Are Markets Being Driven by Fun-Durr-Mentals?

This past week, has been discussed how the current rally since the election has been based on "hopes" for tax cuts and tax reforms as there was little evidence currently to suggest it was based on fundamental underpinnings. To wit:

"Do not be mistaken, this 'rally' IS all about tax cuts. Despite many who are suggesting this has been a 'rational rise' due to strong earnings growth, that is simply not the case as shown below. (I only use 'reported earnings' which includes all the 'bad stuff.' Any analysis using 'operating earnings' is misleading.)"

"Since 2014, the stock market has risen (capital appreciation only) by 35% while reported earnings growth has risen by a whopping 2%. A 2% growth in earnings over the last 3-years hardly justifies a 33% premium over earnings."

The chart below expands that analysis to include four measures combined: Economic growth, Top-line Sales Growth, Reported Earnings, and Corporate Profits After Tax. While quarterly data is not yet available for the 3rd quarter, officially, what is shown is the market has grown substantially faster than all other measures. Since 2014, the economy has only grown by a little less than 9%, top-line revenues by just 3% along with corporate profits after tax, and reported earnings by just 2%. All of that while asset prices have grown by 29% through Q2.

But despite the data, many on Wall Street are suggesting the recent string of "record highs" is all about improving fundamentals and not about the "Trump agenda." To wit:

"Charles Schwab executive Jeffrey Kleintop has a message for supporters of President Donald J. Trump who believe his election is behind recent stock market gains: The rally is not about him.

The president's advocates attribute the upturn to anticipation of Mr. Trump's efforts to cut taxes, decrease regulation and increase infrastructure spending. Mr. Kleintop doubts that the president's anticipated policies have been decisive.

'The Trump rally doesn't exist, it's rooted in the fundamentals.'"

What's driving the markets upward are corporate sales growth and first-quarter earnings, both of which have registered their biggest gains in several years."

Looking at the data above, not so much.

But let's expand this data even more back to 1955. The chart below is an expansion of the real, inflation-adjusted, profits after-tax versus the cumulative change to the S&P 500. Here is the important point – when markets grow faster than profitability, which it can do for a while, eventually a reversion occurs. This is simply the case that all excesses must eventually be cleared before the next growth cycle can occur. Currently, we are once again trading a fairly substantial premium to corporate profit growth.

Since corporate profit growth is a function of economic growth longer term, we can also see how "expensive" the market is relative to corporate profit growth as a percentage of economic growth. Once again, we find that when the price to profits ratio is trading ABOVE the long-term linear trend, markets have struggled and ultimately experienced a more severe mean reverting event. With the price to profits ratio once again elevated above the long-term trend, there is little to suggest that markets haven't already priced in a good bit of future economic and profits growth.

While none of this suggests the market will "crash" tomorrow, it is supportive of the idea that future returns will substantially weaker than in recent years.

No, We Aren't In A New Secular Bull Market

Are we in a strongly trending "cyclical" bull market currently? Absolutely.

Are we in a long-term "secular" bull market as witnessed in the 80-90's? Absolutely not.

Jeffrey Saut, the chief investment strategist at Raymond James, currently believes the latter. He suggests there may be nearly a decade left in this "secular bull" market, which is defined as a market that's driven by forces that could be in place for years.

"I say secular bull markets last 16, 17, 18, 19, 20 years. And even if you start the measuring point in March of '09, you still ought to have another seven, eight, nine years left in this thing. This is going to be the longest, strongest secular bull market of my career and I've been in the business 47 years."

Personally, I hope he's right as it would sure make my job of managing money easier for my clients.

However, as noted above, and as shown below, "secular bull markets," which are long-term growth trends, have never started from 15x valuations and immediately surged to the second highest level on record. Historically, as shown below, secular bull markets are born of excessive pessimism and low valuations that stay in place for years as earnings and profitability grow faster than prices (keeping valuations lower.) Despite Mr. Saut's hopes, that is simply not the case today as valuations exploded as earnings, economic and profit growth lagged the liquidity induced surge in asset prices.

We can see this more clearly by using a 10-year MEDIAN of Shiller's CAPE ratio. By smoothing out valuation cycles it becomes substantially easier to see that "secular bull markets" have never been born at these levels, but rather died.

