Is It 1999? 2007? Or Both?

Authored by Lance Roberts via RealInvestmentAdvice.com,

In last week’s Technical Update, I discussed the potential for the S&P 500 to hit 2700 by Christmas. To wit:

“The current momentum behind the market advance is clearly bullish, and with the ‘smell of tax reform’ in the air, there is little to derail the bulls before year-end.

 

However, in the meantime, there seems to be nothing stopping the market from going higher. As stated in the title, the current push higher puts 2700 in sight by the time Santa fills the ‘stockings hung by the chimney with care."”

With the markets within striking distance of that target, the run to Nasdaq 7000, Dow 25000 and S&P 2700 are all but guaranteed at this juncture. More interestingly, all three will be ticking off milestone gains at some of the fastest paces in market history. In fact, the Dow has posted three all-time records just this year:

• 70 new highs,


• A 5000-point advance in a single year, and;


• 12-straight months of gains.

Just as a reminder of previous market bubbles, here is what they looked like.

As I discussed with Danielle Dimartino-Booth this morning. Not only is the current rally reminiscent of 1999, but to 2007 as well. In fact, the current bubble, as she states, is a combination of both.

As Danielle and I discussed, it seems eerily familiar.

In 1999:

• Fed was hiking rates as worries about inflationary pressures were present.


• Economic growth was improving 


• Interest and inflation rates were rising


• Earnings were rising through the use of “new metrics,” share buybacks and an M&A spree. (Who can forget the market greats of Enron, Worldcom & Global Crossing)


• Margin-debt / leverage was at the highest level on record. 


• Stock market was beginning to go parabolic as exuberance exploded in a “can’t lose market.”


• Speculative asset of choice: Dot.com stocks

In 2007:

• Fed was hiking rates as worries about inflationary pressures were present.


• Economic growth was improving 


• Interest and inflation rates were rising


• Debt and leverage provided a massive “buying” binge in real estate creating a “wealth effect” for consumers and high-valuations were justified because of the “Goldilocks economy.” 


• Margin-debt / leverage was at the highest level on record. 


• Stock market was beginning to go parabolic as exuberance exploded in a “can’t lose market.”


• Speculative asset of choice: Real Estate

In 2017:

• Fed was hiking rates as worries about inflationary pressures were present.


• Economic growth is improving because of 3-hurricanes and 2-wild fires.


• Interest and inflation rates are expected to rise


• Earnings were rising through the use of “new metrics,” share buybacks and an M&A spree. 


• Margin-debt / leverage is at the highest level on record. 


• Stock market was beginning to go parabolic as exuberance exploded in a “can’t lose market.”


• Speculative asset of choice: Bitcoin

Of course, those are just some of the similarities.

Valuations in all three cases exceeded the long-term market peaks of 23x reported earnings. Investor confidence was pushing extremes and deviations from long-term means in prices, relative-strength and moving-averages were all present.

The chart below shows the S&P 500 from 1993-present. As shown, the 100-period RSI, 3-standard deviations above the 200-dma and the 50/200 day moving average MACD line are all at historical extremes. While such readings do NOT suggest a downturn is imminent, it does suggest that risk is elevated and potential upside from current levels is likely limited.

I have combined the three periods below, scaled to 100, so you can see just how far we have currently gone.

Sure. This time could be different. It just probably isn’t.

Our Job As Investors

Again, none of this suggests the market is going to crash tomorrow. But a massive mean reversion process is coming, it is inevitable, the only question is of the timing.

As I noted last week in “The Exit Problem,” it is time to start considering sitting a little closer to the “exit.” To wit:

“Am I sounding an ‘alarm bell’ and calling for the end of the known world? Should you be buying ammo and food? Of course, not.

 

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your ‘risk exposure’ will likely not have the desired end result you have been promised.

 

As I stated often, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered ‘bearish’ to point out the potential ‘risks’ that could lead to rapid capital destruction; then I guess you can call me a ‘bear.’

 

Just make sure you understand I am still in ‘theater,’ I am just moving much closer to the ‘exit.’”

What does that mean?

I have now been in the financial markets in some capacity since prior to the crash of 1987.

Yes, I am that old.

During that time I have watched investors repeat the same mistakes over and over again. From exuberance to fear, buying high to selling low, chasing returns, and always believing this time is different, only to once again be reminded it’s not. 

