Saturday, January 30, 2016

Clif Droke on FSN

An interview I did with Cris Sheridan of Financial Sense Network can be downloaded at the following link:

In it we discuss the implication of the bear market which began in 2015 and the possibilities for 2016.  Special thanks to Cris and everyone at FSN.

Wednesday, January 27, 2016

How the Fed is suffocating the economy

Investors are worried over the prospects that the long-term momentum behind the stock market recovery of 2009-2015 may be in danger of complete dissipation this year.  That would mean a certain date with an extended bear market and, potentially, an economic recession perhaps sometime later this year. 

Normally, within the context of an established bull market, worry would be a good thing given that the bull tends to proceed along a “wall of worry.”  In view of recent actions undertaken by central banks, however, those worries are legitimate as I’ll explain in this commentary. 

There are two established ways of killing forward momentum and induce economic recession.  One is to sharply reverse monetary policy or margin maintenance policy from very loose to very tight.  An example of this is what happened in the months leading up to the 1929 crash; yet another example was the margin requirement tightening in the gold, silver and copper markets in 2011.

The other way of reversing forward momentum is to slowly suffocate the financial market through subtle, incremental policy shifts which favor holding cash over equities.  The central banks of Europe and the U.S. have opted for the latter course.  The ultimate outcome of this policy are being felt even now in Europe and elsewhere, but likely won’t become abundantly clear in the U.S. until later this year.

Tight money policy, especially at a time when the financial market is vulnerable to overseas weakness, is nothing short of a recipe for disaster.  Timothy Cogley, an economist with the San Francisco Federal Reserve Bank, admitted in a 1999 research paper that the Fed’s tight monetary policy in 1928-29 likely contributed to the stock market crash of 1929.  Cogley observed:

“In 1928 there was a synchronized, global contraction of monetary policy, which occurred primarily because the Fed was concerned about stock prices.  These actions had predictable effects on economic activity.  By the second quarter of 1929 it was apparent that economic activity was slowing.  The U.S. economy peaked in August and fell into a recession in September.”  [“Monetary Policy and the Great Crash of 1929: A Bursting Bubble or Collapsing Fundamentals?”]

The Fed’s mistake in those days was in trying to prevent a speculative bubble in the equity market.  In so doing, however, the Fed inadvertently contributed to an even greater problem: the implosion of a speculative bubble.  Moreover, the speculative bubble was fueled in part by a loose monetary policy in the years leading up to the 1928-29 run up in stock prices.

Cogley concluded: “In retrospect, it seems that the lesson of the Great Crash is more about the difficulty of identifying speculative bubbles and the risks associated with aggressive actions conditioned on noisy observations.  In the critical years 1928 to 1930, the Fed did not stand on the sidelines and allow asset prices to soar unabated.  On the contrary, its policy represented a striking example of The Economist’s recommendation: a deliberate, preemptive strike against an (apparent) bubble.  The Fed succeeded in putting a halt to the rapid increase in share prices, but in doing so it may have contributed one of the main impulses for the Great Depression.”

While the Fed’s recent quarter-point interest rate increase may seem insignificant at face value, the magnitude of the move can only be appreciated by realizing the rate of change involved.  The following graph provides some idea of just how huge in percentage terms the Fed’s policy tightening is.

It’s important to put this chart into its proper long-term context.  The bull market which began in 2009 was largely fueled by a loose monetary policy, courtesy of then Fed Chairman Ben Bernanke.  His successor, Janet Yellen, has reversed Bernanke’s accommodative measures and seems intent on tightening the noose around the economy’s throat. 

Although many observers denigrate Bernanke’s stimulus measures as being excessive, there can be no denying that they were successful in not only reviving the stock market and housing market, but also the overall economy to some degree.  Many economists consistently underestimate the extent to which the U.S. economy is tied to the financial market.  Yet the saying has never been more apropos than it is today: “As goes the stock market, so goes the economy.”

Fed Chair Yellen evidently doesn’t understand that truism.  Her restrictive monetary policy, if pursued further, will eventually choke the last remnants of forward momentum in the economy, particularly in the manufacturing sector.  Truly, now is the time the Fed should pursue an aggressively looser policy.  As one observer put it, “With as much headway as the economy has made since 2009, why not open up the monetary floodgates and gun for prosperity?”  Why not, indeed!

