"The Nightmare Scenario" Revisited: Albert Edwards Lays Out The Next "Black Monday"

Is it the onset of a recession or the fear of a recession that causes a crash? That is what SocGen"s bear (or, as he calls himself this time, wolf) Albert Edwards contemplated on the 30th anniversary of Black Monday, before reaching the conclusion that it"s the latter. Having taken several weeks off from publishing his ill-named global strategy "weekly" report to meet with clients, Edwards finds that most clients "seem to harbour similar fears as I, namely that the QE-driven bubble will burst at some stage and lay low the global economy, just as it did in 2007." Yet where clients differ, is on the timing of said burst:

"despite my bearish (or is it wolfish) howling, virtually no clients think the denouement will come any time soon and that the equity bull market should have at least 12-18 months left to run. Most can see nothing on the immediate horizon that might burst this bubble."

So, doing his public service to boost the overall sense of dread, and perhaps fear, Albert takes it upon himself to reprise recent discussions with clients, and in his latest letter explains "what might catch them out in the near term." To do this, Edwards focuses first and foremost on the catalysts behind the abovementioned 1987 "Black Monday" crash.

A retrospective macro-narrative was inevitably wrapped around the ?Black Monday? 19 October 1987 equity market crash. My 30-year recollection is pretty good: 1987 saw a buoyant equity market rising briskly through most of the year as the oil price recovered from the previous year?s collapse (from $30 to $8, see chart below). After a year in the doldrums the US economy started to accelerate notably through 1987 as the impact of 1986 interest rate cuts and a lower dollar worked. By the time of the Oct crash the US ISM had surged from 50 at the start of the year to over 60 - a level seldom ever reached (see chart below). Amazingly the ISM has just last month exceeded 60.0 for only the second time since 1987. Spooky!

 

While one may disagree on the causes, Edwards makes one thing very clear: to hime it was all painfully memorable, and he recalls events from 30 years ago "as if it were yesterday (actually I can?t remember yesterday.)" And whether it was the fear of a recession, or something else, once the selling started, it wouldn"t stop until a fifth of market values were wiped out.

Of course the machines took over the selling in the form of Portfolio Insurance programmes, but speaking to my colleague Andrew Lapthorne, he reminds me we also have similarly pro-cyclical ?doomsday? vehicles today - with so much money being run by volatility targeting, risk parity and CTA/trend following quant funds. A fascinating article by stockmarket guru Robert Shiller in a NY Times article to mark the 30th anniversary of the crash, suggests that it was not the Portfolio Insurance that was responsible for the crash, as most official post-mortems suggested, but fear passed by word of mouth. Shiller thinks, in the internet age, there is even more scope for fear to spread like wildfire to set off a market crash - which would of course be limited to 20% in any one day due to circuit breaker rules.

Putting it together, Edwards concludes that "the trigger for the 1987 crash was the fear of US recession caused by the likelihood of US rate rises to stem a hypothetical dollar collapse."

I am clear in my mind both at the time and now, that the US equity market was priced for a continuation of rapid economic and profit growth and this was under threat. The Dow was on nose-bleed valuations, especially as it had ignored the bond sell-off for most of 1997 (was it really 30 years ago that US 10y yields briefly crawled back above 10% - the last time we would see double-digit yields). None of this would have mattered if the US equity market had been cheap. In my view the record 25% ‘Black Monday’ October 19 decline was due to a horrendously expensive equity market suddenly confronted with the fear of recession. Equity valuations matter.

Fast forward to today, when equity valuations matter again; in fact, as Goldman and virtually all other banks agree, company valuations have never been higher.  And yet nobody cares, at least none of Edwards" clients. He admits that at this moment, SocGen"s clients fear "very little it appears in the near term." Oh, everyone knows stocks are a bubble, but after nearly a decade of crying valuation bubble wolf, so to speak, with no effect whatsoever, "oe thing we hear consistently is that they are not interested in being told equity valuations are expensive. They have been for a while and that does not seem to stop the market going up!"

But, "valuation DOES eventually matter" Edwards writes, as it did 30 years ago, in 1987, when "in the immediate aftermath of the crash, the extreme expense of US equities certainly was clearly a major contributing factor."

So could 1987 happen again, and if so, what would be the catalyst that nobody can see?

The answer to the first, according to Edwards, is that "of course it could. It could happen tomorrow given the extreme expense of US equities and the near universal consensus of a continued acceleration in the economic cycle ? despite the Fed also in the midst of a tightening cycle.As the excellent David Rosenberg of Gluskin Sheff points out, of the13 post war Fed tightening cycles, 10 have ended in unexpected recession."

And, as observed above, one may not even an actual recession, just the fear of one, to start the next 20% plunge: "at these extremes of equity valuation it might not even be an actual recession that produces the next precipitous equity bear market, but the fear of a recession, however misguided that fear may or may not be."

* * *

And yet, as Edwards started off his letter, while "fears" may be pervasive, few clients (or traders, or analysts, or pundits) believe there is a catalyst for a quick and sudden reversal in the market"s nearly 9 year momentum is in the immediate future. But is that accurate?

"Is there anything out there that can cause a rapid change in market expectations of future economic growth? Not according to most investors we speak to. But let?s try and think of some things that we maybe need to watch out for."

Here, in addition to the latent overhang of overvaluation, one main concern is "the expectation, or more importantly the fear of more rapid Fed rate rises threatening the economic recovery might be one thing to watch out for." Yet while Janet Yellen"s replacement at the Fed will hardly seek to pursue tighter monetary policy, they may have no choice if the recent spike in averae hourly earnings proves to be long-lasting and widespread:

wage inflation has been the dog that didn?t bark this year - or indeed the wolf that didn?t howl. Wage inflation actually slowed this year against the expectations of some naysayer commentators (ie me) of an acceleration (and yes I do mean an acceleration rather than a rise). But it was notable that in the September payroll release, average hourly earnings jumped sharply to 2.9% - a high for this cycle (see chart below).

While many have explained the recent spike in inflation as being a transitory consequence of the two Hurricanes to slam the US this summer, "if for whatever reason it is not an aberration and the Phillips Curve is reasserting itself, similarly high wage inflation data in the months ahead could cause a rapid reappraisal of the pace of Fed rate hikes. At these high equity valuations, that could really scare investors."

Going back to what Deutsche Bank discussed two weeks ago, namely that the Fed is trapped in the 60 bps of space between the short and long end, Edwards writes that any expectation of faster rate hikes will impact the yield curve, which has already been flattening rapidly - a usual prelude to decelerating economic activity. Furthermore, "the dollar is likely to reverse the weakness we have seen since the start of this year, which was in large part a result of an unwinding of ultra long speculative dollar positioning against the euro (as suggested by the CFTC data)."

That has now completely reversed and speculators are very short the dollar. The catalyst for the resumption of the dollar?s rise may have been a sharp recent widening of the US 2y spreads with both Germany and Japan as investors embrace the near certainty of a December US rate hike, but this could go considerably further if investors actually begin to believe the Fed?s own forecasts of future interest rates (ie the Fed dots).

Which brings us to a topic Edwards discussed most recently at the end of August, namely the "Nightmare Scenario" for investors.

The nightmare scenario for equities would be if US wage inflation flickers back to life and investors not only decide that they are too far behind the Fed dots, but they also decide that the Fed itself is behind the tightening curve. In that scenario yields would jump sharply higher across the curve, but especially at the short end and the dollar would soar.

Ironically, as an aside, two weeks ago New River"s Eric Peters defined the "Nightmare Scenario" - from the perspective of the next Fed chair - as the opposite: a world in which inflation and wages do not rise, effectively boxing the central bank into continuing to inflate the biggest asset bubble ever leading to a historic crash. To this, we imagine Edwards" response would be that the crash - as is - would be devastating enough.