As the old saying goes:

“The more things change, the more they remain the same.”

If you have been around the markets for any length of time, you can quickly spot the “pigeons at the poker table.” These are the ones that continually rationalize why prices can only go higher, why this time is different than the last, and only focus on the bullish supports. Trying to “draw to an inside straight” is not impossible, it just leads to losses more often than not. 

But therein lies an important point.

As investors, our job is NOT making the case for why markets will go up.

Read that again.

Making the case for why markets will rise is a pointless endeavor because we are already invested.

If the markets rise, terrific. We all made money, and we are the better for it. However, that is not our job.

Our job, is to analyze, understand, measure, and prepare for what will reduce the value of our invested capital. 

Period.

If we are to accumulate capital over the time-span that we have available, from today until we reach retirement, the most important thing we can do to ensure our success is not suffering a large loss of capital. 

Therefore, our job as investors is actually quite simple:

• Capital preservation


• A rate of return sufficient to keep pace with the rate of inflation.


• Expectations based on realistic objectives.  (The market does not compound at 8%, 6% or 4%)


• Higher rates of return require an exponential increase in the underlying risk profile.  This tends to not work out well.


• You can replace lost capital – but you can’t replace lost time.  Time is a precious commodity that you cannot afford to waste.


• Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.

With forward returns likely to be lower and more volatile than what was witnessed in the 80-90’s, the need for a more conservative approach is rising. Controlling risk, reducing emotional investment mistakes and limiting the destruction of investment capital will likely be the real formula for investment success in the decade ahead.

This brings up some very important investment guidelines that I have learned over the last 30 years.

• Investing is not a competition. There are no prizes for winning but there are severe penalties for losing.


• Emotions have no place in investing.You are generally better off doing the opposite of what you “feel” you should be doing.


• The ONLY investments that you can “buy and hold” are those that provide an income stream with a return of principal function.


• Market valuations (except at extremes) are very poor market timing devices.


• Fundamentals and Economics drive long-term investment decisions – “Greed and Fear” drive short-term trading. Knowing what type of investor you are determines the basis of your strategy.


• “Market timing” is impossible– managing exposure to risk is both logical and possible.


• Investment is about discipline and patience. Lacking either one can be destructive to your investment goals.


• There is no value in daily media commentary– turn off the television and save yourself the mental capital.


• Investing is no different than gambling– both are “guesses” about future outcomes based on probabilities.  The winner is the one who knows when to “fold” and when to go “all in”.


• No investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one that is temporarily out of favor.

As an investment manager, I am neither bullish or bearish. I simply view the world through the lens of statistics and probabilities. My job is to manage the inherent risk to investment capital. If I protect the investment capital in the short term – the long-term capital appreciation will take of itself.

We"re Living In The Age Of Capital Consumption

Authored by Ronald-Peter Stöferle via The Mises Institute,

When capital is mentioned in the present-day political debate, the term is usually subject to a rather one-dimensional interpretation: Whether capital saved by citizens, the question of capital reserves held by pension funds, the start-up capital of young entrepreneurs or capital gains taxes on investments are discussed – in all these cases capital is equivalent to “money.” Yet capital is distinct from money, it is a largely irreversible, definite structure, composed of heterogeneous elements which can be (loosely) described as goods, knowledge, context, human beings, talents and experience. Money is “only” the simplifying aid that enables us to record the incredibly complex heterogeneous capital structure in a uniform manner. It serves as a basis for assessing the value of these diverse forms of capital.

Modern economics textbooks usually refer to capital with the letter “C”. This conceptual approach blurs the important fact that capital is not merely a single magnitude, an economic variable representing a magically self-replicating homogenous blob but a heterogeneous structure. Among the various economic schools of thought it is first and foremost the Austrian School of Economics, which stresses the heterogeneity of capital. Furthermore, Austrians have correctly recognized, that capital does not automatically grow or perpetuate itself. Capital must be actively created and maintained, through production, saving, and sensible investment.

Moreover, Austrians emphasize that one has to differentiate between two types of goods in the production process: consumer goods and capital goods. Consumer goods are used in immediate consumption – such as food. Consumer goods are a means to achieve an end directly. Thus, food helps to directly achieve the end of satisfying the basic need for nutrition. Capital goods differ from consumer goods in that they are way-stations toward the production of consumer goods which can be used to achieve ultimate ends. Capital goods therefore are means to achieve ends indirectly. A commercial oven (used for commercial purposes) is a capital good, which enables the baker to produce bread for consumers. 