One of the biggest criticisms the Fed faced when it initiated quantitative easing (QE) and Operation Twist is that its loose policy would inevitably lead to runaway inflation.  Yet here we are some seven years later and inflation is nowhere to be seen.  Nay, deflation actually threatens the global economy and, by extension, aspects of the U.S. financial system.  Why not then throw all caution to the wind and open up the monetary spigots full throttle?  What have we possibly got to lose?

I’ve long maintained that the single biggest threat to the financial system is not an aggressively loose money policy, but an unjustifiably tight one.  Everyone fears financial bubbles these days, but bubbles wouldn’t necessarily lead to catastrophe if central banks and governments didn’t consistently pop them by tightening money.  While it’s true that every bubble has its natural limit, they need not always end in catastrophic implosion.  Indeed, bubbles in an economy as dynamic as ours are welcome events which bring quantum leaps forward in technological progress.  They also tend to raise living standards for nearly everyone.  One could argue that without the many bubbles of the last 30 or so years, America wouldn’t enjoy her current high standard of living. 

Let’s now briefly turn our attention to the stock market outlook.  While several reasons were given by analysts for the latest stock market rally attempt, the most common one was the hope for additional stimulus from the Bank of Japan and the European Central Bank (ECB).  On Jan. 21, ECB President Mario Draghi indicated the bank would consider additional stimulus at its next meeting in March.  Investors were elated by this statement, though it’s surprising that the ECB is sufficiently unconcerned by the global financial crisis to wait until March before even considering action.  If anything, Draghi’s statement is a further testament to the complacency that’s still rife despite the trillions of dollars in damage already inflicted by the crisis. 

That word “complacency” seems to capture the prevailing sentiment among both retail investors and policymakers right now.  Remember that in a bull market the “wall of worry” is what helps to establish the upward trend in stock prices.  In a bear market it’s the “slope of hope” that predominates.  There seems to be a lot of “holding and hoping” going on right now, and that’s not promising from a contrarian’s perspective.  We need to see a much bigger manifestation of fear, doom and gloom among mainstream investors before we completely cast our concerns about the bear aside. 

Another aspect in great need of improvement is the market’s internal momentum picture.  Since last spring, the number of stocks making new 52-week lows on the NYSE has consistently been above 40.  That’s a sign that internal weakness is still present in the broad market.  Moreover, the important 200-day rate of change in the new highs-new lows has been declining now for over a year.  The last time this happened was heading into the 2008 bear market.  The following graph shows the enormity of the decline in this indicator since last year.

As long as this indicator is declining it’s warning us that there is a significant undercurrent of weakness within the market.  This indicator will obviously need to improve before we have any indication that the bear market is ending and a new bull market is forming.  Until then, a continued defensive stance is warranted for long-term investors.

Monday, January 18, 2016

Will 2016 be the year the Fed fails?

To many economists, the biggest mistake the Fed has made has been a lack of aggression in raising interest rates.  After all, they reason, the U.S. job market is as strong as it has been since 2007 and the economy, even if sluggish, is at least back on an even keel.  These same observers cheered the Fed’s decision to raise the Fed funds rate in December by a quarter percentage point. 

Yet there is even more reason to worry that the raising of the Fed funds rate last month may have been a policy blunder of major proportions.  In this commentary we’ll briefly examine the distinct possibility that the Fed has put the U.S. financial market on the cusp of another troublesome year ahead.

Many investors and analysts believe that the quarter percent rate hike enacted by the Fed at its December meeting is inconsequential.  Some analysts, however, believe otherwise.  One such analyst is Bert Dohmen, editor of the Wellington Letter.  In a recent article he points out that in order for the Fed to achieve its goal of raising the benchmark interest rate to 0.25% from virtually zero, it has to drain reserves from the banking system.  It does this through “reverse repos,” which means it sells Treasury bonds to banks and receives payment via the bank’s reserves.  In short, it amounts to decreasing the amount of liquidity in the banking system.

On December 31, 2015, the Fed did almost $475 billion of reverse repos, according to Dohmen.  “Of course, this is not permanent,” he writes, “but usually measured in a few days or less.  But it does reduce the ability of banks to lend to each other for that time.  The above was a record amount, exceeding the prior record of $339.48 billion on June 30, 2014, 1.5 years ago.  On Jan 5, 2016 the fed did a reverse repo of almost $170 billion for one day.”