How to determine if the market is on the verge of said "nightmare scenario" looking at market indicators? "Two critical long-term trend-lines to watch: First our head of technical analysis, Stephanie Aymes, highlights that the breakout point for the 30y downtrend in the dollar against the yen is around Y123/$ (chart left below). Second, as 10y US yields ?smash? above the multi-month support of 2.4%, they can rise all the way to 3% and still be in a bull market (see below)."

Indeed, while many have pointed out the recent breakout in the 10Y above the critical - for the past 6 months - support level of 2.42%, a stronger dollar may be as much, if not more, of a negative factor.

The equity markets? rise this year has been fuelled by profits growth and the expectation of a continuation of the current [weak dollar] trend. Much of that rise in US profits is the direct result of the dollar’s weakness so far this year. Take a look at the two charts below, both comparing US and Japanese profits. On the left, we show forward earnings expectations (TOPIX and S&P500) while on the right we show whole economy profits measures. The key difference is that the stockmarket profits measures have considerably more exposure to overseas earnings and the currency as well as not including smaller and unquoted companies. Hence it is notable that Japanese whole economy profits have considerably outperformed Japanese stockmarket profits, while on the other hand it is startling how US whole economy profits have underperformed US stockmarket profits. I think it?s mainly down to dollar weakness this year.

It"s not just nosebleed valuations, rising rates, a spike in the dollar, however: Edwards also brings attention to the bubble in corporate credit markets, or as he puts it, "corporate debt will be the 2007-like vortex of debility in the next downturn. Even the moderate, reasonable, and usually well behind-the-curve, IMF suggests a staggering 20% of US corporates are at risk of default in the next economic downturn." More:

I certainly believe QE has also inflated US corporate debt prices way above what they otherwise should be. Indeed looking at the top left-hand chart, it is clear that typically, the corporate debt market would be in revolt by now in the face of the cyclical debauchment of corporate balance sheets. The fact that both yields and spreads are near all-time lows is, like over-extended equity valuations, a ticking time-bomb waiting to go off. (The chart on the left uses top-down corporate balance sheet data from the Federal Reserve Z1 Flow of Funds book. But the right-hand chart is stockmarket data from Datastream and shows a higher peak recently for quoted stocks, tying up closely with Andrew Lapthorne?s bottom-up analysis. )

There is one last catalyst: China.

Finally a word on China...which does not seem to concern clients at the moment. Incredible when you consider that a little over a year ago China was investors? number one concern. What changed was that the dollar?s weakness this year subdued jitters about renminbi devaluation and the plunge in Chinese reserves.... although on the surface the Chinese economy looks stable, increasingly volatile swings in credit policy are necessary to keep the show on the road ? most apparent in the boom and bust cycle in house prices (see left-hand chart below). A stronger dollar may necessitate another shift towards easy Chinese policy, including a weaker renminbi. That could cause trouble.

And, of course, the overarching factor behind all of the above is the Fedral Reserve. Which brings us to the conclusion:

So a reappraisal in the market?s expectations on the pace of Fed rate hikes, perhaps because of higher than expected wage inflation data, would likely trigger both a rise in yields along the length of a flattening curve and a resumption in the dollar bull market. When the equity market is ridiculously expensive and priced for profits perfection, these events (or indeed as in 1987, the FEAR of these events) could prove catastrophic for QE inflated equity markets.

Which, for those who have followed Edwards" warnings, is in line with his long-running narrative, and which - one day - will prove prescient. For now, however, just do what the algos do and BTFD.

Breaking Down The Bull Market Thesis

Authored by Lance Roberts via RealInvestmentAdvice.com,

Stocks Rise Following Breakout

In last week’s missive “Bulls Run On Yellen’s Easy Money,” I addressed the breakout and why we increased equity exposure modestly in portfolios.

“However, this changed this past week as Yellen uttered the two magic words: ‘EASY MONEY.’

Okay, it wasn’t exactly two words. It was actually:

‘Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.’

In other words, by saying that interest rates would not have to rise much further, the markets translated that to ‘lower interest rates for longer,’ confirming the Federal Reserve will remain “highly accommodative” to the markets so, therefore, ‘buy stocks.’

And with that, the robots leaped into action pushing markets OUT of the month-and-a-half long trading range of just 1.5%. This push to new highs, as noted above, also triggered a short-term ‘buy signal,’ at the bottom of the chart, which suggests this rally should continue higher over the next week, or so, heading into the month of August.” 

“With the break above 2452 on Friday, assuming it will hold above that level into next week, it will provide an opportunity to increase short-term equity allocations in portfolios. However, be mindful, this is VERY short-term in nature and could be quickly reversed – so manage your risk accordingly.”

As stated, this analysis is VERY short-term in nature. Price trends are currently positive which keeps portfolios long-biased for the time being. However, while our portfolios are “bullishly” positioned for the short-term, we remain much more pessimistic about the longer-term return dynamics.

I want to spend the rest of this weekend’s missive analyzing the ongoing bull thesis that has been pushed out by the media recently.

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Analyzing The Bull Thesis

Michael Santoli via CNBC

“Exactly a decade ago, it was time for investors to start worrying, even as stocks sat at record highs and the signs of onrushing danger were far from obvious.”

I am not so sure that warning signs weren’t obvious. Starting in mid-2007, the market began to struggle to make gains and initial “sell signals” were given as internal measures began to deteriorate.

Furthermore, as shown in the chart below, the “financial crisis” was not a sudden event. Had investors been paying attention to the market, rather than listening to the advice of “buying the dips” or Fed Chairmen declaring “subprime is contained” and “it’s a Goldilocks economy,” there were three separate opportunities to step aside BEFORE the Lehman event ever occurred.  

Yet, in 2007, much like today, individuals were being told to disregard much of the same evidence that existed then as they are today. Let’s take a look at a few of the arguments being made currently.

Earnings Growth Is Driving The Markets

The bulls currently have the “wind at their backs” as the continued “hope” the Trump administration will foster an age of deregulation, infrastructure spending and tax cuts which will boost corporate earnings in the future. Shortly after the election in 2016, Jack Bouroudjian via CNBC wrote:

“Let’s be clear, this market run up to the 20K level has a much more solid foundation for valuation. We are not looking at a P/E which has been stretched beyond historical norms as was the case in 1999, nor are we looking at a dot com bubble ready to implode. On the contrary, between digestible valuations and the prospects of real pro-growth policies, we have the foundation for a run up in equities over the course of the next few years which could leave 20K in the dust.”

The problem is 9-months later there has been no advancement on that legislative agenda while the markets have surged more than 18% since the election. As I discussed previously, the market has already priced in the expected earnings growth from the “promised” Trump agenda which puts the market in danger of disappointment.

“Given that stocks have surged based on ‘hopes’ of deeper tax cuts, a tax cut only roughly half of previous estimates certainly puts valuations at risk. Once again, the market has already priced in earnings growth through 2018, making disappointment a much higher probability.”

“Considering that forward estimates are generally overstated by 33% on average, the risk is high of disappointment.  As shown below, there was a $10 difference between what earnings were expected to be in 2017 at the beginning of 2016 and today. Furthermore, forward earnings have only risen by $4.15/share for the end of 2018. Yet, as shown, above prices have more than priced in that future growth.“

However, as Dr. Lacy Hunt recently discussed, this may not be the case.

“Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for Presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57.0%, respectively, when the 1981 and 2002 tax laws were implemented. Additionally, tax reductions work slowly, with only 50% of the impact registering within a year and a half after the tax changes are enacted. Thus, while the economy is waiting for increased revenues from faster growth from the tax cuts, surging federal debt is likely to continue to drive U.S. aggregate indebtedness higher, further restraining economic growth.