Through capital formation, one creates the potential means to boost productivity. The logical precondition for this is that the production of consumer goods must be temporarily decreased or even stopped, as scarce resources are redeployed toward the production of capital goods. If current production processes generate only fewer or no consumer goods, it follows that consumption will have to be reduced by the quantity of consumer goods no longer produced. Every deepening of the production structure therefore involves taking detours.

Capital formation is therefore always an attempt to generate larger returns in the long term by adopting more roundabout methods of production. Such higher returns are by no means guaranteed though, as the roundabout methods chosen may turn out to be misguided. In the best case only those roundabout methods will ultimately be continued, which do result in greater productivity. It is therefore fair to assume that a more capital-intensive production structure will generate more output than a less capital-intensive one. The more prosperous an economic region, the more capital-intensive its production structure is. The fact that the generations currently living in our society are able to enjoy such a high standard of living is the result of decades or even centuries of both cultural and economic capital accumulation by our forebears.

Once a stock of capital has been accumulated, it is not destined to be eternal. Capital is thoroughly transitory, it wears out, it is used up in the production process, or becomes entirely obsolete. Existing capital requires regularly recurring reinvestment, which can usually be funded directly out of the return capital generates. If reinvestment is neglected because the entire output or more is consumed, the result is capital consumption.

It is not only the dwindling understanding of the nature of capital that leads us to consume it without being aware of it. It is also the framework of the real economy which unwittingly drives us to do so. In 1971 money was finally cut loose entirely from the gold anchor and we entered the “paper money era.” In retrospect, it has to be stated that cutting the last tie to gold was a fatal mistake. Among other things, it has triggered unprecedented instability in interest rates. While interest rates displayed relatively little volatility as long as money was still tied to gold, they surged dramatically after 1971, reaching a peak of approximately 16 percent in 1981 (10-year treasury yield), before beginning a nosedive that continues until today. This massive decline in interest rates over the past 35 years has gradually eroded the capital stock.

An immediately obvious effect is the decline in so-called “yield purchasing power”. The concept describes what the income from savings, or more precisely the interest return on savings, will purchase in terms of goods. The opportunity to generate interest income from savings has of course decreased quite drastically. Once zero or even negative interest rate territory is reached, the return on saved capital is obviously no longer large enough to enable one to live from it, let alone finance a reasonable standard of living. Consequently, saved capital has to be consumed in order to secure one"s survival. Capital consumption is glaringly obvious in this case.

It is beyond question that massive capital consumption is taking place nowadays, yet not all people are affected by it to the same extent. On the one hand, the policy of artificially reducing the interest as orchestrated by the central banks does negatively influence the entrepreneurs’ tasks. Investments, especially capital-intensive investments seem to be more profitable as compared to a realistic, i. e. non-interventionist level, profits are thus higher and reserves lower. These and other inflation-induced errors promote capital consumption.

On the other hand, counteracting capital consumption are technological progress and the rapid expansion of our areas of economic activity into Eastern Europe and Asia in recent decades, due to the collapse of communism and the fact that many countries belatedly caught up with the monetary and industrial revolution in its wake. Without this catching-up process it would have been necessary to restrict consumption in Western countries a long time ago already.

At the same time, the all-encompassing redistributive welfare state, which either directly through taxes or indirectly through the monetary system continually shifts and reallocates large amounts of capital, manages to paper over the effects of capital consumption to some extent. It remains to be seen how much longer this can continue. Once the stock of capital is depleted, the awakening will be rude. We are certain, that gold is an essential part of any portfolio in this stage of the economic cycle.

 

Examining The Most Hated Bull Market Ever

Authored by Lance Roberts via RealInvestmehtAdvice.com,

From last week:

“The seemingly “impervious” advance since the election last November, has had an interesting “stair step” pattern with each advance commencing from a breakout of a several month 3%-ish consolidation range. Furthermore, each advance then pushes to a 3-standard deviation extreme, black circles, of the 50-dma before beginning the next consolidation trading range.”