He points out that the Fed must continue doing this in order to keep the Fed Funds at or above 0.25%.  In doing so, the Fed is draining liquidity from the financial system at a time when liquidity is in great demand.  E.D. Skyrm, managing director of Wedbush Securities, has calculated that starting at zero, the Fed’s rate hike to 0.25% is “infinite” in percentage terms.  He further estimates the Fed needs to drain between $310B and $800B in liquidity to achieve this. 

As if that weren’t enough, comments by St. Louis Fed President Bullard this week suggest the Fed is completely oblivious to the effects that rate increases are having on the financial market.  Incredibly, Bullard suggested that four more rate increases were likely in 2016, underscoring the Fed’s total blindness to the global market crisis.

The Fed, duly chastised by its dilatory response to the 2008 crisis, claimed for years that it would vigilantly prevent another bubble from forming in the credit market.  Yet there is growing evidence that it has failed miserably in that duty as well.  Credit analysts Edward Altman and Brenda Kuehne, in an article entitled “Credt Market Bubble Building” (Business Credit, March 2015), observed last year that a bubble was building in the high yield corporate debt market.  They pointed out that the corporate high yield (HY) and investment grade (IG) sectors had been refinancing and increasing their debt financing continuously since 2010 when the Fed began ramping up its loose money policy.  They also wrote that “new HY issuance topped $200 billion in 2012 and almost matched that in 2013,” adding that corporate debt issuance was even more substantial in Europe in 2013-14.

“In a nutshell,” Altman and Kuehne concluded, “market acceptance of newly issued high-yield junk bonds has been remarkable, with record amounts issued at relatively low interest rates.  This reinforces that a seemingly insatiable appetite exists for higher yields in this low-interest rate environment.”  Further, the authors found that HY corporate bonds in 2015 carried a higher default risk than those outstanding in 2007.  The outcome of this can be clearly seen in the following graph of the SPDR High Yield Bond ETF (JNK), which is testing levels not seen since the depths of the 2008-09 credit crisis.

And so it would appear that after feeding another credit market bubble with its persistent zero interest rate policy of the last few years the Fed is committing a far more grievous error by raising rates at the worst possible time. 

Perhaps the biggest danger for central banks this year is hubris.  The Fed spent the better part of last year insisting that benchmark rate would be raised at some point in 2015.  It also consistently (and correctly, I maintain) passed on raising rates in meeting after meeting.  Only when December’s policy meeting came around did the Fed finally see fit to raise the benchmark interest rate.  There was essentially no justification for raising the rate; it seemed merely a case of the Fed feeling obligated to keep a promise it had made months earlier.  In other words, the Fed was merely trying to save face.

Robert Campbell, in the latest issue of his Campbell Real Estate Timing Letter, made an observation about market forecasters that could easily be applied to central bankers.  He wrote:

“It’s [a] natural tendency for humans to stock to a given forecast come hell or high water.  Instead of adjusting to changing conditions, most investors get married to their outlook for the markets – which only proves they would rather be right than change their positions according to changing realities and make money.  I know it sounds crazy but it’s human nature: most people would rather defend a bad idea (or investment position) – and prove they are right – than admit they made a mistake (and change and be happy).” []

Is it just possible that the Fed is oblivious to the bear market now underway in the equity market, along with the threat of additional weakness being imported from overseas?  Could it actually be serious about wanting to incrementally raise interest rates (thereby tightening money availability) in 2016 when the data argues it should be doing everything to make liquidity more plentiful?  While the jury is still deliberating those questions, the preliminary evidence would answer both questions in the affirmative.

Fed Chair Janet Yellen has been painted as a monetary dove by many Fed watchers, yet her actions since assuming control of the Fed have been anything but dovish.  Despite the many threats posed by the global economic crisis, the Fed is acting as if the U.S. is perfectly insulated against any ripple effects from global weakness.  She appears blithely unaware that her misguided monetary policy stance risks undoing the equity market rebound her predecessor helped engineer in the years following the credit crisis.

Wouldn’t it be ironic if in 2016 the Fed’s lack of sensitivity to the threat posed by the global crisis turns out to be its downfall?  The Fed appears to have painted itself into a corner with its monetary policy decisions.  Rates are too low to be used as an effective weapon against a further deflationary threat from overseas.  To lower the Fed funds rate from here would be to admit that it made a mistake in raising it in the first place.  It’s unlikely the Fed would do this since it fears anything that would potentially undermine its credibility and smack of indecision.  Moreover, it’s unlikely that the Yellen Fed would risk the appearance of being unduly aggressive by increasing liquidity at this early stage of the crisis.  History shows the Fed, like most institutions, to be a reactionary creature.  If the Fed under Bernanke was late in aggressively loosening monetary policy in 2008 when the credit conflagration was in full flame, why should we expect anything different from Yellen.

