Weekly Economic Update 06-30-2017

The Fed’s Illusion of Prosperity
When central banks start tightening the money supply it leads to the failure of Quantitative Easing (QE) programs. When that happens, historically asset prices fall. Nobody wants to think about their homes, business, cars or stock portfolios losing value, but that’s what usually happens when central banks tighten the money supply. Imagine what happens when a bubble pops—after growing in size, glistening in the sun, seeming so smooth and perfect. And, after getting just a little too big, the soap and water molecules burst apart into a soapy mess! When you understand what happens when bubbles pop, then you begin to understand why Warren Buffett and other experts are holding on to so much cash.

History suggests such investors, which includes us, are going to have an opportunity to buy real assets (stocks) at very low prices. However, you might believe that this is the first time in history that things will be different. If you do, you’re not alone. Janet Yellen said, in an interview this week, that she didn’t think there will be another financial crisis in our lifetime. I strongly and respectfully disagree.

Last week in my update titled, The Worst Crash in Your Lifetime is Coming, I explained how QE programs work. They involve increasing the money supply to increase asset prices, which leads to increased inflation. With inflation rising and interest rates falling, it encourages savers to become spenders, and businesses and consumers to take out loans. As that money gets poured back into the economy, demand increases. Increased demand forces businesses to hire and those new employees demand a higher wage due to inflation. Once those higher wages are passed down to the other employees, then the increased asset prices also hold their value. Once the economy is standing on its own, the money supply and interest rates are slowly normalized. As I mentioned last week, there has never been a monetary expansion policy in the history of the world that has worked. This this week I will talk about the flaws in QE programs and what happens when they fail.

QE is Steroids for the Economy
The purpose of Quantitative Easing (QE) programs is to stimulate spending. Central bankers believe the public can get “spooked” into not spending, and they view it as their role to make the public believe that everything is okay and that it is safe to spend. This is why you rarely ever hear a central banker say the economy is doing badly, even in the midst of a financial crises!

In a central banker’s eyes, the public is never consuming to their full potential. By lowering interest rates and stoking inflation people become motivated to spend. When QE programs run for years on end, or for 8.5 years like the current trend, (Yes, the Fed is still buying bonds!) it pulls forward future demand. This causes consumers and businesses to spend money on things today that they might have spent in the future.

For example, let’s say you buy a new car every five years, but due to low-interest rates and high used-car prices, you decide to buy one a year earlier than planned. And so, future demand is pulled into the present. That dynamic happens throughout the economy when interest rates fall.

The problem with pulling forward consumption is the central bankers don’t believe it happens. When consumption eventually slows down, they just think it’s the public holding back on their spending again. When demand or consumption peak, the business cycle come to an end. It’s at that point there is a prolonged period where demand is low because future consumption has already been spent.

QE Increases Debt
Low interest rates and easy-money policies motivates consumers, businesses, and governments to borrow money. All of this borrowing has led to record amounts of debt. Many forget that the financial crisis of 2007-08 was due to unsustainable debt levels. Yet today we have more consumer, corporate and government debt than in 2008; yet nobody seems too concerned.

The problem with too much debt is obvious. If the economy doesn’t grow, or even worse, if it contracts, everyone is stuck making payments on all this debt. Since debt is a tax on future consumption, it’s not until the debt levels are eventually paid down before the economy can grow again. That de-leveraging process can take many years or even a decade.

QE Causes a Malinvestment of Capital
Excess borrowing leads to a malinvestment of capital. When interest rates are below their expected rate, money is borrowed and spent on things that it wouldn’t normally be spent on. This is evident throughout today’s economy.

It can be seen in the automobile industry, commercial real estate, multi-family real estate and luxury real estate, to name a few. Overspending in these sectors is seen through oversupply; too many new cars, too much commercial office space, too many luxury homes, etc. Here again, if the economy slows or contracts, it can take years before the oversupply has been drawn down to normal levels.

But oversupply isn’t the biggest abuse going on. Corporate share buybacks are the worst offender because they create no real value to the economy.  When central bankers lower interest rates and expand the monetary base, they want consumers and businesses to spend the money. Consumers are all too willing, but businesses sometimes have ulterior motives.

In an ideal situation, a business would borrow money to make capital improvements, such as upgrading their factories and equipment. Increased capital expenditures lead to increased demand in the economy. But demand hasn’t been strong enough to force businesses to increase capital expenditures. This is evident in the monthly capacity-utilization data that shows that factory utilization-rates are already low, so there’s really no demand to invest in increasing capacity.