The last leg higher has been directly responsive to the ramp up in the political “marketing surge” surrounding “tax cuts and tax reform.” With the House having already passed their respective budget resolutions, late Thursday, the Senate passed a budget blueprint for the next fiscal year. With both of the “budget resolutions” in place, it was seen as clearing a hurdle to the goal of overhauling the tax code.

This is not new, of course, as the entire rally for the markets since the election has been driven by hopes of lower taxes, despite disaster, floods, fires and Central Bank threats of liquidity extraction.

The bulls are clearly in charge which keeps us allocated to towards equity risk currently.

Do not be mistaken, this “rally” IS all about tax cuts. Despite many who are suggesting this has been a “rational rise” due to strong earnings growth, that is simply not the case as shown below. (I only use “reported earnings” which includes all the “bad stuff.” Any analysis using “operating earnings” is misleading.)

Since 2014, the stock market has risen (capital appreciation only) by 35% while reported earnings growth has risen by a whopping 2%. A 2% growth in earnings over the last 3-years hardly justifies a 33% premium over earnings. 

Of course, even reported earnings is somewhat misleading due to the heavy use of share repurchases to artificially inflate reported earnings on a per share basis. However, corporate profits after tax give us a better idea of what profits actually were since that is the amount left over after those taxes were paid.

Again we see the same picture of a 32% premium over a 3% cumulative growth in corporate profits after tax. There is little justification to be found to support the idea that earnings growth is the main driver behind asset prices currently.

We can also use the data above to construct a valuation measure of price divided by corporate profits after tax. As with all valuation measures we have discussed as of late, and forward return expectations from such levels, the P/CPATAX ratio just hit the second highest level in history.

The reality, of course, is that investors are simply chasing asset prices higher as exuberance overtakes logic and their actions prove the case.  According to data from FactSet, stock-based exchange-traded funds have seen nearly $16 billion in inflows over the past week, which represents an acceleration from recent positioning. Over the past month, about $31.3 billion has gone into stock-based ETFs. The chart below of data from ICI shows much of the same with monthly equity ETF inflows surging since the election.

The same is seen when we also add in equity mutual funds for a look at total equity asset flows.

Not surprisingly, those actions have been backed by their massive elevation in bullish sentiment.

As UMich noted:

“Consumer sentiment surged in early October, reaching its highest level since the start of 2004. The October gain was broadly shared, occurring among all age and income subgroups and across all partisan viewpoints.

 

There is an unmistakable sense among consumers that economic prospects are now about as ‘good as it gets."”

Most hated bull market ever…hardly.

Historically speaking, you only witness such exuberance in the latter stages of an expansion, not the beginnings of one. The latest survey indicates that consumers do not anticipate an economic downturn anytime in the foreseeable future, which from a contrarian perspective may be a clear warning sign.

Clearly, the expected benefits of tax cuts and reforms is leading investors to overpay for something today they are hoping will become fairly valued tomorrow. In other words, instead of prices catching “down” to market fundamentals, investors are hoping fundamentals will “catch up” to prices.

Unfortunately, there isn’t a previous case in history where this has been the case.

Also, when we look at 20-year trailing returns, there is sufficient historical evidence to suggest total, real returns, will decline towards zero over the next 3-years from 7% annualized currently. 

(These are trailing 20-year total real returns, not forward)

Re-read that last sentence again and look closely at the chart above. From current valuation levels, the annualized return on stocks by the end of the current 20-year cycle will be close to 0%. A decline in the next 3-years of only 30%, the average drawdown during a recession, will achieve that goal. 

For investors, this is crucially important. In the article “Apathy & The Death Of Your Financial Goals,” I discussed the reality of the damage caused by market drawdowns. As I stated:

“Crashes matter, a lot.” 

While investors may “get back to even,” eventually, following a crash, the shortfall from their actual financial goal continues to build.

This is why using some method of risk management, such as a simple moving average crossover, can help alleviate some of the financial damage caused by drawdowns.

• YES! You will miss out on some gains in the market.


• YES! Sometimes you will be “stopped out” and have to “buy back in.” 


• YES! You will be much more successful in obtaining your financial goals long-term.

After all, isn’t that why you invest in the first place?

What I can assure you of is that you WILL be wrong from time to time and you WILL lose money. But that is the inherent nature of investing. It is a “RISK” based endeavor.