However, if the household and corporate tax reductions and infrastructure tax credits proposed are not financed by other budget offsets, history suggests they will be met with little or no success. The test case is Japan. In implementing tax cuts and massive infrastructure spending, Japanese government debt exploded from 68.9% of GDP in 1997 to 198.0% in the third quarter of 2016. Over that period nominal GDP in Japan has remained roughly unchanged. Additionally, when Japan began these debt experiments, the global economy was far stronger than it is currently, thus Japan was supported by external conditions to a far greater degree than the U.S. would be in present circumstances.”

With analysts once again hoping for a “hockey stick” recovery in earnings in the months ahead, it is worth noting this has always been the case. Currently, there are few, if any, Wall Street analysts expecting a recession at any point the future. Unfortunately, it is just a function of time until the recession occurs and earnings fall in tandem.

Valuations

Another argument often used to support the “bullish” meme is that valuations aren’t as high as they were in 2000. While that is true, there is a vase fundamental difference between now and then. In 2000, as valuations surged toward 42x CAPE earnings, there were MANY technology companies with negative earnings which skewed the valuation measure. Most of the companies are now gone, or the ones that survived finally begin generating earnings.

While valuations are NOT a good market timing indicator, and are not predictive of the end of a bull market advance, by all historical measures, they are expensive. Most importantly, while high valuations certainly aren’t predictive of bear market onsets, they are HIGHLY predictive of very low returns in the future. 

One of the other arguments to justify higher valuations has been that interest rates are so low. Okay, let’s take the smoothed P/E ratio (CAPE-10 above) and compare it to the 10-year average of interest rates going back to 1900.

Importantly, the statement of “lower future returns” is very misunderstood. Based on current valuations the future return of the market over the next decade will be in the neighborhood of 2%. This DOES NOT mean the average return of the market each year will be 2% but rather a volatile series of returns (such as 5%, 6%, 8%, -20%, 15%, 10%, 8%,6%,-20%) which equate to an average of 2%.

Sentiment Is Bullish

Of course, as discussed previously, investor behavior makes forward long-term returns even worse.

The bulls have continually argued the “retail” investor is going to jump into the markets at any moment which, with all the “cash on the sidelines,” will keep the bull market alive. The chart below suggests they are already in. At 30% of total assets, households are committed to the markets at levels only seen near peaks of markets in 1968, 2000, and 2007.  I don’t really need to tell you what happened next.

Furthermore, as I have discussed repeatedly in the past, there is NO “cash on the sidelines” to begin with. To wit:

“Every transaction in the market requires both a buyer and a seller with the only differentiating factor being at what PRICE the transaction occurs. Since this must be the case for there to be equilibrium to the markets there can be no ‘sidelines.’

Furthermore, despite this very salient point, a look at the stock-to-cash ratios also suggest there is very little available buying power for investors current.”

There is no cash on the sidelines.

Furthermore, the dearth of “bears” is a significant problem. With virtually everyone on the “buy” side of the market, there will be few people to eventually “sell to.” The hidden danger is with much of the daily trading volume run by computerized trading, a surge in selling could exacerbate price declines as computers “run wild” looking for vacant buyers.

This thought dovetails into the “hyperextension” of the market currently. Since price is a reflection of investor sentiment, it is not surprising the recent surge in confidence is reflected by a symbiotic surge in asset prices.

The chart below shows the deviation above the 3-year moving average. Importantly, at the peak of the previous two bull markets, the deviation never pushed into the 3-standard deviation range as it is currently. This suggests there is VERY little room left to the upside before some corrective action occurs.

The problem, as always, is sharp deviations from the long-term moving average always “reverts to the mean” at some point. The only questions are “when” and “by how much?”

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Managing Past The Noise

There are obviously many more arguments for both camps depending on your personal bias. But there is the rub. YOUR personal bias may be leading you astray as “cognitive biases” impair investor returns over time.

“Confirmation bias, also called my side bias, is the tendency to search for, interpret, and remember information in a way that confirms one’s preconceptions or working hypotheses. It is a systematic error of inductive reasoning.”

Therefore, it is important to consider both sides of the current debate in order to make logical, rather than emotional, decisions about current portfolio allocations and risk management.

Currently, the “bulls” are still well in control of the markets which means keeping portfolios tilted towards equity exposure.  However, as David Rosenberg recently penned, the markets may be set up for disappointment. To wit:

“So we have a sluggish U.S. economy on our hands with growth revisions to the downside. We have a situation where some investors see the softness enduring long enough that Fed funds futures are now pricing in less than 50-50 odds that Yellen et al make another rate move by year-end. Yet the Fed is signaling that it will begin to shrink the balance sheet by the fourth quarter, with no economic liftoff.

The political backdrop is rife with gridlock — unbelievably, there is still hope among investors that tax reform is coming by 2018. At the same time, evidence is mounting that the Dems have a serious shot of taking the House next year. We have a White House that, with the help of inside leaks and the media, continues to find itself embroiled in controversies. And health care reform, which was always pledged to be the first item to be done, is looking more and more like a pipe dream. When hasn’t governing been complicated? It took the Gipper five years and endless bottles of scotch with Tip to get tax reform legislated in 1986!

We have heightened geopolitical risks from North Korea and China has instructed the U.S. that it will not be pressured to invoke sanctions against its unstable satellite.

We have a central bank chief who looks to be a lame duck…a recent WSJ survey found that economists only peg her odds of staying on past February 2018 at 20.8%. Just more uncertainty to deal with.”

Currently, there is much “hope” things will “change” for the better. The problem facing President Trump, is an aging economic cycle, $20+ trillion in debt, an almost $700 billion deficit, unemployment below 5%, jobless claims at historical lows, and a tightening of monetary policy and 80% of households heavily leveraged with little free cash flow. Combined, these issues alone will likely offset most of the positive effects of tax cuts and deregulations.

Furthermore, while “bearish” concerns are often dismissed when markets are rising, it does not mean they aren’t valid. Unfortunately, by the time the “herd” is alerted to a shift in overall sentiment, the stampede for the exits will already be well underway. 

Importantly, when discussing the “bull/bear” case it is worth remembering that the financial markets only make “record new highs” roughly 5% of the time. In other words, most investors spend a bulk of their time making up lost ground.

The process of “getting back to even” is not an investment strategy that will work over the long term. This is why there are basic investment rules all great investors follow:

1. Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.


2. Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.


3. Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

These rules are hard to follow because:

1. The bulk of financial advice only tells you to “buy”


2. The vast majority of analysts ratings are “buy”


3. And Wall Street needs you to “buy” so they have someone to sell their products to.

With everyone telling you to “buy” it is easy to understand why individuals have a such a difficult and poor track record of managing their money.

Trying to predict the markets is quite pointless. The risk for investors is “willful blindness” that builds when complacency reaches extremes. It is worth remembering that the bullish mantra we hear today is much the same as it was in both 1999 and 2007.

Again, I don’t need to remind you what happened next.

David Rosenberg: "This Is A Bubble Of Historic Proportions"

Shortly after we remarked most recently on the unprecedented Canadian housing bubble that has migrated from Vancouver to Toronto, Gluskin Sheff"s Chief Economist David Rosenberg joined the growing chorus of calls for government intervention into the Toronto housing market. In an interview on BNN, Rosenberg, who correctly called the U.S. housing bubble in 2005 when still at Merrill Lynch, said the massive deviation from historical norms has him drawing comparisons between the two situations.

“This bubble is on par with what we had in the States back in ’05, ’06, ’07,” he said. “We have to actually take a look at the situation. The housing market here is in a classic price bubble. If you don’t acknowledge that, you have your head in the sand.”

Rosenberg warned unchecked increases in home prices are becoming a social issue. “It’s not an equity, it’s not a bond -- it’s where people live,” he said. “Where home prices are in Toronto, they absorb 13 years of average family income. That is completely abnormal. We’ve never seen this before.”

