Market Commentary

Market Commentary

July 27, 2016

Brexit happened. 

Global markets panicked.

Then global markets slumped.

And as night follows day, the Brexit slump was followed by a well-engineered “Brexit Bounce."

Rest easy, seems to be the message. The plunge protection teams are alive and well!

Strange Fruit:

To what can we attribute this new “All-Time High” in the stock market? In case you haven’t been paying attention (and congratulations if you have not) the S&P 500, the NASDAQ, and the DJIA all recently hit new all-time highs!

Naturally this is meant to prove that everything is awesome.

But facts are stubborn things, as President John Adams long ago noted. The chart at left shows the strange behavior of the S&P500. While billions of dollars have been flowing out—the index has continued to stretch to new highs.

Never before seen” is a word-string dangerously close to becoming trite, just as “not since Lehman” has. But this truly boggles the mind. If billions are flowing out of the stock market, shouldn’t the index sag? It always did before. You can see for yourself how the index level mirrors the capital flows, as well it should. But if you guessed that things are different, well, “since Lehman” then you’re right as rain.

Figure 1, at left, shows that the Central Banks have stepped up their asset purchases.   As the Emerging Market (EM) countries’ central banks have been forced sellers of late, the Bank of Japan, and ECB have stepped up to table – once again – to gorge themselves.

Whenever you read financial news about the advent of “price-insensitive buyers” of assets, remember this chart. That phrase stumped me for years…but now I get it. Don’t be slow on the uptake like me... recognize when price insensitive buyers appear – and sell to them!


Almost no one predicted Brexit. 

And, yet, ironically, almost everyone has an opinion on what it means. I am sure that you have been carpet-bombed with commentary on "What Brexit Means (“ Your Portfolio", or "…to your 401(K)”, and even "…to Trump's Election Chances").  Opinions are cheap and plentiful, and, comically, self-assured.  Naturally, since most of this nonsense is the product of investment firms, it will always have the benign ending that investors "should not panic" & "should stay the course".

And while the “leave” vote may have been the proximal cause of global stock markets selling-off, if the truth is to be told, the air has been leaking from the tires of global trade for quite some time.  The "leave" vote is just part of this long-running script.   I mean, if everything were dandy, would the vote have even happened?  So let's accept Brexit's symbolic value, but hold-off on weighing its economic value.

The chart next door may be familiar to friends and clients of HBA, since it's a repeat showing.  However, it emphasizes the decline in global trade volumes (far more significant that the dollar value of trade) that has bedeviled the global economy since 2014Q3.   It is also noteworthy that S&P 500 earnings also peaked in 2014Q3 - almost two years ago now. Trailing 12 month earnings for the index are now down 18% from that peak.  

According to FactSet, “For 2016Q2, the estimated earnings decline is -5.3%. If the index reports a decline in earnings for Q2, it will mark the first time the index has recorded five consecutive quarters of year-over-year declines in earnings since 2008Q3 through 2009Q3. Something never-before-seen outside of recession.

So here we have a global slump reflected clearly in our own domestic markets.  If it is still true that earnings drive stock prices this doesn't bode well for the index value.  Prior to last week’s “Brexit Bounce” peak on the S&P 500, the index had peaked at 2130 on May 21, 2015 - over one year ago.  Since then the market had been travelling sideways, veering off-road and into a few ditches, then managing to climb out. This is what the adepts call 'distribution' where sellers match or outnumber buyers and the index value trades in sideways fashion.   But what now? Remembering that a stock market top is a process rather than an event should keep us all on our toes. 

And, please, let’s not forget that the S&P 500 Index soared to an all-time high after two Bear Stearns [real estate related] hedge funds imploded in the summer of 2007. So far, with up to eight of the largest UK realty funds imploding, yet another not-since-Lehman-moment could appear. We must add the economy was also rolling over in 2007 as equities prices surged.

Figure 2 comes to us courtesy of Dr. Daniel Thornton, who toiled for 33 years as part of the St. Louis Federal Reserve. It plots household net worth as a percent of disposable income. The last two times that US Household Net Worth was this high relative to Disposable Personal Income was in 2008.  Before that, the earlier peak occurred in 2000 Q1. What followed in each case was a dramatic decline in net worth of US Households, in the first instance with the bursting of the dotcom bubble in 2000, and more recently with the decline in real estate and stocks following the real estate crash and the onset of the Great Recession.