However, I can absolutely guarantee that trying to “passively index” in the current market environment will absolutely wind up screwing up your long-term goals.

Think about it this way. IF investing was as easy as just buying a bunch of stuff and sitting on it, then why are so many Americans dependent on Social Security for retirement? Via Jared Dillian:

• 19.7% of retirees get 100% of their income from Social Security.


• A full third (33.4%) depend on it for 90% of their income.


• And 61.1% get at least half their income from Social Security.

The federal government’s unfunded 75-year liability for Social Security and Medicare combined is $46.7 trillion.

Are you absolutely sure you want to rely on the Government for your retirement?

Think about it the next time someone tells you to just “buy and hold.”

Financialization & The Destruction Of The Real Economy

Authored by Charles Hugh Smith via OfTwoMinds blog,

Strip an economy of capital, productive incentives, talent and yes, ethics, and what are we left with? An economy spiraling toward an inevitable collapse.

Financialization is destroying the real economy, but few in power seem to notice or care. The reason why is painfully obvious: those in power are reaping vast fortunes from the engines of financialization--for example, former President Obama: Obama Goes From White House to Wall Street in Less Than One Year.

This is not to single out President Obama as a special case; politicos across the spectrum depend on the engines of financialization to fund their campaigns and make them multi-millionaires, and corporate managers and financiers have skimmed billions of dollars in gains not from producing new, better and more affordable goods and services but by playing financialization games such as borrowing billions to buy back stocks, leveraged buyouts, and so on--all of which have reaped the insiders gargantuan fortunes while hollowing out the real economy.

Financialization necessarily hollows out the real economy, as Gordon Long and I detail in this new video program: The Results of Financialization - Part I (34 minutes)

The key dynamic is that financialization creates irresistible incentives to ramp up debt and leverage at the expense of the real economy. Those who fail to exploit financialization will underperform the market and be fired.

As Gordon explains, if a CEO refuses to load a company up with debt, a private-equity financier with access to cheap Federal Reserve credit will scoop up the company in a private buyout, fire the management, extract immense profits by loading the company with debt, then take the hollowed-out shell public again, reaping another windfall of financialized gains.

Note that the private-equity financiers have every incentive to lay off employees, especially experienced workers who earn higher salaries, to reduce costs before they take the hollowed-out shell public.

How can corporations pay out more to shareholders than they actually earned? Easy--financialization.

Another key dynamic in financialization is limitless liquidity and super low interest rates set by central banks--rates that are so low and liquidity so abundant that corporations can roll over their debt and actually add more debt and keep their interest payments unchanged.

This dynamic inevitably leads to zombie corporations--corporations with low rates of growth and profitability and high debt loads that in an unfinancialized economy would be recognized as insolvent and liquidated.

As we explain, financialization skews the risk-reward in favor of financial games, so real-world investments no longer make sense. Why risk building a factory in the U.S. or training workers when the pay-off is uncertain, when there are so many ways to reap immense fortunes via financial games that are ultimately backstopped by the Federal Reserve or federal agencies (i.e. the taxpayers)?

As many observers have noted, these perverse incentives have siphoned human talent away from productive employment and into enormously well-compensated but parasitic, exploitive financialization-related jobs.

Strip an economy of capital, productive incentives, talent and yes, ethics, and what are we left with? An economy spiraling toward an inevitable collapse. The metaphor I"ve used to explain this in the past is the Yellowstone forest fire. The deadwood of bad debt, extreme leverage, zombie companies and all the other fallen branches of financialization pile up, but the central banks no longer allow any creative destruction of unpayable debt and mis-allocated capital; every brush fire is instantly suppressed with more stimulus, more liquidity and lower interest rates.

As a result, the deadwood sapping the real economy of productivity and innovation is allowed to pile higher.

The only possible output of this suppression is an economy piled high with explosive risk. Eventually Nature supplies a lightning strike, and the resulting conflagration consumes the entire economy.

The Yellowstone Analogy and The Crisis of Neoliberal Capitalism (May 18, 2009)

The Financial Markets Now Control Everything (April 29, 2015)

I explain all this in greater detail in my short book Why Our Status Quo Failed and Is Beyond Reform.