Instead, corporate executives, who are motivated by their stock-price-based incentives, figured out that they could borrow money to buy back the shares of their company. When a company buys back its shares it increases the share price. Higher share prices on a quarter-to-quarter basis means the executive team gets a big bonus. Share buybacks benefit the wealthy who are the large shareholders and generally don’t add any real value to the economy. When companies choose to invest in share buybacks over capital expenditures, it leads to lower future earnings.

When Inflation Turns to Deflation
As I mentioned in a previous update, the Fed really wants inflation. Inflation minimizes the cost of debt while deflation increases it. The Consumer Price Index’s largest two components are rents and the price of oil. Oil prices have been declining on a year-over-year basis and rents are starting to roll over. This means that deflation is going to return and cause a major headache for the Fed.
All the debt that consumers and businesses took on is going to cost more to repay because wages and earnings usually fall during times of deflation. This is really bad news when you consider that the central bankers’ plan was to encourage everyone to take on more debt under the guise of economic prosperity. Whoops.

What if Wage Growth Sputters
The one key component to monetary expansionary policies is wage growth. If all else fails but wages grow, then the program can be successful. Higher wages mean people can afford to pay down their debt and continue to spend money. It also means that the increased value of asset prices can hold because higher wages mean people can afford higher prices.

But wages haven’t grown. Even worse, they’ve been stagnant for a couple decades. On top of that, disposable incomes have been falling.

Now we have a situation where consumers have record levels of debt and declining disposable income. More of their income must go to debt service, which means there is less money to spend on goods as and services. That decreased spending leads to an economic contraction. And, if the unemployment rate starts to rise, it’s game over. As consumers lose their jobs, delinquencies and defaults will increase which will all lead to a financial crisis.

Without wage growth, it’s just a matter of time before things fail. And when they do, it puts consumers and businesses in a worse situation than before.

QE Means Most Will Be Worse Off
Currently, we have a situation where the economy is in a prolonged contraction – recession or possible depression—because the Fed is attempting the largest monetary experiment in history. I use the term experiment because every prior attempt in history to expand the money supply to create prosperity has failed. This experiment will leave everyone worse off due to the sheer amount of debt and excess in the economy—an excess that will take years or more to work off.

Perhaps things would be different had the Fed let the 2007-08 recession happen. But the Fed believes this time will be different and that they have engineered a solution to eliminate economic downturns. If they’re wrong, they are setting up the biggest economic collapse as the biggest generation heads into retirement.

Video Topic of the Week
This week I discuss Fed Chairman Janet Yellen’s recent comment that we will never experience another financial crisis in our lifetime along with my thoughts on the banks passing the recent round of stress tests. I also cover in more detail how a momentum portfolio compares to more traditional portfolios.

Chart of the Week – 10-Year Treasury Yields vs Treasury Futures
Hedge funds have made a major move in the Treasury futures market. For those who think interest rates can only go up, you might be surprised to find out how the smart money is positioned.

Client Update
As promised, here are some of the back tested date. The strategy takes a pool of Exchange Traded Funds (ETFs) that have high trading volume and ranks their 6 month return from high to low. It then takes the top percentage (notated below) and based on a proprietary formula, allocates the funds based on volatility. The strategy is run and adjusted on the first of each month. Data does not include June 2017.

Momentum Data (taking the top 25% each month)
Returns (annualized):
1 year: 16.10%; 3 years 6.3%; 5 years 9.98% and 10 years 8.08%
Beta (S&P 500 has a beta of 1, lower is better):
3 years 0.48; 5  years 0.61; 10 years 0.37 (65% less risk than the S&P 500)
R2 (how much the returns correlate to the S&P 500, lower is better):
3 years 30.15; 5 years 44.07; 10 years 24.61 (only a 25% correlation to the market – typical growth portfolio will have a correlation of 85+)

Momentum Data (taking the top 15% each month)
Returns (annualized):
1 year: 21.21%; 3 years 6.95%; 5 years 10.79% and 10 years 9.95%
Beta (S&P 500 has a beta of 1, lower is better):
3 years 0.52; 5  years 0.67; 10 years 0.35 (65% less risk than the S&P 500)
R2 (how much the returns correlate to the S&P 500, lower is better):
3 years 15.83; 5 years 28.81; 10 years 13.19 (only a 13% correlation to the market – typical growth portfolio will have a correlation of 85+)

These numbers are very impressive. Anytime you can create a portfolio strategy that beats the S&P 500 over a 10 year period with less risk and minimal correlation to the movement of the broad equity market – that’s exactly what we want as investors. I’m going to run a couple other tests to see how it performs taking the top 10% and top 20%. If data exists, I’ll see if I can run a 15 year back test. ETFs really gained popularity in 2008+, so there may not be enough ETFs available to run a proper 15 year back test.

Hopefully in a few weeks I’ll be able to append a proper Morningstar snapshot for you to see.