The Fed isn’t the only central bank that seems to be underestimating the potential danger of the global crisis.  European Central Bank (ECB) President Draghi famously pledged his bank would do “whatever it takes” to reverse the deflationary undercurrents within the euro zone.  Yet the ECB has failed to live up to that promise to date.  Although the ECB recently lowered its deposit rate from -0.2 percent to -0.3 percent and extended its 60-billion-euro monthly asset purchase program, the ECB hasn’t shown the necessary urgency commensurate with the magnitude of the crisis.  The result of the bank’s efforts to date has been an anemic euro zone economy and a lack of confidence among the region’s investors.

The lack of urgency among central bankers and investors alike is troubling since it means – from a contrarian’s perspective – that the global crisis likely has a lot further to run before it abates.  In the meantime, traders and investors should continue to maintain a defensive posture and avoid new long commitments due to the continuing internal weakness. 

Robert Moriarty’s New Book

My old friend and colleague, gold mining stock analyst extraordinaire Bob Moriarty, has written an entertaining new book.  Although a work of fiction, it’s based on his real-life exploits as a Marine fighter pilot during the Vietnam War.  Bob’s avid followers will want to read this exciting and quick read, entitled “Crap Shoot” which is available for download at

Monday, January 11, 2016

Could the unthinkable happen in 2016?

The most important question investors should be asking at this point isn’t whether the secular bull market which began in 2009 is over, but whether continued equity market weakness in 2016 will lead to the unthinkable, namely an economic recession.  A recession in 2016 has been deemed virtually impossible by most mainstream economists, so much so that all discussion of this possibility has evaporated.  And while most U.S. economic data categories are still admittedly strong, the persistent weakness under the surface of the equity market over the last several months demands that the topic be reexamined.   

One of the tenants of Charles Dow’s conception of the stock market is that the market’s primary trend is a precursor of U.S. business conditions in the aggregate.  Dow maintained that a steady decline of the major indices typically precedes trouble in the business economy by at least 6-9 months.  And while there are a few instances when the economy was able to withstand a bear market without entering recession, such cases are the exception instead of the rule. 

The stock market’s problems can be traced primarily to weakness in commodities, particularly crude oil.  Commodity weakness has been a result of diminished industrial demand in Asia and Europe as the leading industrial countries are still suffering the effects of the misguided tight money and austerity policies pursued by central banks and foreign governments in recent years.  As predicted, those austerity chickens have come home to roost and they aren’t in any hurry to leave the chicken house.  If our own experience in 2008 is any guide, it will likely take the better part of 2016 for the stimulus measures enacted by the People’s Bank and the ECB to have any measurable impact, and that’s assuming both entities remain committed to an aggressively loose money policy.

So the bigger question is whether the U.S. economy has enough forward momentum to withstand the impact of the global slowdown.  The effects of this slowdown are clearly being felt by equity investors, and that should be a warning sign to economists that a consumer spending slowdown is a real possibility in 2016.  Most economists consistently downplay Dow’s theory that the stock market is a leading indicator, however, so any slowdown in business this year will likely take most of them by surprise.  Moreover, most economic statistics that most economists rely on for making forecasts are lagging indicators.  This means these numbers won’t reveal a weakening domestic economy until it’s too late to take preventive measures. 

The key “statistic” for measuring the condition of the U.S. consumer should be the stock prices of the leading consumer retail, consumer discretionary and business service and transportation stocks.  Examples would include FedEx (FDX), United Parcel Service (UPS), Amazon (AMZN), WalMart (WMT), and Starbucks (SBUX).  These and other stocks are included in the New Economy Index (NEI), which I devised in 2007 to measure the underlying strength or weakness in the U.S. consumer economy.  Here’s what the NEI looks like as of Jan. 8.

Remarkably, NEI has managed to stay above its intermediate-term uptrend line for months on end despite the continual erosion in the global economy.  This can be attributed to the increasing willingness of consumers to make discretionary purchases, as well as their blithe unconcern at the possible domestic impact of the global slowdown.  NEI is finally showing signs of weakening, however, and may be on the verge of finally breaking its intermediate-term uptrend.  If this happens it will be the first indication in several years that the U.S. consumer is beginning to lose confidence.  I should mention that the only consumer confidence that really counts is whether the consumer is actually spending money, not the opinions he expresses to some pollster on the state of the economy.  