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If you found value in this content, please join me in seeking solutions by becoming a $1/month patron of my work via patreon.com. Check out both of my new books, Inequality and the Collapse of Privilege ($3.95 Kindle, $8.95 print) and Why Our Status Quo Failed and Is Beyond Reform ($3.95 Kindle, $8.95 print, $5.95 audiobook) For more, please visit the OTM essentials website.

The Real Reason Wages Have Stagnated: Our Economy Is Optimized For Financialization

Authored by Charles Hugh Smith via OfTwoMinds blog,

Labor"s share of the national income is in freefall as a direct result of the optimization of financialization.

The Achilles Heel of our socio-economic system is the secular stagnation of earned income, i.e. wages and salaries. Stagnating wages undermine every aspect of our economy: consumption, credit, taxation and perhaps most importantly, the unspoken social contract that the benefits of productivity and increasing wealth will be distributed widely, if not fairly.

This chart shows that labor"s declining share of the national income is not a recent problem, but a 45-year trend: despite occasional counter-trend blips, labor (that is, earnings from labor/ employment) has seen its share of the economy plummet regardless of the political or economic environment.

Given the gravity of the consequences of this trend, mainstream economists have been struggling to explain it, as a means of eventually reversing it. The explanations include automation, globalization/ offshoring, the high cost of housing, a decline of corporate competition (i.e. the dominance of cartels and quasi-monopolies), a failure of our educational complex to keep pace, stagnating gains in productivity, and so on.

Each of these dynamics may well exacerbate the trend, but they all dodge the dominant driver of wage stagnation and rise income-wealth inequality: our economy is optimized for financialization, not labor/earned income.

What does our economy is optimized for financialization mean? It means that capital and profits flow to the scarcities created by asymmetric access to information, leverage and cheap credit--the engines of financialization.

Optimization is a complex overlay of dynamically linked systems: the central bank optimizes the flow of cheap credit to the banking/financial sector, the central state tacitly approves the consolidation of cartels and quasi-monopolies, and gives monstrous tax breaks to corporations even as it jacks up taxes and fees on wage earners and small business.

Financialization funnels the economy"s rewards to those with access to opaque financial processes and information flows, cheap central bank credit and private banking leverage. Together, these enable financiers and corporations to get the borrowed capital needed to acquire and consolidate the productive assets of the economy, and commoditize those productive assets, i.e. turn them into financial instruments that can be bought and sold on the global marketplace.

These commoditized assets include home mortgages, student loans, and specialized labor forces which are "sold" with their employers or arbitraged globally. Once an asset is commoditized, the profits flow to those who process the transactions of packaging and marketing these assets globally.

Take auto loans as an example: the big money isn"t made from collecting the interest on the auto loans; the big money is made by processing and assembling the loans into tranches that can be sold to investors globally.

One way of understanding financialization is to ask: what"s the quickest, easiest way to make $10 million in our economy? Is it building a business based on the labor of employees over a decade or two?

You"re joking, right? The easiest way to make $10 million is to be part of the investment banking team overseeing a $10 billion corporate buyout or merger deal, or investing seed money in a tech company that subsequently goes public.

How about the easiest and quickest way to make $100 million? The answer is the same: working a vein of financial wealth based on commoditized instruments, leverage and credit.

Labor"s share of the national income is in freefall as a direct result of the optimization of financialization. The money flows to those with the capital, credit and expertise to optimize financialized skims. As for selling one"s labor in an economy optimized for capital and the asymmetries of finance--there"s no premium for labor in such an economy, other than technical/managerial skills required by finance to exploit markets.

This is the driver of the rising income-wealth inequality this chart reveals:

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If you found value in this content, please join me in seeking solutions by becoming a $1/month patron of my work via patreon.com. Check out both of my new books, Inequality and the Collapse of Privilege ($3.95 Kindle, $8.95 print) and Why Our Status Quo Failed and Is Beyond Reform ($3.95 Kindle, $8.95 print, $5.95 audiobook) For more, please visit the OTM essentials website.

Do The Roots Of Rising Inequality Go All The Way Back To The 1980s?

Authored by Charles Hugh-Smith via OfTwoMinds blog,

Unless we change the fundamental structure of the economy so that actually producing goods and services and hiring people is more profitable than playing financial games with phantom assets, the end-game of financialization is financial collapse.

I presented this chart of rising wealth inequality a number of times over the past year. Do you notice something peculiar about the inflection points in the 1980s?