“We’re out of equilibrium, and when we’re out of equilibrium, or there’s some sort of market failure, are there grounds there for government intervention? I think even the most ardent libertarian would say ‘yes"." Rosenberg said there are a trio of levers the government can pull to cool down the market. Authorities can address supply, which he said has already been “kiboshed.” Interest rates can be raised, but Rosenberg doesn’t believe the Bank of Canada will do that.  Or new policy can be drafted to address the prevalence of speculation.

“These are not prices driven by the local fundamentals -- this is the foreign buyer coming in,” Rosenberg said. “Toronto has really emerged as a first-class city, not just politically, not just culturally and economically, but also in terms of being a major financial centre. But if you’re going to ask me at this stage, ‘do we need to approach taxation of this capital coming in differently to curb the demand?’ [That’s] absolutely right.”

And just to make his position clear, Rosenberg also an op-ed in Canada"s Financial Post on the topic, titled simply enough:

"Make no mistake, the Toronto real estate market is in a bubble of historic proportions"

by David Rosenberg

The concerns about froth in Toronto’s housing market are not likely to subside given the sticker-shock from the latest report from the Toronto Real Estate Board.

As per the March report, the average single-detached house in the Greater Toronto Area (GTA) sold for $1,214,422 last month up from $910,375 in March of last year — that is a 33 per cent YoY surge, and follows a 16 per cent run-up over the prior 12 months.

Whatever the term is for an acceleration in an already parabolic curve, well, that is what we have on our hands today.

And it isn’t just detached homes seeing this degree of rapid price appreciation — the benchmark single-family home selling price was up 29 per cent YoY, the benchmark townhouse price was up 28 per cent and the condo/apartment composite was up 24 per cent.

This is a bubble of historic proportions.

Not only to have home prices in the GTA now absorb an unprecedented 13 years of median family income, but to have 30 per-cent-ish run-ups against a backdrop of a 2 per cent inflation rate, wages that are barely going up 2 per cent as well, and nominal GDP growth of around 4 per cent. This should put 30 per cent into some sort of perspective when we conclude that what we have on our hands is a near three standard deviation event.

That alone qualifies as a bubble — if you don’t like that term, then call it a giant sud. In the past, Toronto home prices went up at an annual rate of 4 per cent in real terms, in the past year they have surged by nearly 30 per cent.

Some context, however, is needed here.

First, this aggressive increase in home prices in Canada’s most populous city has come (at least in part) due to strong competition among potential buyers for comparatively scant homes for sale.

Active listings of homes available for sale in Toronto plunged 35.2 per cent YoY in March, which means that the months’ supply of houses on the market is a miniscule 0.65, down from 1.18 last March — for reference, a “balanced market” sees a months’ supply figure around 6.0. The average home that was put up for sale remained on the market for just 10 days, down from 16 days a year ago.

These measures of “tightness” in the market are without precedent — not even the red-hot late-1980s bubble experience could ever compete with today’s backdrop.

As well, the sales-to-new listings ratio sits well into “sellers’ market” territory at 70.8 per cent, which compares to 69.4 per cent a year ago — a ratio between 40 per cent and 60 per cent is considered indicative of a “balanced market.”

No wonder nobody wants to list their home! It’s become such a valuable asset.

But you see, this is where the danger comes in: when people start to view their house as some investment as opposed to a home — a place to raise the kids and play with them in the backyard.

A house is an asset indeed, but should never be compared to a stock or a bond or even other investable properties. It is a place to live.

Unlike a stock, which you can sell anytime and tuck away the winnings, if you sell your house, well, you still need a roof over your head. A stock with a dividend gives you an income stream, as does a fixed-income instrument. Unless you are a landlord, your house is burning cash (utilities, property taxes, maintenance), not bringing in cash.   

So there are indeed some supply and demand fundamentals that are underpinning prices. Insofar as the demand is rising because people think they are investing in something hot just because of the accelerating momentum, well, these people are going to end up being pretty big losers. For if the government catches a whiff that it is now speculative fever that is dominating the uber-hot housing market, well that could very well elicit a response (as in capital gains taxes for those who sell within a year or two).

At some point, a correction would be very healthy because on the other side, owners of homes will then realize that no, they did not win some lottery, and will finally be willing to start listing their property, especially those who deep down want to sell (it could well be that the move-up buyers would like to sell but can’t afford that mansion of their dreams).

Not to mention first-time buyers who do not have the income for a down payment that any lender would consider appropriate. After all, we have hit the bizarre stage where a typical home now (and we are talking about a bungalow in Pape Village, not exactly an estate on Warren Road) would absorb 13 years of median household income.

Not even in the late 1980s, did housing get this expensive on this basis, and we know all too well how the Bank of Canada ultimately reacted and what happened next. Stephen Poloz is definitely no John Crow — though things can always change.     

One caveat should be noted because what is different this time around (oh, how I hate using that phrase) is that Toronto has emerged as a world-class city and the foreign buyer is clearly having an impact.

So while Toronto residential real estate is indeed expensive for the locals, it is far less so for foreign investors, especially for Americans who can buy Canadian assets at a 25 per cent discount from a currency perspective.

In the mid to late 1980s, Toronto did not have the Rogers Center. It did not have the Raptors. It had no decent hotel outside of the Four Seasons and the Windsor Arms. Truly great restaurants were not to be found (unless you want to count Winston’s!). There was no Drake. And Toronto FC was not in existence. Not to mention there was very little in the way of a theater district.

While the separatist threat in Quebec gave Toronto the mantle of being Canada’s financial center back in 1976, the city was never seriously viewed as a global player in this respect until very recently. With more than 250,000 employed in the financial services sector, Toronto has very quietly emerged as the second largest financial hub in North America (after New York). Of the 84 cities surveyed in the 2015 Global Financial Centres Index, Toronto ranked 8th!

So while prices may seem a little nutty, it is important to note that Toronto is a major financial, economic and cultural centre, and when compared to its peers globally, prices appear far less crazy, too.

This doesn’t make the current price action justified based on local income fundamentals, but based on the foreign incomes of those wanting to establish a toehold in a stable Toronto amidst a sea of global instability, the prices are not that much out of whack.

As per data compiled by Global Property Guide, Toronto home prices on a U.S. dollar per square metre basis rank just 14th in the world, well behind the likes of London, New York, Paris and Tokyo.

And at the same time, if you are a family in say, Brooklyn Heights looking to buy property in Toronto it would only absorb six years of income; and if you reside in Santa Monica and feel like dipping your toes in the Toronto real estate market, it would only take up four years of your annual median take-home pay. The same (four years) holds true for those wealthy enough to be living in Knightsbridge.

You see, when Toronto home prices are measured against incomes in other places of the world, it is not nearly as onerous (especially in Canadian dollar terms).

In other words, many well-heeled foreigners can far better afford what the locals can’t afford here, and housing in recent years has truly become in internationally-traded asset class (though I wouldn’t recommend ripping out the foundation and exporting the structure anywhere).

So it goes without saying that if the name of the game is to tame the flame then have the foreign investor share the blame. A tax on foreign transactions, as was already done in Vancouver, seems like a pretty good idea. And the government can at the very least use the revenues to either provide greater tax incentives to build and/or provide tax relief for the low/mid income entry-level buyer who is struggling to cobble together the funds for a down payment.

So yes, in this sense, I would be advocating a Robin Hood style of economic policy.

Indeed, what may be needed is a very progressive tax on foreign buying of local residential real estate in the bid to cool demand and reverse the exponential surge in home prices — a surge that is creating tremendous social problems by crowding out young families (or individuals) from chasing the homeownership dream (a typical response is for these folks is to go out and buy a condo instead, but the reality is that average prices here have also skyrocketed 24 per cent in the past year and are in a bubble of their own).

Everyone says that the Bank of Canada cannot raise interest rates to curb the excess demand because of the deleterious effect this would have on the economy writ large (for example, taking the Canadian dollar back up to or above 80 cents which would thwart our export competitiveness which has become a longstanding role of the central bank).