Importantly, the drivers behind the long-term secular bull market of the 80's and 90's are trends which simply do not exist currently. In the early 80's and 90's: 

Inflation and interest rates were high and falling which boosted corporate profitability. 

The extreme negative sentiment of the late 70's was finally undone by the early 90's. (At the turn of the century roughly 80% of all individual investors in the market began investing after 1990. 80% of that total started after 1995 due to the investing innovations created by the Internet. The majority of these were "boomers.") 

Large foreign net inflows to chase the "tech boom" drove prices to extreme levels. 

The mirage of consumer wealth, driven by declining inflation and interest rates and easy access to credit, inflated consumption, corporate profits, and economic growth. 

Corporate profits were boosted by deregulation of industries, wage suppression, outsourcing and productivity increases. 

Pension funding requirements and accounting standards were eased which increased corporate profits. 

Stock-based executive compensation was grossly expanded which led to more "accounting gimmickry" to sustain stock price levels. 

The dual panel chart below shows the economic fundamentals versus the S&P 500 and the change that occurred beginning in 1983. (Red dividing line)

Despite much hope that the current breakout of the markets is the beginning of a new secular "bull" market – the economic and fundamental variables suggest otherwise. Valuations and sentiment are at very elevated levels which are the opposite of what has been seen previously. Interest rates, inflation, wages and savings rates are all at historically low levels which are normally seen at the end of secular bull market periods, not the beginning of one.

Lastly, the consumer, the main driver of the economy, will not be able to again become a significantly larger chunk of the economy. With savings low, income growth weak and debt back at record levels, the fundamental capacity to re-leverage to similar extremes is no longer available.

While stock prices have certainly been driven much higher through the Federal Reserve's ongoing interventions, that support both in the U.S. and Europe is coming to an end. The inability for the economic variables to "replay the tape" of the 80's and 90's, increases the potential of a rather nasty mean reversion at some point in the future. It is precisely that reversion that will likely create the "set up" necessary to start the next great secular bull market. However, as was seen at the bottom of the market in 1974, there were few individual investors left to enjoy the beginning of that ride.

Of course, with the virtual entirety of Wall Street being extremely bullish on the markets and economy going into the end of the year, along with bullish sentiment at extremely high levels, it certainly brings to mind Bob Farrell's Rule #9 which states:

"When all experts agree – something else is bound to happen."

Yawning Debt Trap Proves the Great Recession is Still On

While David Stockman stated early this year with resolute certainty that the debt ceiling debate would blow congress up and send the nation reeling over the financial precipice, I avoided jumping on the debt-ceiling bandwagon. While I was convinced major rifts in the economy would start to show up in the summer, I was not convinced they would have anything to do with the debt ceiling debate. If there is anything you can be certain of this in endless recovery-mode economy, it is that the US will just keep pushing its bags of bonds up a hill until it can finally push no more. So, I figured another punt down the road was more likely.

The Debt Ceiling Debate that Didn't Happen

The reason I didn't think that debate would blow apart is that Republicans have more than once experienced the political reality that comes from taking the nation to the brink of default or of shutting down government. Each time that kind of thing has happened, it has hurt Republicans far more than it has hurt Democrats. I doubted establishment Repubs (the majority) had the stomach to take us through another credit downgrade, though I've noted such an event was possible.

Unsurprisingly to me, then, Congress did the only thing it seems to be capable of any more and just kicked that can a little further down the road with hardly a kerfuffle about it. Hurricane Harvey made things a lot easier for congress to kick the can again by providing a good excuse to dodge that unwanted debate on the basis of massive human suffering that truly did need tending to. Much-talked-about government shutdown put off for a better time

The debate was entirely avoided even as the national debt broke over the $20 trillion mark this summer, keeping US debt at more than 100% of GDP, which is the stratosphere we've been in since 2011.

A group of progressive economists affiliated with the University of Massachusetts predicted in 2013 that a debt burden [that reaches 90% of GDP for five years] would result in an annual growth rate of just 2.2 percent, which means economic stagnation. 

We're already well past that five-year marker. Not surprisiing, then, that the Congressional Budgeting Office expects economic growth to stay at 1.8% through 2027.

George Will observed that the difference between 2 percent annual growth and 3 percent annual growth is the difference between a positive, forward-looking country in which politics recede from everyday life and a Hobbesian nightmare in which interest groups slug it out over a barely growing pie. Note that he was talking about 2 percent annual growth, which seems positively aspirational in the 21st century.