Correspondent W.S. noted that the inflection point for the top .1% (late 1970s) preceded the inflection point of the bottom 90% (around 1986): both increased their share of household wealth from 1978 to 1986, and then the share of the top .1% took off, essentially tripling from 8% to over 22%, while the share of the bottom fell precipitously from 36% to 23%.

(Note that the data stops at 2012; if we extend the trends to the present, the lines have certainly crossed and the share of the .1% now exceeds that of the bottom 90%.)

So what happened between 1978 and 1986? The first phase of the financialization of the U.S. economy. What is financialization? In a financialized economy, speculating with highly leveraged debt and exotic financial instruments is far more profitable than producing goods and services.

Financialization hollows out the productive assets of an economy by incentivizing leverage, debt, opacity, speculation, financial fraud, collusion and the perfection of crony capitalism, i.e. financial Elites" ownership of the government"s regulatory and legislative bodies.

Here is another less pungent description via Wikipedia: "Financial leverage overrides capital (equity) and financial markets dominate traditional industrial economy and agricultural economics."

Here is my more formal definition:

Financialization is the mass commodification of debt and debt-based financial instruments collaterized by previously low-risk assets, a pyramiding of risk and speculative gains that is only possible in a massive expansion of low-cost credit and leverage.

Another way to describe the same dynamics is: financialization results when leverage and information asymmetry replace innovation and productive investment as the source of wealth creation.

I describe the dynamics in What"s the Primary Cause of Wealth Inequality? Financialization (March 24, 2014)

Correspondent W.S. submitted commentary and references this 2005 book Financialization and the World Economy:

In the US "total credit market debt divided by GDP was about 1.5 from 1961 to 1981. It accelerated rapidly in the decade of the 1980s - from 1.6 in 1981 to 2.3 in 1989 - as the federal budget deficit soared, hostile takeovers and leveraged buyouts loaded corporations with debt, and household borrowing increased. Corporate and household borrowing raised indebtedness further in the 1990s; by 2001 the debt to GDP ratio was 2.8, almost double the ratio in the Golden Age. Moreover, average real interest rates have been much higher in the neoliberal era than they were in the three decades that preceeded it.

W.S. Also referenced FINANCIALIZATION OF THE ECONOMY and added this commentary:

While “bloated” conglomerates were linked by some to the sluggish performance of the American economy in the 1970s, for corporate raiders they presented a get rich quick opportunity via the “market for corporate control” (Manne 1965). Outsiders could buy the firm from its existing shareholders, fire its managers, and sell off the parts for a quick profit.

After the election of Ronald Reagan in 1980, this became possible on a grand scale due to relaxed antitrust guidelines, changes in state antitakeover laws, and financial innovations that enabled raiders to get relatively short-term financing on a large scale (Davis & Stout 1992). Within a decade, nearly one-third of the Fortune 500 largest industrial firms had been acquired or merged, often resulting in spinoffs of unrelated parts, and by 1990 American corporations were far less diversified than they had been a decade before (Davis et al 1994).

The other thing that happened in the mid-1980s was computer technology became cheap enough and powerful enough to start replacing human labor on a wider scale. Spreadsheets such as Excel became accessible to small business, and the desktop publishing combo of the Apple Macintosh and laserprinters revolutionized the cost structure of marketing.

The rise of the Internet (coupled with cheap memory and processing power) further fueled the productive expansion of digital technologies. As I describe in my book Get a Job, Build a Real Career and Defy a Bewildering Economy, these tools-- which are now ubiquitous and inexpensive--enable one person today to equal the output of what once took four people to produce in the late 1980s.

In effect, labor entered an era of dynamic over-supply just as healthcare costs began to rise, making it more costly to hire workers. Some skills and trades remain scarce and thus well-paid, but as a generalization it became cheaper and more efficient to replace increasingly expensive human labor with increasingly inexpensive and powerful software and digital tools.

Unless we change the fundamental structure of the economy so that actually producing goods and services and maximizing opportunities for people is more profitable than playing financial games with phantom assets, the end-game of financialization is financial collapse.

