Weekly Economic Update 07-14-2017

When Bank Lending Contracts, Watch Out Below

In past updates, I have mentioned it is the Federal Open Market Committee (FOMC) or Fed, that engineers every expansion and contraction in the economy by expanding or contracting the money supply in our country. The evidence is compelling because out of the past thirteen tightening cycles, they created full-blown recessions in ten of them and mere soft landings in three of them. All tightening cycles involved the stock market falling in some fashion or another. The Fed isn’t entirely to blame because the banking system has the power to create and remove large amounts of money from our economy.

Before I share with you how the banking system is involved in our money supply, I want to revisit why a growing economy needs an ever-expanding money supply to fuel growth. In last week’s update, I introduced “Metremarks” that were the currency of our fledgling two-person economy. I showed that if our economy started with 100 Metremarks and we wanted it to grow by 5% then, at the end of the year, we would need 105 Metremarks in the economy – (100 multiplied by 5% equals 5; added back to 100 which equals 105.)

If we wanted our economy to grow at an annualized rate of 5% then the amount of Metremarks would need to grow by 5% per year. The following year we’d need 110.25 Metremarks (105 multiplied by 5% equals 5.25; added back to 105 equals 110.25). The year after, 115.76 Metremarks, the year after that, 121.55 Metremarks and so forth. As long as our money supply is growing then our economy can expand. Last week I also mentioned that it didn’t matter where the Metremarks came from, so long as we had more of them.

Where does our money supply come from? Most people would assume it’s the government, who has the authority to print money. However, it’s the banking system which creates money when a new loan is made. The banking system is responsible for about 95% of all new money created, putting the banks in a very powerful position. Banks must be creating more loans and larger loans each year in order for the money supply to continue to grow.

When banks cut back on lending they take in more money than they lend out. As loans are repaid that money is removed from the money supply. Remember, money is only created when new loans are made. As old loans are repaid, money is removed from the economy. So, as you can see, the banks are in a powerful position. When they lend, the economy grows and when they don’t, the economy contracts.

And this is the point where we come back to the business cycle, which the Fed believes doesn’t exist. We are currently in the third longest expansionary cycle in history and quickly approaching the second longest cycle in history. Business cycles always end with a recession.

Business cycles end for two reasons: consumers have bought all the stuff they want to buy (or demand decreases) and banks cut back on their lending. This is why I review the year-over-year change in commercial and consumer lending statistics each month, along with the year-over-year money supply each week. Both commercial and consumer lending have been contracting, which completely validates the fall in money supply since October 2016. Yet, nobody seems to be too concerned about this but they should be.

What I find interesting is that a very small decrease in commercial lending back in 2008 triggered a recession, while a huge drop in commercial lending since 2015 has not triggered a recession. It’s not a matter of ‘if’ there will be a recession, it’s a matter of when and which financial crisis will trigger the next recession.

Bank lending isn’t too hard to understand – I’ll give you my generalized version. Banks prefer to lend to their most creditworthy customers, which they tend to favor when the economy comes out of a recession. Once they start running low on their top tier customers, they then reduce their standards a bit and seek out those that are good credit risk. As the years pass the banks run low on their preferred customers. Now you might think this would be a good point for the banks cut bank on their lending, but you have to keep in mind that banks need to originate new loans on a regular basis to generate profit. Not only is profit good for their bottom line and stock price, but for the majority shareholders that benefit from an increased stock price and regular dividends.

For that reason, as the business cycle moves into the later stages, banks will lend to lower creditworthy clients or subprime lenders to generate loan growth. This is where the problems begin, because as the economy reaches the late stages and demand falls, banks realize that those subprime loans can quickly turn into delinquencies which may lead to defaults. This is usually how financial crises begin. Compound that with a contraction in lending and you have a perfect storm.

My concern is that with the Fed raising rates and bank lending contracting, our economy is going to experience a shock which is going to translate into an earthquake to the stock market.

Demand is falling. The money supply is falling. The Fed is raising interest-rates. Credit growth is falling and soon to turn negative.

None of these have been friendly to stock prices in the past, but today the public has bet their life savings on it. They are betting that the Fed can get us out of the next recession. I hope for those who are gambling their life savings on the Fed that they are right, because stock prices usually fall 20% to 80% in a bear market.

Client Update

The good news is I finally cracked the code on the Momentum Strategy. There was an ongoing issue where it wouldn’t pivot when markets bottomed to take advantage of the move off the bottom. As a result, every few years the strategy would have an underperforming year.

I had the opportunity to dig through the data to discover the problem. In the most recent model, I used three bond-funds to slow the strategy down when stocks dropped. It worked extremely well – much like those fancy emergency braking systems they are putting on cars these days, it would bring the downward move to an immediate halt.

The problem was that once the emergency was past, the allocation would hold those low-risk bond-funds too long. Equity markets would move up off the bottom and the model would be stuck in neutral.

I theorized that I could accept more downside risk, not that the strategy had much to begin with, in exchange for more upside return. I kicked out the two lower duration bond funds and decided to run the model with three equity funds and one bond fund, taking the top three funds based on their six-month price return, with the weightings set by a volatility algorithm I developed.

When I ran the back test I expected bigger drawdowns, but they didn’t happen. In the past ten years the strategy only had one negative year. The volatility algorithm worked so well that it countered the downward move in equity prices!

Here’s the numbers:

1 Year Return

Momentum 21.30%

S&P 500 15.46

3 Year Return

Momentum 12.62%

S&P 500 7.33%

5 Year Return

Momentum 15.68%

S&P 500 12.21%

10 Year Return

Momentum 12.54%

S&P 500 4.89%

Alpha 10 Year (higher is better)

Momentum 8.59

S&P 500 0.00

Beta 10 Year (lower is better)

Momentum 0.65

S&P 500 1.00

R2 10 Year (how much returns correlate to the S&P 500, lower is better)

Momentum 64.99

S&P 500 100.00

Sharpe Ratio 10 Year (higher is better)

Momentum 0.99

S&P 500 0.29

Cumulative 10 Year Return (higher is better)

Momentum 225.77%!!!

S&P 500 61.20%

I’d say those numbers are impressive.