Nation caught in a debt trap

The biggest (or most likely threat) from the national debt is what economists refer to as a debt trap. The nation can be considered caught in a debt trap if the Federal Reserve loses the ability to raise interest because the rise in interest would immediately drown the economy or cause the nation to default on its debt. So long as interest rates are low, the US government can afford its huge debt; however, we are now at a point where, if interest rates rise to historically normal levels, we're in big trouble. That means we are in, at least, enough of a debt trap that interest rates can never be allowed to normalize.

Several debt traps are shaping up besides the one formed from government debt. One is thecorporate debt trap, where corporations have kept earnings per share high by taking out huge piles of debt year after year to buy back shares. If businesses have to refinance all this debt at a higher interest rate, they could be in big trouble. We hear over and over that today's high stock valuations are justified by the fact that earnings keep growing; but it is not top-line revenue that is growing, it is earnings per share, and most of that "growth" is due to corporations taking out debt in order to buy back shares and thus reduce the number of shares over which those earnings are divided. If interest rises, corporations will no longer be able to afford to buy back shares on debt, and that support for the market will crash. They might not even be able to afford to pay off the debt they have already taken on. So, there is another reason the Fed can never allow interest to normalize by historic standards.

Yet another debt trap now exists in personal credit where many households have reached peak debt. Household debt maxed out this summer above the level it had hit at the peak of the 2007 credit bubble — one more of those big signs of trouble in the economy that I said we could anticipate seeing by the time summer rolled around.

Income, in the meantime, has not improved in order to support this higher level of debt, now at a level that already proved unsupportable in the past. That puts the US back in the unstable position where households that already carry all the debt they can afford can be suddenly sunk if they have any variable-interest credit cards or an adjustable-rate mortgage. That is yet another reason the Fed can never allow interest rates to normalize.

Harvard economist Kenneth Rogoff warns that a sudden spike in interest rates is the biggest threat to the global economy…. People have got used to ultra-low interest rates…. "If something was to happen that pushes interest rates up, we could see a lot of soft spots — places where there is high debt — start to unravel," Rogoff said. (NewsMax)

It should be no surprise, then, that the number of credit-card accounts moving into delinquency swung upward for the third consecutive quarter this summer, a nine-month trend not seen since the bottom of the 2009 crisis. Yet another summertime crack in the economy — one that is not large yet but will become large quickly if the Fed allows interest to move upward any more than it already has.

In short, the national economy is riddled with high debt everywhere, which leaves every area of the economy with little wiggle room. So, the one certain thing about the huge piles of debt that have built up in the last few years is that we have reached the point where they are actually starting to box the Fed in to where raising interest to combat inflation will not be possible because it will cause damage throughout the economy. The tide has already closed in around the Fed to where it can no longer move to normalize interest in any direction without going deeper into rising waters.

S&P's chief economist, Beth Ann Bovino, wrote recently that "failure to raise the debt limit would likely be more catastrophic to the economy than the 2008 failure of Lehman Brothers and would erase any of the gains of the subsequent recovery."

The Great Recession is still with us

If you want to get a sense of how the debt trap affects the nation's real net worth, consider what the total gross domestic product of the United States looks like if you subtract all that debt that we've added each year in order to create that product:

Note: Federal Reserve Economic Data sheets express GDP in billions while Federal Debt is expressed in millions, so in this chart they multiply their data numbers for GDP by 1,000 in order to express both in terms of the number of millions (there being a thousand millions in every billion).

That is essentially the debt trap in a snapshot. And that's just subtracting the federal debt from GDP. What would it look like if we subtracted out all the business debt that was piled up in the creation of our total domestic product and all the personal debt? You can see the picture looked positive right up until the Great Recession hit, and it has deteriorated precipitously ever since.

Based on this picture we have remained in a huge depression since the financial crisis. I have been saying all along that we are still in the Great Recession, which is why I called this blogThe Great Recession Blog. The Great Recession still defines our present economy. We never exited; we just propped the economy up (created positive GDP) with mountains of debt (federal and corporate) so that we cannot feel how deep that depression really is; but the debt trap will suck us into this abyss as soon we can no longer sustain the creation of that debt. We have not powered out, as the Fed planned. If we had, GDP would be growing faster than debt.

