Weekly Economic Update 07-21-2017

Will the Fed Rescue the Banks Again?

A couple of weeks ago the Fed announced that our major banks passed a stress test and that the banks were approved to reduce the amount of capital they are holding in reserve. Without delay, the major banks announced plans to return this excess capital to their shareholders by increasing their dividend payments over the next 24 months – news which was well received on Wall Street. The news of a financially-sound banking system and increased dividends is designed to give the public reassurance that it’s okay to borrow and spend, which the Fed desperately wants the public to do. Meanwhile the banks are tightening their lending standards as they already know that during the next financial crisis, which is looming, that they will once again need to be bailed out.

The reason the banks passed this stress test with relative ease is because in 2009 the Financial Accounting Standards Board (FASB) voted to suspend mark-to-market to prevent the entire banking system from failing. Since then, mark-to-market has not been reinstated. Because of its suspension, nobody really knows just how bad of shape the banking system is in.

Mark-to-market requires a company or financial institution to value its underlying assets (loans in this case) based on the selling price of the asset. In an illiquid market, such as the 2008-09 financial crisis, markets for many of these loans dried up—meaning they had little or no marketable value. Banks are required to hold capital in reserve based on the value of its underlying assets. If those assets are deemed worthless, or near worthless, then the amount of capital they hold must increase. In a financial crisis, this can make banks insolvent overnight.

By suspending mark-to-market, banks can value their underlying assets based on a normal, fully liquid market, even if a fully liquid market doesn’t exist. This means that even amid a financial crisis when the true value of a banks underlying assets may be very low, they can appear to be financially strong. This is important because if investors fear their bank is insolvent, they will seek to withdraw their money quickly, further driving the bank into insolvency. Furthermore, in an era of online banking where funds can be transferred in a matter of seconds, it gives new meaning to how fast a run-on a bank could occur. In times past, account owners had to physically go to a branch to withdraw their money. Not anymore.

You might think that suspending mark-to-market doesn’t really matter too much, as long as the good times continue to roll. Consider this, during the next financial crisis, how will you know if the money at your bank is safe? There’s no way to know.

As I mentioned, the same day the Fed announced the results of the stress test, the banks announced stock buybacks and increased dividend payouts. The major shareholders are eager to get their money out before the economy recesses, because when it does, those shareholders can forget about pulling their equity out.

As I have discussed in past updates, this is what Quantitative Easing (QE) has done. It has allowed the very wealthy to strip equity out of companies with little concern. The banks know the Fed will be forced to bail them out, because there aren’t very many banks. But it wasn’t always this way.

Around one-hundred years ago, there were lots of banks. And if some became insolvent, they were allowed to fail. Bailouts were rare. It was not unusual to see, in times of crisis, that hundreds of banks would end up failing. Today that’s not the case, simply because there are so few.

To make regulating the banks easier, the Fed has created this system of fewer banks. As a result, we now have banks that are considered “too big to fail.” The Fed’s system concentrates all the risk into a small number of large banks.

In a diversified system, where there are banks of all sizes, the smaller, less capitalized banks could fail without damaging the entire banking system. Can you imagine the panic that would ensue if one of the big banks, such as Bank of America, Chase, or Wells Fargo, went insolvent? Such an event would likely lead to a run on the banks which would cause further destabilization of our financial system; one that could bring the entire banking system down.

This is the risk we face because of the Fed’s policies. They have dumped money into the economy and lowered interest rates in hopes to spur demand. It hasn’t worked. Instead we have a record amount of debt concentrated among a small number of banks. If you ask a banker, and I have, they’ll tell you they are well reserved against anything that could happen, as shown by the stress tests. Ask that same banker how well they could handle asset-price deflation and you probably won’t get a response.

The 2008 housing crisis is a perfect example of asset-price deflation. One day the housing prices were going up and the next, they were going down. As owners and speculators panicked and sold, the faster prices fell. As people realized they were upside-down on their mortgages and unable to make payments on them, delinquencies started turning into defaults. Those defaults nearly caused the entire US banking system to collapse.

When I hear the Fed announce that everything is okay and that the banks’ response is to unload their excess reserves, it makes me suspicious. Every month I review the amount of bank credit, which is massively contracting. Its contracting at a rate that we’ve only seen during recessions. The Fed’s announcement just doesn’t sound right.

If the banks are well capitalized, then they should be holding those excess reserves to create more loans. More loans lead to higher long-term profits. Yet lending standards are tightening and credit is collapsing. It tells us that the banks know something we don’t: either their financial position isn’t as strong as the Fed is telling us or the banks realize we are about to head into a recession. In the latter case, since they know the Fed is going to bail them out, it makes sense as to why the major shareholders want their equity out now.

Therefore, I believe that during the next recession the Fed will be forced to increase the size of their balance sheet by buying more toxic debt from the banks and to further lower interest rates. Historically, after any period where a government has undergone a massive money printing operation to create prosperity, a massive amount of deflation occurs during the next crisis.

The Fed has locked itself into a position where it can’t let the banks fail. But the major shareholders of those banks know that too, which is why they are all too eager to get their equity out. If I am right, this means that long-term interest rates are going to go below their prior low levels and that bond prices are going to break out above their prior highs. This is also why I also believe that our assets (homes, cars, stocks, etc.) are all going to drop in value during the next recession. And not by a small amount.

Deflation is a disease that no central banker has been able to cure by printing more money and by lowering interest rates. However, it hasn’t stopped them from trying.

Video Topic of the Week

I discuss the Great Depression as it relates to the post WWI gold standard and how that compares to the US Dollar standard of today.

Chart of the Week – NYSE Investor Credit and the Market

If you think this market rally is built on profits, earnings, valuations, fundamentals or anything reasonable, then this chart will change your whole perspective. It shows the amount of margin or borrowed money that has been used to buy stocks.