US Equities
Pick the metric you like and this market is overvalued and completely detached from its fundamentals. However, there is a great deal of excitement about how the stock market is finally going up forever, which is giving it upward momentum.

Reward: Possibly +3-7% depending on who you ask.
Risk: Bear markets usually experience somewhere between -20 & -80%.

Risk clearly outweighs the reward. When market turn they turn fast and this post-election rally could disappear very quickly. There is a potentially bigger opportunity to be short US equities when the market turns.

6/23/17: Money supply continues to fall. Mergers and acquisitions are drying up. Corporate stock buy backs are drying up. Not a positive outlook for equity prices going higher.
6/30/17: Momentum appears to be drying up and volatility is starting to show up… not good for equity bulls.

International Equities
Looking at Europe specifically, they trail our business cycle, meaning many believe there is significant upside potential. It also helps that the European Central Bank is continuing to dump money into the economy and is willing to keep interest rates low. There still seems to be a high correlation between US equities and European equities, meaning when the US falls, they do too. As much as I want to like this, it concerns me that we could drag them down.

Reward: +50% to get back to prior all-time highs.
Risk: Unknown due to correlation with US equities; possibly -40%.

Too many unknowns here.

6/23/17: Some experts are now saying that European equities will be the ticket for the next 12-18 months. Not too much evidence based on how the foreign ETFs are moving.
6/30/17: Wednesday’s US market selloff is a leading indicator because the International Equities section of my trading software was flashing red that day with big drops in international equities across all continents. I understand the narrative for why European equities should go up, but I am not seeing it happen. Perhaps in a future update I’ll outline the story.

Emerging Markets
I do have a potential buy signal on emerging markets equities. There is a correlation emerging markets and oil. Unless there’s a clear break between the two, there’s a high amount of risk here if oil prices continue to fall. The upside is their inverse correlation to the US dollar could trigger a sustainable rally.

Reward: +25% or more depending on how close they track a declining dollar.
Risk: Potential correlation to falling oil prices means there could be a significant drop in price.

6/23/17: I want to like emerging market stocks due to their inverse correlation to the US dollar, but so far they are stuck going nowhere.
6/30/17: Emerging markets failed to close over the monthly momentum target, meaning I do not have a buy signal.

Gold/Silver Miners
I like the miners over the metals, but the rally I had hoped for hasn’t started. In 2008 gold and gold miners dropped with the market, but I’m not sure that will happen this time. Central bank policies have weakened the global banking system and with massive money printing, I believe investors will seek out precious metals as a means to protect their wealth when the next financial crisis hits.

Reward: +200% (for the miners)
Risk: -10%

6/23/17: I’m just waiting for prices to bottom.

Agricultural Commodities
These performed will during the last recession, nearly doubling in a 12-month period as stocks plummeted. Prices are currently trading below momentum and technical breakout levels, but are holding a price level established back in early 2016. Recently legendary investor Jim Rogers said he’s invested in agricultural commodities and he’s well known for making investments in asset classes that generate large returns.

Reward: +100% if a new bull market breaks out and prices return to their prior all-time high, which is normal in bull market rallies.
Risk: -5% which is back to all-time lows.

This is one asset class where the risk-reward scenario makes sense and is why we have bought in.

6/23/17: Prices have slipped, but are still within the target range. In the chart pack, you will see the long-term inverse correlation between the US dollar and agricultural commodities. The reason I choose this sector is that I don’t feel comfortable trying to identify which currency will trade inversely the dollar. Some say the Euro, others the Yen, but it could be some other currency. Commodities hold a long-term inverse relationship. Plus, when stocks (paper) go down in value, investors tend to run into hard assets (commodities), which we can see back in 2007-2008. Since agricultural commodities can’t go to zero and we have multiple data sources showing a larger move down in the US dollar, this is a long-term position to take advantage of a declining dollar and a recession.

6/30/17: Strong rebound in prices and volume have brought prices about 12 cents below our average buy point. The move down was clearly to flush out the weak. This sector remains a long-term buy.

US Treasuries
Every time there has been a recession yields make a new all-time low and bond prices make a new all-time high. While many have called for the end of the secular bull market in bonds, with a weak global economy and record levels of debt, it’s more likely that interest rates will fall during the next recession.

Reward: 5-6%+
Risk: The risk was that yields would break out but stopped twice at 2.6% and have fallen since. I believe the downside risk on Treasuries has been established.

Given the high probability there will be another recession and that it will be one of the worst in history, I like US Treasuries. I also expect the Fed to quickly react and cut interest rates which would be very bullish for Treasuries.

6/30/17: Yields moved back up but it is not a structural change. Inflation data continues to fall and yields are likely to head back down. They remain a strong hedge against the next recession.