We are essentially at that point of stark realization now as the Federal Reserve reduces its reinvestment in government debt (bonds) this month. (A process slated to start slow but to become huge by the end of 2018.) Until now, when a government bond matured during this past decade of Fed stimulus so that the government became responsible for repaying the bond principle to the Fed, the government just issued another bond, and the Fed bought that. The new issuance gave the government the money it needed to pay off the first bond. Now that the Fed is backing away from buying new government bonds (starting to divest), the government will be forced to find other financiers.

That will most likely raise the interest the US government has to pay in order to attract new buyers of its bonds, making the national debt less and less sustainable. What happens, then, to GDP as the government finds it harder to maintain its huge deficit spending that is propping up GDP (because the things government buys with that debt have always been included in GDP calculations)?

This unwinding scenario, of course, depends on what happens in the rest of the world because the US doesnt finance all of its debt internally. If Europe, for example, starts to collapse ahead of the US (as it now contemplates its own unwind), the US could once again prove to be the best looking horse in the glue factory and, so, still find ready foreign buyers at low interest for bonds that have to be issued to someone other than the Fed now that the Fed (the buyer of last resort) is backing away from repurchasing. That could purchase the US yet, again, a little more time. (That could just as easily swing the other way, of course, with the US collapsing first, sending money fleeing to Europe.)

Another way to look at our present situation since the Great Recession began — in order to see that its new economy stays with us — can be seen in this chart:

The trend line in GDP per capita (with government deficit spending still included in the calculation of GDP) broke off at the start of the Great Reession, and it clearly never recovered. It relentlessly sputters along at a decreased rate of growth. Moreover, it has only been maintained at that much lower trend because of the massive amounts of government debt and Fed stimulus. So, what happens to the new trend line when when that money is withdrawn from the economy and interest is allowed to rise?

The bags full of bonds we are pushing up the hill will become significantly heavier if interest rises and will exhaust us, and the present change in Fed repurchasing is a big enough change to tip that balance (given that the amount on the balance sheet the Fed is planning to now unwind is equal to more than 20% of GDP). That is why Jamie Dimon of JPMorgan Chase warned that we've never seen anything on the scale of what is about to happen and had better be careful.

One essential truth underlying this blog has always been that you cannot dig your way out of a debt-based financial crash by digging the debt trap deeper and deeper. I called this The Great Recession Blog because I believe the most fundamental truth about our current economy is that we are still in the Great Recession. It broke us for good in that we have not recovered from that event even with massive amounts of stimulus (beyond anything the world has ever attempted). GDP looks marginally acceptable but only on the surface and is clearly continuously now on a lower trend. Underneath it all is a yawning pit of debt, more than capable of swallowing our entire economy.

Tales From A Late Stage Bull Market

An endearing quality of a late stage bull market is that it expands the universe of what's possible. Somehow, rising stock pricesmake the impossible, possible. They also push the limits of the normal into the paranormal.





Last week, for instance, there was a Bigfoot sighting near Avocado Lake in Fresno County, California. But it wasn't just one Bigfoot. According to a local farmer, there was a family of five or six Bigfoot running across his ranch in the middle of the night. Paranormal expert Jeffery Gonzalez offered the following Bigfoot sighting anecdote:



"One of them, which was extremely tall, had a pig over its shoulder. And the five scattered and the one with the pig was running so fast it didn't see an irrigation pipe and it tripped, with the pig flying over."

What to make of it?

Bigfoot sightings, no doubt, are pro-growth. They're bullish for stock prices. So, too, are warnings from North Korea that nuclear war "may break out at any moment."

How do we know these two unrelated events are bullish? Because if you plot the S&P 500's price movement since their occurrences,you'll find that the market is up. There is a direct – albeit false – correlation.

And these days a correlation of any kind is what matters. No one cares that correlation does not imply causation. Such a pesky detail doesn't matter to Phillips Curve adherents. Why should it matter for anything else?

Indeed, there are plenty of things that used to matter, which no longer matter. For example, stock valuations don't matter. Profits don't matter. Most of all, deficits don't matter.
The Greatest Fools of All

The point is an eight-year run of rising stock market indices has suspended, if not eradicated, the natural laws of the universe. What was once considered rash or ridiculous is now shrewd and savvy. Conversely, tried and true investment principles, including evaluating business fundamentals, are for losers who lack imagination.