Behind the weakness is a drop in the dollar value of commodity prices, which reflects the deflationary undercurrent still present in several European and Asian nations.  While deflation is no longer a major threat to the U.S., the residual effects of the weak global economy are beginning to erode corporate profits.  This is one reason for the internal weakness in the NYSE broad market in the last few months.  A critical precursor to an improvement in the equity market then will be a reversal of the overseas economic weakness. 

To that end, the European Central Bank (ECB) announced a year ago its first round of quantitative easing (QE) with monthly purchases of EUR 60 billion worth of public bonds.  The European QE is expected to last until September 2016, with any extension dependent on the exigencies of the euro zone economy.  The goal of this stimulus measure on the part off the ECB is to reverse the deflationary trend and hopefully replace it with some inflation. 

In the March 2015 issue of Business Credit, economists for the euro zone economics team Euler Hermes S.A. forecast a “positive but limited impact” for Europe’s QE of 0.5 percentage points of GDP growth and 0.3 percentage points on inflation through July 2016.  That forecast, which many economists shared, looks to have been a tad optimistic in light of recent developments.  Although the ECB stepped up its stimulus program in December, the latest data show consumer prices have remained unchanged at an annual 0.2 percent, below consensus expectations. 

Euler Hermes rightly observed that the ECB lags far behind the U.S. Federal Reserve and the Bank of England when it comes to rapidly responding to deflationary threats.  The Euler Hermes team also pointed out that the “transmission mechanism of QE is less clear in the euro zone because the private sector is less intertwined with financial markets than the United States or the United Kingdom.”  Moreover, non-financial corporations in Europe tend to finance between only 10-20 percent of their debt in the market.  Euro zone households have less equity market holdings, preferring savings deposits or bonds; real estate holdings also have less impact on consumption than in the U.S.  With these fundamental differences between the euro zone and the U.S., it’s easy to see that the success of Europe’s QE program faces many obstacles.

The biggest hope or success of euro zone QE is, as Euler Hermes observed, the “policy signaling effect” which would theoretically help to increase business confidence and therefore raise inflation expectations and loan demand. Unfortunately, however, the ECB was late “coming to the QE party” which will make it more difficult to reverse the effects of deflation.  In Euler Hermes’ words, “If the ECB was a credible deflation-fighter, it would not need to print humongous amounts of money; the mere announcement of a credible target would trigger a virtuous circle leading to that target.”

Perhaps the old saying “better late than never” applies to the ECB’s attempts at staving off deflation.  But given the central bank’s poor track record, investors shouldn’t get their hopes up too high that success will be met anytime soon.

So if European QE won’t be a major factor in reversing the global economic malaise in 2016, what could possibly bring about an improvement?  Confidence is the keystone of a thriving economy, as any economist will testify.  When consumers, investors and business owners are confident in the strength and stability of business conditions they express this confidence by spending money, either to consume or to invest and expand business.  The lack of confidence in the long-term strength of the recovery is what has held back U.S. economic growth in recent years.  Every time it looked as if the economy was ready to take off it was hindered from doing so by some foreign threat or another.  In 2015, uncertainty over the global outlook led to cost-cutting and a complete lack of capital expenditures among S&P 500 companies.  Revenue growth and net income were also down for the year due to the strong dollar and hard-hit oil sector.  Thus confidence in the long-term outlook has been sorely lacking.

Without confidence, the next best thing is outright fear.  The type of profound fear that was common in the years immediately after the credit crisis hasn’t been seen since the recovery gained traction in 2013 and beyond.  While confidence is far preferable to fear, at least fear can generate the kind of action needed to stimulate the economy – much as was the case with the Fed’s QE program after the crisis.  So without a return of confidence in 2016, perhaps it will come down to how much fear is needed to generate concerted and aggressive action by governments and central banks in the coming months.

The U.S. Congress abdicated much of its authority to the Fed in the wake of the credit crisis; Congress must reassert its authority in the nation’s fiscal affairs, however.  Businesses and investors would find renewed confidence in the economic outlook if taxes were lowered and regulatory burdens were lifted.  The current administration has done much damage to the economy by way of increasing both, which has added to the uncertainty among investors and has hindered capital investment.  

Of the two major factors – confidence and fear – it would appear the safer bet that fear, rather than confidence, will be the dominant force behind efforts at reversing the damage caused by the global economic slowdown in 2016.