are the use of forward earnings estimates and pro-forma, non-GAAP numbers.  Wall Street’s old habit of discounting peak earnings at peak margins far into the future is the reason stocks typically broadly correct 40% around recessions.   At the same time, the debt side of the balance sheet is mostly being ignored.  That is leading to enterprise values (stock plus debt) that are commonly north of 15 times EBITDA.  That is wildly overvalued versus historic numbers.

We are late in the economic cycle and central banks have exhausted a bag of tricks that proved futile in creating sustained growth and hindered future growth prospects.  Equity valuations remain at extreme levels that rival past peaks that were followed by years of poor returns.

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.

Fed Caves

In the final weeks of the year, too many market participants were trying to get positions off their balance sheets at the same time in an environment where economic doubts have started to creep into the picture.  After months of Fed balance sheet shrinkage and higher short rates in an economy that had previously been held aloft by ultra-easy monetary policy for a decade, it has finally become obvious that buyers can be hard to find when real selling commences.   

Investors have become pessimistic about prospects quite suddenly after having been overly optimistic.  Nonetheless, pockets of value have appeared as it seems likely that participants have become too negative in the near term. 

In response, the Fed has changed its tune just as abruptly as the market’s mood.  Various FOMC members are now tripping over themselves to provide dovish encouragement to investors who demanded reassurances that the Fed was still on their side.  It is unseemly, but a sign of the times. 

The economy is clearly decelerating, and earnings estimates for 2019 look quite questionable.  Key areas of growth like housing are fading.  Sherwin Williams is selling less paint and mortgage originations are soft.  Retailers like Macy’s did not meet lofty expectations for Christmas sales.  Major companies like Apple, Delta, Goodyear, and FedEx have noticed slowdowns in their businesses. Elsewhere, weaker growth in China is negatively impacting the global picture.  Germany is perhaps facing a recession.

The cycle’s excesses will continue to be worked out regardless of how trade issues with China resolve themselves, when the government shutdown ends, or whether Brexit takes place in some fashion. The overriding theme will still be that central bank policy was too easy for too long and there will be a payback playing out in coming quarters.

Aggressive selling into year-end has created some value.  We are struck by the increase in the number of stocks that trade near ten times earnings.  On the other side of the equation, many stocks still trade at very rich multiples, though cheaper than they were just a few months ago.  Of course, the overriding theme is that equities are still broadly quite expensive.

In the end, 2018 was broadly the worst year for global markets since 2008, but that was hidden below the surface to some degree as major U.S. stock indices fell by mid to high single digits for the year.  Most stocks performed much worse than that and most asset classes failed to provide positive returns.

The Fed is clearly coming around to the idea that we have been espousing for months: it will have a very hard time continuing to normalize policy.  The ECB will likely conclude this as well.  While the central banks will likely become more dovish as the year progresses, rallies on friendlier monetary policy or jawboning should prove short-lived until it becomes clear that the trough in economic growth and earnings are in sight.  Most importantly, we can’t emphasize enough that, in aggregate, central banks will be draining liquidity from the global financial system for the time being.  This matters a lot as 2018 demonstrated.

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.