Recent podcasts/video programs:

Deep State Fractures Under Populist Revolution (TruNews, 37:27)

How A Major Bank "Calculated" That 20x P/E Is Now "Fair Value"

Carbon-based traders of a certain vintage - which excludes today"s 20-year-old hedge fund managers - may recall a time when a 15x P/E was considered "fair." Not any more. In fact, according to a new analysis by Barclays" equity strategist Keith Parker, which tries to factor in so-called "animal spirits" as a driver of valuation has found that 20x P/E is perfectly normal and fair for the current market, further demonstrating just how deep into the goalseeking rabbit hole US capital markets have fallen.

First, to prove we are not joking, here is Barclays explaining why it is important to quantify animal spirits as a input factor of "permanently high plateaued" P/E multiples:

Core drivers of the P/E multiple and animal spirit indicators

In order to estimate the effects of “animal spirits”, or the potential effects of some of President Trump’s agenda, we first model the S&P 500 P/E using the core fundamental drivers of equity valuations. We then compare the residual from the model (actual minus fitted P/E) to various indicators of “animal spirits” or potential policy changes, including: tax policy, credit spreads, inflation, macro volatility, long-term growth expectations and corporate/consumer sentiment data.

Rates, growth and payouts are the core drivers of the P/E. Using a dividend discount framework, an equity price is the present value of future dividends. Dividing both sides of the equation by earnings, the P/E multiple is equal to the dividend payout ratio divided by the cost of capital minus the growth rate. Accordingly, the US 10y yield, US real GDP yoy and the dividend payout ratio explain 57% of the movement in the S&P 500 trailing P/E multiple from 1955 to 1997. We use the 1955-97 sample period because confiscatory tax policies prior to 1955 distorted returns to equity holders (excess profit taxes, etc), and thus affected valuations, while the 1998-2001 tech bubble would also distort results.

Other “animal spirits” indicators also affect the P/E, even controlling for the core drivers. Including the US 10y, real GDP and dividend payout ratio variables in each regression, we assess the statistical significance of other variables as it relates to the S&P 500 P/E.

The punchline: "Based on our findings we incrementally add other variables to build a more comprehensive P/E model, to better evaluate the potential effects of “animal spirits” on equity valuations"

At this point Barclays provides numerous pages of tortured, goalseek "empirical evidence" to extract the result it is after. What it "finds" is that what was once a "fair" 15x P/E is now really 20x P/E thanks to, drumroll, animal spirits.

Post-election rally closed the valuation gap with the P/E now near “fair”. The current fitted S&P 500 trailing P/E of 19.6x reflects the historical average of 15.2x adjusted for lower rates (+3x), lower dividend taxes (+2x), slightly higher analyst long-term EPS growth (1.4x), lower macro vol (+0.5x), lower dividend payout ratios (-2.6x) and the net of credit spreads and growth (+0.3x). Accordingly, the current P/E of 19.4x, although high by historical standards, is far from pricing excessive optimism, based on our model.

Here is Barclays" rationalization:

It is difficult to discern how the fundamental drivers are impacting equity valuations using current values, let alone trying to assess the potential ramifications of policy changes. As a starting point, we lay out how the variables in our model are affecting the fitted P/E relative to the historical average (Figure 14).

By separating out the drivers of the multiple, we are then better able to assess how policy changes may impact each variable and thus the P/E. The historical average trailing P/E is 15x.

• The US 10y yield at ~2.5% is much lower than the in sample average of 7%, which leads to a fitted P/E of 18x, all else equal.


• Lower dividend taxes than the historical average adds another 2x.


• Long-term EPS growth expectations using IBES data are now ~40bp above the historical average, which adds another 1.4x.


• Earnings flat-lined since 2014 and EPS moved slightly below trend, which adds 0.5x to the trailing P/E.


• Finally, inflation and IP volatility have been below historical averages, which adds another 0.5x.

On the negative side, dividend payout ratios are much lower than the historical average, which in turn reduces the fitted P/E by 2.6x. Real GDP growth is below average and is a 0.2x offset to the fitted P/E  value. Lastly, credit spreads are near the historical average.

Overall, the current fitted P/E is 19.6x based on the macro drivers of the multiple, compared to 19.4x for the actual P/E using broker adjusted earnings.

And here is Barclays" goalseeking exercise distilled to its undisputed visual glory:

And that, ladies and gentlemen is how sellside analysts use "animal spirits" to explain that a market which is valued 33% higher than historical average, is really "fairly valued."