Dr. Thornton is now leading D.L. Thornton Economics, an economic consultancy.  He writes: "I published the graph [above] in a recent essay titled "Why the Fed's Zero Interest Policy Has Failed" but the graph deserves special attention because of what it seems to imply going forward.  Household net worth as a percentage of disposable personal income increased dramatically in the mid-1990s.  Its collapse precipitated the 2000 recession.  It increased even more dramatically during the subsequent expansion, only to collapse again, precipitating the 2007-2009 recession. Once again, household net worth has increased dramatically.  Since the end of 2012, household net worth has increased by nearly 100 percentage points to 640% of disposable income.  This is scary; not just because it is an incredibly large rise in wealth in a short period of time, but because it happened twice before with very bad consequences."

In both prior cases the rise in household net worth, first driven by the NASDAQ bubble, and then later by the equally large - and equally unsustainable - rise in house prices.  Not surprisingly, household net worth and the NASDAQ both peaked in 2000Q1 and again household net worth peaked conterminously with the level of house prices in 2006Q4.

Dr. Thornton continues: "The relevant question is whether the 100% rise in household net worth sustainable, or will house and equity prices fall dramatically again?  The latter answer seems most likely.  One reason is that the behavior of household net worth has been unusual since the mid-1990s.  The graph below shows the level of household net worth over the period 1952Q1 to 2015Q4.   The graph also shows a quadratic trend line estimated over the period 1952Q1 to 1994Q4 and extrapolated to 2015Q4.  

During the entire period from 1952Q1 to 1994Q4, household net worth tracks the trend line very closely.  Since 1995Q1, however, household net worth has been consistently above the trend line and the gap has been getting progressively larger.  Such behavior would be a concern in any circumstance, but it is particularly troubling because we know that the previous two boom cycles were followed by busts.  The recent rise in household net worth has not been accompanied by a correspondingly large increase in output or the price level.  Hence it, too, does not appear to be supported by economic fundamentals- it appears to be unsustainable.”

In our humble opinion, Dr. Thornton is right. Real per capita GDP has risen by a trifling 1.3% annualized since the ‘recovery’ began in 2009. This result is less than half the 2.7% average expansion since records began in 1790 (never-before-seen…since Hamilton!). Real median household income has declined in the 2009-2016 expansion and is at the same level reached in 1996. Further confirming the slowdown in global trade shown in the earlier chart, real U.S. exports and imports both contracted 1.6% in the trailing 12 month period.

The Narrative is Broken:

How many things served us yesterday as articles of faith, which today are fables for us? – Michel de Montaigne, The Complete Essays (1580)

“The idea of negative interest rates strikes many people as odd. Economists are less put off by it. … The anxiety about negative interest rates seen recently in the media and in markets seems to me to be overdone. Logically, when short-term rates have been cut to zero, modestly negative rates seem a natural continuation; there is no clear discontinuity in the economic and financial effects of, say, a 0.1 percent interest rate and a -0.1 percent rate.” – Financial Blogger, Citadel Hedge Fund Adviser & Former Fed Chair Ben Bernanke, “What Tools Does the Fed Have Left?”, March 18, 2016

In The Twilight of Illusion, written over two years ago, we opined that the “narrative of the “omnipotent central banker” was coming to a close. So much for timing.

Yet the world seems more fraught today. Debt levels continue to climb, and along with them, asset prices.   Incomes stagnate, anxiety and conflicts proliferate. We wait and wait for the long-promised recovery to gain escape velocity.

It is painfully comedic to watch the world’s central bankers declare that they are not impotent. In their vainglorious attempt to prove that they are still in control they have unveiled negative interest rates. Over $13 Trillion (the amount has rapidly expanded in the past two weeks) of sovereign debt now has a negative yield. The full 50 years of the venerable Swiss yield curve is now underwater.

I keep handy a copy of Sidney Homer’s magisterial A History of Interest Rates (2nd Ed.; Wiley 1977). Homer notes that “[In] historical times, credit preceded the coining of money by over two thousand years. Coinage dates from the first millennium B.C.E., but old Sumerian documents, circa 3000 B.C.E. reveal a systematic use of credit based upon loans of grain by volume, etc.”

Thus, I have before me a 5000 year history of credit and interest rates and search as I might throughout this strikingly ample volume, I can find no instance of negative interest rates. In our January 2015 HBA blog post,  Our Prediction- Be Proud, You Are Making History, we suggested as much. But even we are humbled an event never-before-seen in a sample size that covers over five millennia.