Be that as it may, the home price surge in the GTA over the past year has impaired homeowner affordability to such an extent that it is basically the equivalent of the Bank of Canada having raised rates 150 basis points — actually a 200 basis point increase if you were to look at what home prices have done to affordability ratios over the past two years (so you can’t have it both ways; the price action is basically equivalent to having five-year mortgage rates closer to 5.75 per cent than the actual posted rate of 3.75 per cent).

Barring a bold move by the government to bring home prices to levels consistent with domestic economic fundamentals as opposed to income levels from well-heeled buyers from the U.S., China, and Europe, maybe it is time for the Bank of Canada to start playing a role and follow the Fed on a gradual rising interest rate path.

It's 1994 Again: Why Albert Edwards Expects An Imminent "Bond Market Bloodbath"

Following the Trump presidential victory, two prominent macro strategists have undergone a significant change in their outlook: while David Rosenberg, who started off with a deflationary, and bearish outlook, then flipped to inflationary (and bullish), has recently once more "mean-reverted" and expects a further drop in yields as deflationary forces return, his SocGen peer, Albert Edwards - while still expecting a deflationary "ice age" in the longer-run (in case there is any confusion, he expressly states "make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over") now expects an imminent "bond rout" in the coming weeks as the Fed"s rate hike cycle leads to an aggressive selloff in short- as well as long-term rates. The result will be another "central bank-inspired recession", which will lead to the convergence of yields on the 10Y US Treasury with Japanese and European bonds below zero, as the global deflationary ice age enters the final round.

Edwards" summary of his current state of mind, just as the Fed is about to make (yet another) historic mistake, is - as usual - rather picturesque:

Make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over. I believe the US Fed has created another massive credit bubble that will, when it bursts, lay the global economy very low indeed. Combine this with the problems of a Chinese economy dependent on increasingly ineffective injections of credit to produce increasingly pedestrian GDP growth and you have a right global mess. The 2007/8 Global Financial Crisis will look like a soft-landing when the Fed blows this sucker sky high. The seeds for that debacle have already been sown with the Fed having presided over one of the biggest corporate credit bubbles in US history. All that is needed now is for the Fed to sprinkle life-giving rate hikes onto these, as yet dormant, seeds of destruction. Accelerated Fed rate hikes will cause tremors in the Treasury bond markets, forcing rates up, most especially in the 2 year – just like 1994. But as yet another central bank-inspired global recession unfolds, I  believe US 10y bond yields will ultimately converge with Japanese and European yields well below zero – in other words, buy 10y bonds on weakness!

And speaking of 1994, and the reason why Edwards is confident that despite the market "pricing in" the Fed"s upcoming rate hikes, nobody has any clue what is about to be unleashed, the SocGen strategist reminds his clients of the Orange County "havoc" unleashed with the 1994 rate hike cycles.

For those few of us in the markets of a certain age, Orange County conjures up only one thing: 1994 goes down in infamy as one of the biggest ever bond market bloodbaths in history culminating at the end of the year with Orange County in California going bankrupt (younger clients in their late 20s will only know the OC as the mid-2000s teen programme based in Newport Beach, which I watched religiously with my then teenage son and daughter).

I remember the 1994 period as if it were yesterday (unlike yesterday itself). Despite the Fed telegraphing the series of rate hikes and market participants forecasting multiple hikes, it was most curious how the market went into total convulsion. I was chatting to my ?similarly young? colleague Kit Juckes about this and he reminded me that the whole yield curve gapped up some 50bp immediately! It was a bloodbath, especially for 2y paper.

For the benefit of readers who may have missed this particular episode in bond market history, Edwards here are some more details of how the 1993/1995 rate hike cycle flowed through to the bond market, and then promptly resulted in an inverted curve.

You really had to be there at the end of 1993 to understand just how widely expected the 4 February 25bp Fed rate hike was. I was at Kleinwort Benson back then and I remember articulating that rates could rise somewhat more than the market expected on our December 1993 macro European tour. There was no real pushback. I have managed to lose my Global Strategy Weekly files from that time to see exactly what I was saying then, but I have my yellowing press cuttings file! From the FT on 8 Feb 1994 I find this, “on Thursday (the day before the Fed’s first hike), Mr Albert Edwards of Kleinwort Benson  wrote: In the US, Alan Greenspan could not have been clearer. He regards 3% as an excessively low rate which has served its purpose to eliminate the banking crisis and alleviate the credit crunch. The Fed does not care what headline inflation is, rates are heading higher. The risk is that the markets do not view a ¼% rate increase in isolation but the first in a series of tightenings, which it will be”. I was not alone in that view. It was quite common on the sell-side. What though we could not anticipate was quite how savage the bond sell-off would be.

Additionally, Edwards also shares two articles from that year, first from Fortune entitled “The Great Bond Massacre of 1994” see link, and also from December, when The New York Times analysed events surrounding the most high profile casualty of that year, namely Orange County, link. In a word the problem was leverage.

Fortune Magazine wrote in 1994, “Just as in the U.S., European bond investors were operating on lots of leverage. That made them just as vulnerable when the margin calls started to come. The result: "You had a snowballing liquidation completely out of proportion to the (economic) fundamentals," says Gilbert de Botton, chairman of Global Asset Management in London. "Both the U.S. and Europe had been overexploited by investors on margin."

“Back in New York, the report of extremely strong 6.3% real growth in the fourth quarter of last year, combined with Greenspan"s well-publicized fears about incipient inflation, struck new fear into bondholders. The Clinton Administration didn"t help matters. "The saber rattling over Japanese trade hurt a lot," says de Botton. "(U.S. Trade Representative) Mickey Kantor"s allusions to the effect that the U.S. was not in favor of a strong dollar was an indirect source of forced selling (of U.S. bonds) by European investors." Fearing currency losses and declining bond values, foreign holders of U.S. bonds began to pull out.

“Given all the leverage in the market, it shouldn"t have been surprising that long rates moved up sharply when the Fed finally began boosting short-term rates. Indeed, some members of the Open Market Committee voiced fears at the February 4 meeting that even a small increase in the Federal Funds rate could rattle the bond market. Rattle it did. The initial rise in long rates brought forth a flood of margin calls. Rather than put up more money, which many of them didn"t have anyway, speculators liquidated their holdings. With individuals bailing out of bond mutual funds as well, and little or no new money  coming into the market, bond prices had nowhere to go but down."

Edwards" rhetorical question, here: "Does that snippet not sound eerily reminiscent of current events?"

He also points out that while the Fed has so far hiked rates twice in the current tightening cycle, "these have become such isolated hikes that the market (Fed Fund futures strip) has lost confidence that the Fed will ever deliver their promises as represented by the Fed dots." With next week"s rate hike, however, all this will change.

There is another key similarity between 2017 and 1994:

The top chart shows that back in 1994, just before the Feb 4 rate hike, 2y yields were trading some 100bp above Fed funds. That one 25bp rate hike prompted the 2y-Fed Funds spread to soar from 100bp to 250bp within the space of three months while the 10y-2y curve flattened rapidly, destroying carry-trade bets along the curve. The key similarity with 1994 is that currently US 2y yields at 1.35% still trade tightly to the current Fed Funds rate of 0.75% (see left-hand chart below). If the market really takes on board Janet Yellen?s much more aggressive rhetoric, then we could easily see 2y yields rise towards the 10y as we did in 1994. If that happens and the US 2y spread with German and Japan continues to soar (see righthand chart below), this will be like rocket fuel strengthening the US dollar

Finally, while Edwards is hardly a technician, he provides two charts to substantiate his claim that a historic bond rout may be imminent: while the right-hand chart shows that US yields have now broken out and are heading to 2.65% and then 2.85% in the short term, it is the left-hand chart that is most interesting, "showing that US 10y yields can rise all the way to 3¼% and beyond and the secular Ice Age bull market in government bonds would still be intact."