The proof of the pudding is in the eating, goes the maxim. Certainly, investors are lapping up this market like boysenberry funnel cakes at the county fair. They can't get enough of it.



They'll stand in line in the hot sun for hours to buy Amazon stock at $1,000 per share at a price-to-earnings ratio above 250. Because in this late stage bull market, growth and revenue are where it's at. That's what today's savvy market participants want. They don't care if, like farming, the attainment of growth and revenue comes at a loss.

To be fair, Amazon no longer operates at a loss. Last year they booked $2.4 billion in net income. Unfortunately, they had to bring in $136 billion in revenue – a net profit margin of 1.7 percent – to do so. While some profit is better than no profit, in our book. The Amazon folks sure did a lot of running around without much money left over to show for it.

So, what is it that attracts investors to Amazon? Do they want to become part owners of a profit generating machine with an abundance of after tax income? Is there a dividend they get paid for placing their money at risk?

To the contrary, Amazon investors receive no tangible income stream. Instead, they make a bet that there will be a greater fool standing by to pay a premium when they're ready to sell their shares. In fact, those who bought at $1,000 per share may find that there are no greater fools left – yesterday's close was $986. Thus, if there are no greater fools left, by default, they're the greatest fools of all.
Tales from a Late Stage Bull Market

Obviously, Amazon stock has been a fantastic speculation over the last 20 years. Its stock price has risen from a split-adjusted $1.50 at its 1997 initial public offering to over $1,000. That's over a 60,000 percent increase. Each dollar invested has transformed to $600.

But at this late stage in the bull market it is unlikely that Amazon will continue its trajectory into the upper stratosphere for much longer. The fact is, Amazon's profitability will never rise to its present market capitalization. Those who bought shares of Amazon at $1,000 may not have the opportunity to sell at that price again until the year 2040, if ever.

From a broader perspective, the stock market is currently overvalued on 18 of 20 valuation metrics. Naturally, timing the stock market's ultimate crest is for wizards and palm readers. However, anyone with half an inkling about anything knows the market's much closer to its next top than its last bottom.

Hence, if you're determined to buy stocks, you should take a moment to understand just what it is you're buying. Are you buying growth and revenue that's pumped up by massive levels of debt? Or are you buying a business that cranks out tangible after tax profits that are distributed to shareholders?

Knowing the difference is critically important. Sure, high growth and revenue companies – pumped up by massive monetary intervention – were the hot lottery tickets over the last few years. But when the dust settles following the next crash, and when Bigfoot sightings no longer serve as bullish indicators, boring old profitable businesses will be the prized holdings for investors. Anything less will be detested.

Gundlach Warns "The Order of The Financial System Is About To Be Turned Upside Down"

"I'm not a big fan of bonds right now," may seem like an odd way for the so-called Bond King to begin, but in an audience at Vanity Fair's Establishment Summit, DoubleLine's Jeff Gundlach told Bethany McLean, "I haven't been really [a fan of bonds] for the past four years, even though I manage them, and institutions have to own them for various reasons."

Gundlach urged investors to be "light" on bonds.

As Vanity Fair's William Cohan reports, Gundlach admitted "I'm stuck in it," of his massive bond portfolio, adding that interest rates have bottomed out and been rising gradually for the past six years.

Gundlach said his job now, on behalf of his clients, "is to get them to the other side of the valley."

When the bigger, seemingly inevitable hikes in interest rates come, "I'll feel like I've done a service by getting people through," he said.

"That's why I'm still at the game. I want to see how the movie ends."

But it can't end well. To illustrate his point about the risk in owning bonds these days, Gundlach shared a chart that showed how investors in European "junk" bonds are willing to accept the same no-default return as they are for U.S. Treasury bonds, pointing out that this phenomenon has been caused by "manipulated behavior" by central banks.

European interest rates "should be much higher than they are today," he said,

"...[and] once Draghi realizes this, the order of the financial system will be turned upside down and it won't be a good thing.

It will mean the liquidity that has been pumping up the markets will be drying up in 2018...

...Things go down. We've been in an artificially inflated market for stocks and bonds largely around the world."

"My job is to find scary things," Gundlach told McLean...

"My critics say, 'You find seven risks for every one that exists.' Guilty. That's my job. My job is to try to find out what can go wrong, not cover my ears and hum. It's better to keep your eyes open."