Tying It All Together :  

“It seems fair to say that free market long-term rates of interest for any industrial nation, properly charged, provide a sort of fever chart of the economic and political health of that nation” - Sidney Homer

If Sidney Homer is right, and there is no reason to doubt that he is, what do the lowest interest rates in over 5 millennia mean for us going forward? Has the ‘fever’ of economic activity fallen so low that the body economic (and body politic) now suffers from hypothermia?

Most interestingly, interest rates are plumbing record lows while stocks ascend to record highs – this, too, (you guessed it!) is an event never-before-seen. Nor should these two conditions co-exist. Changes in interest rates are usually a very reliable economic indicator- as Sidney Homer attests above - forecasting future growth and inflation for a nation.   The recent plunge to all-time lows has even taken out the lows set during the Great Depression. Put another way, the bond market is “forecasting” abysmal prospects for the economy.

Yet, on the other hand, the stock market is bursting out to new highs. Valuations for the median stock are at levels never-before-seen. Thus the stock market is signaling that it is more euphoric about future growth than ever before. Which market will be proven correct?

It is true that central banks have, by their own admission, bid-up the prices in stocks and real estate to boost the economy through a (very questionable) wealth-effect. This they freely admit – yet the promised economic growth has gone missing. Certainly this has muddied the waters.

Yet central banks, from the Fed, to the ECB, BOJ and BOE are rapidly losing credibility. Considering that the equity/stock market sports such high valuations, and the fact that we are surely in the late phases of a bull market, there are three forms of defense that have historically performed: (a) US Treasuries, (b) cash, and (c) real assets & alternatives

Most clients of HBA are well represented in the first two categories.

In relation to the categories mentioned above; (a) Long-dated US Treasuries have increased in price between 18-24% in the first half of 2016. Given the (global) recessionary indications we see, we still feel that this trend will continue a while longer. Further, one can simply observe that no bonds carried a negative interest rate two short years agowhile now over $13 Trillion of sovereign bonds carry a negative handle. We are now at a point where the returns on long-term bonds have exceeded the returns on the S&P 500 over the 7, 10, 15 and 20 year period. This best illustrates the benefit of a long-term investment horizon.

Our favorite form of (b) “cash” at HBA has long been precious metals (gold/silver)- which blends well with (c), real assets. The gold price has appreciated by 24% in the first half of 2016, while the silver price has risen 22%. Mining shares, which we also hold in the form of the Tocqueville Gold Fund (TGLDX) are up 89.7% over this same period. It is true that these commodities suffered steep declines in 2013 and in the second half of 2015, but with negative rates and the prospect of cash bans looming (on which more later), it would seem that their greatest difficulties lie in the past. Savers continue to trust gold and silver over bank deposits –and central bank promises- in parts of the world where rates are negative.

While precious metals are close to our hearts in this environment, and are considered “real assets” we also feel that certain types of real-estate, infrastructure investments, some private equity and even intellectual/digital property (often referred to as “alternative assets”- assets that do not typically trade in public markets) meet this definition. Why real assets? Because while nothing is fully inoculated from the confiscatory demands of desperate central banks and illiberal government(s), real assets are more insulated from both than are publicly traded financial assets.

And while we would much rather own an asset that generates some sort of cash flow than one that yields nothing (i.e. gold), we have learned that price will usually (but not always) close the gap. However, for us the greatest potential benefit to be gained from the use of “alternatives” is to get as close as you can to a fractional ownership share in the asset itself - and as far away as you can from the “casino chip”- as well as the capricious manipulation of that chip’s value. 

One last note - volatility in markets has increased significantly, especially since 2014. To hedge this volatility there is another defensive category… (d), not mentioned above: long volatility.  We have recently chosen to invest in the Catalyst Macro Strategy Fund (MCXIX; early 2016).  That fund is down -11.5% so far this year.  Yet we still have confidence in the management of this fund and believe that maintaining a long-term mindset with regard to this investment will pay off for investors, just as it has with the previously-mentioned investments.

We have learned, often painfully, that we should never underestimate what global central banks are willing to try to support stock and real estate prices – which is anything, really. Whether running roughshod over democratic processes (remember the “Oxi” vote in Greece, June 2015?), buying junk assets far beyond what sober bank charters allow, pushing rates negative and proposing the banning of cash, the central banks will keep experimenting at our expense until we revolt due to unbearable income inequality.

We feel that the portfolios we manage have built up a robust defense against such predations. The early part of 2016 gives us confidence that this will continue to be the case.

Thank you all for your patient reading, investing, referrals and support. Please feel free to contact me at 626-529-8347 or by email at with any questions - or clarifications- you might wish to offer.