Edward"s conculsion: "In 1994, it was excess leverage that broke the market, culminating in December 1994?s bankruptcy of Orange Country and also the Mexican Peso crisis in that same month (due to dollar strength). I?m going to look harder for my 1994 Global Strategy Weekly file, for despite remaining a secular bond bull, I think we are in for a rough ride - especially with equity markets at record highs."

The S&P Has Now Gone 36 Days Without A 1% Intraday Move: The Longest Streak In History

Heading into Monday"s session, the S&P had gone for 34 consecutive trading sessions in which it hadn"t experienced an intraday move greater than 1%: according to the WSJ"s Market Data Group, this was the longest such streak going back over two decades, to 1995. And, following the Monday close, the market made history when it ended yet another day by being confined to a 1% trading range. This made it 35 consecutive sessions without an intraday move of 1% or more. With Tuesday"s somnolent market action and virtually unchanged close, the streak extended to 36 consecutive sessions - the longest streak in history.

For those who have followed the market, the boredom - at least on the surface - is palpable, despite what RBC pointed out last week when it said that "it is CRAZY what is going on “under the hood,” when on the index level, it’s so optically calm.” However, with most market watchers looking simplistically at aggregate level data, the S&P gives a sense of calm that is at odds with the recently documented surge in political uncertainty. 

The recent calm is a sharp contrast with what was taking place in the market just a year ago: on this week in 2016, oil was $26/bbl, the HY spread was 900bps, the S&P was 1810, EPS was negative, inflation expectations were 1%, VIX 30. Today, oil is $54/bbl, the HY spread 400bps, and the S&P is just shy of 2300, EPS positive, inflation expectations are 2%, and VIX 11.

Some observations: the average daily range between a session’s intraday high and low over that stretch, dating back to Dec. 14, is just 0.54%, according to FactSet. That compares to the S&P 500?s average daily trading range in 2016, which was 0.96%.

As the WSJ further notes, despite the lack of sharp moves, the stock market has mostly been levitating higher "even though the daily moves have been soporific." Since the streak began in December, the index has climbed just 1% in total, but it’s still managed to set a new all-time highs along the way, most recently this week. Still, uncertainty about the future of Trump administration policies have worked in concert with record high valuations and the wait-and-see approach on the part of the Federal Reserve about when next to raise interest rates to hold stocks in check.

“The market is bobbing and weaving around new highs,” wrote David Rosenberg, chief economist, and strategist at Gluskin Sheff.

That’s a sharp contrast to how the S&P behaved just three months ago, in the immediate aftermath of the surprise victory of President Donald Trump on Nov. 8, when the S&P 500 shot up 6.2% from Election Day to Dec. 13, just over a month later.

Furthermore, the absence of a one-day move in the S&P 500 is consistent with other readings of ultra-low volatility. The historical volatility of the SPY ETF, a measure of how volatile that S&P 500 has been over two months, sits at 6.5, the lowest in at least two years, according to CBOE Livevol. Ninety-day historical volatility is barely higher at 8.1, also the lowest in two years.

Expectations for future prices swings in the S&P 500 over the next 30 days are scarcely higher. The VIX has been depressed to near record lows since the election. The VIX is currently at 11.3, well below its long-term average near 20.

Still, the doldrums may be ending soon. As Jason Goepfert at SentimenTrader, quoted by Art Cashin, notes the market is showing little enthusiasm to the upside despite the record highs in the S&P:

Negative momentum is picking up under the surface. Even as the major stock indexes hit all-time highs, or were close to them on Friday, stocks in the S&P 1500 index weren"t showing as much enthusiasm. Gauged by the Relative Strength Index, an abnormally low number of stocks have seen extreme positive momentum, and a rising number are seeing extreme negative momentum.

Indecision after a buying thrust. Friday"s surge at the open left an unfilled gap, as prices never neared Thursday"s closing price during the day. Then on Monday, traders showed indecision with an inside day, a lower high and higher low than Friday"s session. That has led to subpar returns, even during this bull market.

Ultimately it will be up to traders to force a break out to a new trading range, and since they have been unable to do so for nearly two months to the upside, perhaps it is time to revisit what a market drop actually means.

David Rosenberg Crushes The Trump-flationary Dream: "That's Just Not Gonna Happen"

"It seems to me like a lot of people think we"re in a new inflationary boom," but, warns Gluskin-Sheffs David Rosenberg, "the answer is no... that"s just not gonna happen. It"s not like Ronald Reagan at all in that regard."

Full podcast:

Submitted by Patrick Ceresna via Macrovoices.com,

• This time around, not only are valuations at 15-year highs but we"re entering it into the eighth year of the expansion of the bull market. You have to respect where were you are in the market cycle in the business expansion and we"re much more mature now than we were in that early stage of Reagan or you can argue the early stage of Bill Clinton or Barrack Obama. I mean the benefit of being elected at the bottom of the cycle, then you can just ride it up and just take credit for it. I think that the challenge for Donald Trump with all deference to the animal spirit rally they were seeing right now is that the multiples are really stretched and that maybe if were not even in the ninth inning of the game here, we"re certainly somewhere in or around the seventh inning stretch. So, the answer is no. It"s not like Ronald Reagan at all in that regard.


• So basically, I"m supposed to take it at face value because the markets are telling me that this is their view today, and their view today might not be the market"s view 3, 6, 12 months from now or 5 years from now. But the market"s telling me that one man, President Trump is gonna be able to, with fiscal policy, will be able to do what Bernanke and Yellen and Draghi and Trichet and Koroda and Carney, who actually run the printing presses, what they couldn"t do in the past 8 years a president"s gonna be willing to do, or be able to do, on inflation? And the answer is no. That"s just not gonna happen.


• What did inflation do during this supply side Reagan era? Went from 12 percent to down below 5 percent over his 8-year term? Why anybody thinks that Trump"s policies themselves are gonna create inflation, I can"t build an inflation view out of that.

Excerpts of the full interview:

Erik:       Is it just me? I mean everybody"s talking about the analogy to Trump is the new Ronald Reagan and I can"t help but think wait a minute, first 2 years of Reagan"s presidency was a massive bear market and recession. Am I missing something here Dave?

Dave:    Well, you know the other thing, I don"t think you"re missing anything, no. I mean the Reagan presidency is well you know, and it goes to show in those first 2 years after the honeymoon period when the market is down 25%, that really basis-point-for-basis-point, what matters you know for the market is the shift in the market multiple as oppose to earnings growth and the Fed certainly showed its hands. Volcker raised, and we had the recession starting 6 months after Reagan got elected. People looked benevolently of course and the entire Reagan regime entire 8 years and a lot of that wasn"t just his pro-business stance but also the fact that the FED continued to cut interest rates that reinforced the expansion of the market multiple. But I remember that the starting point in 1982 for the bull market was a multiple that was 8, you know, not the 17 on forward and almost 20 on trailing and that point the onset of the bull market occurred in 1982 after a huge recession.

This time around, not only are valuations at 15-year highs but we"re entering it into the eighth year of the expansion of the bull market. You have to respect where were you are in the market cycle in the business expansion and we"re much more mature now than we were in that early stage of Reagan or you can argue the early stage of Bill Clinton or Barrack Obama. I mean the benefit of being elected at the bottom of the cycle, then you can just ride it up and just take credit for it. I think that the challenge for Donald Trump with all deference to the animal spirit rally they were seeing right now is that the multiples are really stretched and that maybe if were not even in the ninth inning of the game here, we"re certainly somewhere in or around the seventh inning stretch. So, the answer is no. It"s not like Ronald Reagan at all in that regard.