Client Update

Momentum Strategy Update

I ran a full fourteen years back test on the strategy. You might wonder why I choose fourteen years and the answer is simple: the bond Exchange Traded Funds (ETFs) didn’t exist prior to fourteen years ago. Even though ETFs have taken the stock market by storm in recent years, most of them didn’t exist prior to 2008. In terms of the stock market, they are new.

The results were impressive. For the first four years the strategy keeps pace with the S&P 500 while taking less risk. The last ten years the strategy takes off and leaves the S&P 500 in the dust. There is little doubt that the strategy does exactly what I designed it to do: generate long-term equity returns with less risk.

Next on the list is to get the Morningstar factsheet in a client-approved format. I just haven’t had a chance to work on the design of it this week, but the data is all there.

As far as implementing the strategy, today is not the right time. It’s important to understand how the strategy works at market peaks and market bottoms before committing to it. The strategy looks back at the six-month price return of the S&P 500, Russell 2000, Nasdaq-100 and 30-year Treasury yields. It ranks them based on price return from highest to lowest, then allocates the top three based on a volatility formula I developed.

As of right now the recommended allocation as of July 1st would be 50% in equities and 50% in bonds. That is a good defensive strategy, but not against a rapid drop that is historically associated with overvalued markets.

Assuming at some point stocks start to sell off, the strategy will increase the bond allocation to around 80% or so. In the past 14 years, it never recommended a 100% bond allocation. The strategy was designed to minimize downturns, not capitalize on them.

There is a bigger opportunity to capitalize on a global recession as I have previously discussed through commodity producers, agricultural commodities and short equity positions. For now, I’ll monitor the strategy and implement it when it is more appropriate. If this was an appropriate time, there’s no question I would implement it immediately.

US Equities

Speculation has reached a record high as central banks continue to buy stocks and investors have borrowed a record amount of money to buy stocks. Like any bubble, they are easy to spot but hard to time. Just like the 2008 real estate bubble was built on leverage and speculation, this stock market bubble will eventually burst. How high it will go before that happens is hard to say. What I can tell you is that history has shown that in a very short period of time, as fast as an hour, a year or more worth of returns can be wiped out. Markets that rise on speculation typically have an equally rapid decline.

We are in the third longest expansionary business cycle in history and we are within 10 months of becoming the second longest expansionary cycle. This is now the second most expensive market in history, surpassing the valuations set back before the Great Depression, based on the Cyclically Adjusted Price-to-Earnings (CAPE) ratio. The most expensive based on ratio Price-to-Sales ratio. The second highest based on Price-to-Revenue ratio and very close to being the highest. Not to mention that debt levels are at a record high, growth over this past cycle is the worst in any prior cycle and wage growth has been weak.

Those who believe earnings are driving the market need to be aware that earnings are below the 2014 peak of this cycle. The reason they appear to be good is that earnings are reflected on a per share basis. Corporations have been engaging in aggressive stock buyback programs. That reduces the number of shares, which can make even mediocre earnings look good. This is why profits matter, but nobody seemed to mention that corporate profits declined in the first quarter of 2017 and are below their 2014 highs.

US Treasuries

Very few people own US Treasuries, but when the stock market blows up, people will flee to safety. US Treasuries historically perform very well during recessions. Even though the Fed has been raising rates, the misconception is that bond yields go up as well. For the past thirty years, there has been no correlation between the Fed raising rates and bond yields rising. If anything, the Fed has created every recession by raising rates, which is why yields have fallen from their recent peak as the Fed continues to hike.

The inflation data tells us where bond yields are headed. As inflation decreases, which it has been, bond yields fall. As bond yields fall, bond prices rise. US inflation data fell again last month along with European inflation data. Despite popular view, mass money printing initially leads to massive deflation. Deflation and a recession are reasons why US Treasuries remain one of the best hedges against this market. Before this is all done, I predict interest rates will see a new all-time low.

European Equities

The European business cycle runs about eight weeks behind us. While I want to like European stocks because their valuations are attractive compared to the United States, it’s important to understand that a rising Euro (their currency) is not good for their economy. The belief is that if the US stock market sees new all-time highs, other markets must as well. This is a false narrative. Back in the late 1920’s, the US stock market was in a speculative bubble and that didn’t lead to new highs for foreign indices. When the global recession started and the stock market bubble burst, foreign equities fell less.

Emerging Markets

While I want to like emerging markets, there isn’t a long-term focus here. Emerging markets have been correlated to European Union policy rates. As they seek to normalize their rates, emerging markets should underperform.

Agricultural Commodities

I like this sector as it is the most undervalued sector in the markets. It’s a buy low, sell high opportunity, which is why we have invested in it. Plus, in 2008 as the equity markets were blowing up, commodity prices nearly doubled in a 12-month period. While it hasn’t taken off yet, all positions are showing a positive return. The crop reports show that weather conditions are less than favorable. Lower yields lead to higher commodity prices.

US Dollar

As I predicted the US dollar was overvalued and would embark on a multi-year decline. So far the dollar index is down about 8% from its high. Normally a falling dollar is bullish for agricultural commodities and precious metals. It hasn’t been, but that doesn’t mean it won’t be.

Commodity Producers

If there’s one asset class I’m in love with, it’s this one. What I’m referring to are mining stocks which are a leveraged play against precious metals. My long-term outlook on these is still very high. My short-term outlook isn’t as optimistic.

In both the gold and silver miners, prices have been following a descending right triangle pattern. Based on classical charting techniques, this is a bearish pattern that suggests prices are likely to further fall. It won’t surprise me if mining stocks fall as the market falls, but at some point, that will change. There is likely to be a global recession, global deflation, and a global financial crisis. Precious metals like those things.