Erik:       And in terms of where we are and what comes next obviously as much as you and I see a lot of reason for concern here, you can"t fight the tape and clearly the trend has been upward. So, are we gonna see several months do you think of exuberance over this election before reality sets in? And it seems to me like a lot of people seem to think we"re in a new inflationary boom. You wrote an excellent piece back in December saying wait a minute, there"s a lot of good reasons to think that Trump would bring back the disinflation trade. So, do you still see it that way and give us a little bit of background on where that viewpoint comes from?

Dave:    Well, I mean the second question is a lot easier, the inflationary boom. So basically, I"m supposed to take it at face value because the markets are telling me that this is their view today, and their view today might not be the market"s view 3, 6, 12 months from now or 5 years from now. But the market"s telling me that one man, President Trump is gonna be able to, with fiscal policy, will be able to do what Bernanke and Yellen and Draghi and Trichet and Koroda and Carney, who actually run the printing presses, what they couldn"t do in the past 8 years a president"s gonna be willing to do, or be able to do, on inflation? And the answer is no. That"s just not gonna happen. There"s just too many powerful secular forces a play whether it"s demographics, intense global competitive pressure that aren"t going away and of course with the fact that you"ve got tremendous excess supply of retail space net and states and Amazon creating tremendous margin pressure and price discounting in the rest of the consumer goods and services area. So, no and I"m not a buyer of the view and especially with the US dollar likely to still be a strong currency even though it"s a very crowded trade, it"s probably the right trade. I don"t see the big inflation out there.

You know people wanna compare to Ronald Reagan, fine. I mean there"s differences, there"s some similarities but what did the inflation do during the Reagan era? What did inflation do during this supply side Reagan era? Went from 12 percent to down below 5 percent over his 8-year term? Why anybody thinks that Trump"s policies themselves are gonna create inflation, I imagine that the wall with Mexico will create demand for cement and concrete and the likes and you"ll see some commodity inflation perhaps coming out of there, infrastructure probably much the same, but that"s a very small sliver of the overall inflation pie and ultimately what will matter for the markets is the extent towards any inflation at the backend of the economy comes to the frontend of the economy. And looking at the Trump"s policies deregulation should reduce business costs. What is inflationary about that? Yes, the infrastructure works. The only way it"s gonna work is if it ultimately improves productivity like the good old fashioned Eisenhower structure of the interstate highway in the 1950s really showed true in the 1960s in terms of increased productivity growth, well productivity growth in that itself is anti-inflationary because it brings down unit labour cost. So, what if Donald Trump reduces tax rates along with congress corporate tax rates? Well what"s inflationary about lower corporate tax rates? It actually means that wages can rise without crimping margins and forcing companies to have to pass it on to consumers. So outside of cement, concrete, some base metals, the things that might go initially into the stuff that"s needed to build the wall of Mexico or needed to see upgrade airports and pave bridges and roads, I don"t see where the big inflationary impulse is gonna come from. If anything, if Trump is successful, it means that the potential GDP growth rate, the non-inflationary GDP growth rate of the United States is gonna be rising overtime. I can"t build an inflation view out of that.

Barron's: Next Stop Dow 30,000... On One Condition

The financial magazine which has made an art out of calling for big, round numbers in the Dow Jones Financial Index (as a reminder over 20% of the Dow"s surge since the election is due entirely to Goldman Sachs), most recently with its "get ready for Dow 20,000" call from just over a month ago, has done it again:

While there are still those - pretty much anyone who still cares about fundamentals - who are scratching their heads at Dow20K, according to Barrons "the Dow hitting 20,000 was no fluke. Today’s stock prices are well supported by solid prospects for corporate earnings and economic growth." 

In fact, Dow 30,000 is just around the corner... well by 2025. All President Donald Trump has to do, according to Barron"s, is "avoid stumbling into a trade war—or a real war." Some of the profound insight behind this forecast so reminiscent of the infamous "Dow 36,000" prediction which hit just around the time of the last market bubble.

Clearly, part of the propulsion behind stocks has been the Trump administration and its flurry of business-friendly edicts. If Trump can succeed in reducing regulation and lowering corporate taxes, stocks should surge further this year. An additional 5% or even 10% gain in 2017 wouldn’t be surprising. Our projection of 30,000 by 2025 is based on our analysis of historical data provided by Jeremy Schwartz, director of research at WisdomTree. This data, which looks at stock market returns for rolling five-year periods dating back to 1871, suggest stock market gains will fall below the market’s typical annual gain of 6% after inflation in the next five years before accelerating above the average in the years after that.

Then again, perhaps Dow 30,000, which would require China to inject in at least another $30 trillion in debt in the next decade without somehow hitting the Minsky moment tipping point, is not so certain: it all depends on whether Trump can avoid war, either literal of metaphorical:

"a few of the new administration’s policies pose a serious threat to the economy and stock market. The most evident one last week was the trade spat with Mexico, with the White House at one point floating the idea of a 20% border tax on Mexican goods entering the U.S. If Trump gambits like this were to trigger a trade war, the world economy would suffer. The Dow would have a hard time getting to 30,000 by 2025."

Alternatively, one can make the argument that a trade, or real war, would guarantee hitting the Dow 30,000 that much quicker: after all, it would force the Fed to resume QE, monetizing not just bonds, but ETFs, equities, and everything else in capital markets in order to preserve confidence in the global financial system.

Ironically, in the same Barron"s edition, we also read a more nuanced take of what Dow 20,000 really means from Randall Forsyth who notes says that "while the Dow is the gauge that regular folks use to keep track of the stock market, a columnist in the Financial Times condescendingly called the attainment of the 20,000 mark last week “fake news.” The flaws in the price-weighted DJIA are known to anyone who cares about such things, but it was the best method available to Charles Dow before the turn of the 20th century. As a result of its modus operandi, David Rosenberg, chief economist and strategist at Gluskin Sheff, observes that moves in Goldman Sachs Group (ticker: GS) have eight times the impact on the Dow as those in General Electric (GE).

So-called survivorship bias also has benefited the Dow. Since April 2004, Dave found that, if the eight companies that were replaced in the DJIA had been kept on, the blue chips would have been at just 12,885 now. That date, by the way, is the furthest back he could go to find former Dow companies that are still around. In the process, Apple (AAPL) was added in 2015, after a seven-for-one stock split that prevented the tech giant from having an outsize impact on the DJIA. While Rosenberg notes that tech stocks now account for a quarter of the Dow, up from 2% at the peak of the dot-com boom in 1999, the so-called FANG stocks— Facebook (FB), Amazon.com (AMZN), Netflix (NFLX), and Google parent Alphabet (GOOGL)—wait to be admitted to the blue chips.

Not surprisingly, President Donald Trump was more than willing to take credit for the Dow’s hitting 20,000 five days into his administration (arguably more deserved than President Barack Obama getting the Nobel Peace Prize months after taking office in 2009)—a reversal of his declaration that the market was in a “fat bubble” last September.

To a more dispassionate observer—in this case, Peter Berezin writing in the BCA Research Global Investment Strategy—the shift represented an evolution from undue pessimism about global growth to unbridled optimism.

And, as JPM has warned every single day in the past month, the next step in the market climbing the wall of optimism may be slippery:

The centerpiece of the Trump program—tax cuts and tax reform—can’t be enacted by executive order. That will take approval by Congress. However, the White House has widening rifts with GOP leaders, writes Greg Valliere, chief strategist at Horizon Investments and a four-decade Washington watcher: “Make no mistake—[House Speaker] Paul Ryan and [Senate Majority Leader] Mitch McConnell can’t stand Trump, and the feeling is mutual.”

While the Dow has been happy to stay above 20K for the time being, the next step may be determined by the Fed, which is meeting next week with the S&P over 200 points above where Janet Yellen warned sstocks are overvalued. As the Fed chair said in May 2015, "I would highlight that equity market valuations at this point generally are quite high," Yellen said.

"There are potential dangers there" Yellen said.

And the main one is that Yellen decides to finally pull the rug from under Trump"s market honeymoon. As Forsyth writes, "the FOMC could signal its readiness to raise its fed-funds target at the March 14-15 meeting. The fed-funds futures market puts only a 34.6% probability on a March move, according to Bloomberg’s analysis, instead pricing in the next boost for June and another in September, but not in December. The shock for the markets would be if the central bank actually delivers the three rate increases that it has signaled."

Trump was quick to take credit for Dow 20,000, and as long as stocks keep rising, nobody will complain or contest. But how will traders and politicians react after the first 5% or 10% correction, the first bear market, and soon thereafter, an economic collapse because without central banks injecting another $14 trillion in liquidity, real economic price discovery will finally happen. With Trump"s tendency to accelerate all timelines, we won"t have long to wait to find the answer.

David Rosenberg: "The Travesty Is We Have 23.5 Million Americans Aged 25-To-54 Outside The Labor Force"

Some observations on recent negative trends in productivity, employment mismatch, and labor training and education from the increasingly more bearish David Rosenberg, who notes that the Trump"s proposed policies may end up helping growth on the margins, but fail to focus on what is really important, making tens of millions of US workers competitive and qualified for today"s jobs market.

From Breakast with Rosie, via Gluskin Sheff

I don"t think we have a productivity problem — in fact, the demise of productivity is vastly overstated and that is because the Bureau of Labor Statistics (BLS) is likely vastly overstating labor input, and I’m talking here about how hours worked are estimated.

But the real travesty, and what I think deserves top priority (but I don’t see it), is that we have, in addition to 7.5 million officially unemployed (a number that is closer to 15 million when all the hidden unemployment is accounted for), 23.5 million Americans aged 25-to-54 who reside outside the confines of the labor force. And at a time when job openings are at record highs.

The problem is that unqualified applicants for these openings also are at a record high. The number of jobs available that are not being filled because the skill set is absent is at an unprecedented level — and this was an overriding theme in the latest edition of the Fed"s Beige Book.

The question is what is in the policy playbook to redress this situation?

What we need is a policy playbook that makes education, apprenticeship and training a major priority — the one plank that I had hoped would be yanked out of Bernie Sanders" platform.

While deregulation and simplifying the tax code obviously are constructive segments of the Trump plan, they are not the most important obstacles in the way of growth. Neither is globalization.

Even the most ardent ""supply-sider" would admit that labor input is key to the outlook and this should really be at the top of the agenda — closing the widening and unprecedented gap between job openings and new hiring. There simply is no replacement for excellent education achievement with respect to maximizing labor productivity.

I see scant attention being paid to this file — surely this is more important than U.S. involvement in Brexit or trying to play a role in breaking up the European Union, don"t you think?

David Rosenberg Calls For A Multi-Trillion, "Helicopter Money" Stimulus Package

With the inherent weakness in US GDP and the rising probability of a recession (two weeks ago Bank of America modeled that the next recession would likely start roughly one year from now), Gluskin Sheff"s David Rosenberg thinks that with monetary options exhausted it will take a fiscal boost in the trillions of dollars to kickstart the economy. These issues were discussed in an extended interview with Real Vision TV, where the chief economist and strategist at Gluskin Sheff proposed some radical policies to engineer the growth needed in nominal income. 

His ideas, some of which can be seen here in a clip of the interview, include helicopter money attached to a $2 trillion perpetual bond, massive infrastructure spending and measures to tackle the $1 trillion student debt load that has seriously hamstrung the economy.

Here are some of the interview highlights:

Doing the Same Thing Over Again and Expecting a Different Outcome

Whether the US will in fact experience the technical definition of a recession is a matter of fervent debate, with the odds something like 20%-30%, according to Rosenberg (60% according to Deutsche Bank), but with growth averaging around 1%, there is no doubt the economy is weak.

“There are some people saying a recession is here right now,” Rosenberg says, “I don"t think that we meet those conditions yet. But people say, well, look. Twelve months in a row of negative year on year industrial production, that"s never happened outside recession, check. We"ve had now going into six quarters of profit contraction, year over year. That"s only happened in the context of a recession, check. I mean, all that is true, but so much of this has been related to the oil shock that we had.”

Rosenberg’s problem with monetary policy, now in its 7th year of unorthodox experimentation, is that it has become a weak antidote to structural problems in the economy (even if it is still quite potent at boosting financial asets). Fiscal policy on the other hand, if constructed right, could be the answer due to its very powerful multiplier impact. “I can"t say that I know for sure, but it"s the old Einstein adage about the definition of insanity,” Rosenberg said. “And we"re finding that we"re really-- if we"re not hitting the wall on monetary policy, we"re certainly seeing classic economics 101 of the law of diminishing returns.”

In terms of infrastructure spending, he said that one lesson from recent history and the Great Recession is that you"ve got to have the credibility to convince people that this is going to be permanent and not temporary, in terms of the impact on the economy. “So it can"t be transitory. It"s got to be very big. With interest rates as low as they are, there"s certainly the capacity. I mean, you"ve got a lot of governments around the world issuing 50 or 100-year bonds. So this is a once in a lifetime opportunity to borrow money.”

A Couple of Trillion Dollars of Helicopter Money

While companies have been taking advantage of these conditions to borrow money, the funds have not been invested in the real economy. Share buybacks have become more popular, while personal savings rates have increased amid the economic uncertainty. This all boils down to a big case for government spending, with monetary policy joining forces with fiscal policy in the form of helicopter money.

“What you do with helicopter money is you finance it off the central bank"s balance sheet because we"re talking doing something very dramatic to reflate the economy,” Rosenberg said. “It"s not a few hundred billion dollars. It"s a couple of trillion...I know I"ll get accused of bailing out the sinners, but, my lord, we"ve already done that. I mean, nobody went to jail.”

One of the things holding the economy back is the $1 trillion student debt load, which he said has left 35% of males aged 18 to 34 living with mom and dad, not getting jobs and not becoming first time home buyers. Employment growth for the 65s and over is 7%, meanwhile, as the aging boomers have to work longer because they didn’t save enough for retirement. 

“Helicopter money is QE plus where, say, the treasury issues a perpetual-- call it, like, a century bond, a $2 trillion bond on the Fed"s balance sheet. And so when that bond matures, it"s, like, we"re all dead in the long run at that point. And then the Treasury can use that money to stimulate growth. "

The beauty of this idea, according to Rosenberg is that you don’t have to go through Congress, with such difficulty in achieving corporate or personal tax reform.  “It would lead to a permanent increase in the monetary base. Inflation expectations would go up, which means that real interest rates would go negative. And the theory is that that would provide a bigger thrust towards getting what we all want, which is sustainable and accelerating nominal income growth.“

Real Risk of Fed Mistakes or Trump Trade War

Sustainable and accelerating nominal GDP is certainly what’s required while the risk persists that we could be shocked into recession, or the Fed could make a mistake in raising interest rates too aggressively.

“That"s what happened in December of last year. They raised rates 25 basis points, but the overall financial tightening, in terms of what it meant for the dollar or in credit spreads and the stock market, it was really, like, 75 basis points of tightening. And the next thing you know, the economy slows to stall speed."

Another concern for investors is the prospect of a Trump presidency, bringing with it the potential start of a trade war. That could provide the sort of exogenous shock to cause the economy to go into recession, Rosenberg stated, noting that historically all the recessions in the post war period have been created by the Fed.

“The problem is that when you have the economy running on average 1% growth, or 1% plus, which is not a big cushion. And so, you know, it"s a complicated question to try and handicap a recession on us right now. There"s a lot of people out there that are convinced that a recession is coming.”

To watch the full interview with David Rosenberg, visit Real Vision TV.  You can access this and many more interviews with a free trial. 

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Oh, if Rosenberg"s idea gets traction - and execution -  which it will eventually, as we have said since our first days in 2009, buy lots and lots of gold.