I know what you're thinking. The nearly 80 percent rise in the S&P 500 since the March lows of 2009 doesn't make sense. The unemployment rate is close to 10 percent, home foreclosures are at new record highs, businesses are closing shop or laying off workers, the government is running trillion-dollar deficits and backing trillion-dollar bailouts—how can stocks be going up under these conditions? If the economy is on the road to recovery it sure doesn't look like a normal one. You may have lost your job, or your neighbor may be out of work. You may have a son or daughter or grandchildren who have been laid off or can't find work. You may see empty store fronts or "for lease" signs everywhere you go. So if the economic conditions are this bad, why does the stock market keep going up?
Following the Money
The answer is simple: markets are going up due to liquidity. In the words of J Anthony Boeckh: "The banking system has always been the centerpiece of liquidity flows, and the financial markets are driven principally by changes in liquidity."[1] The Great Recession of 2008–2009 produced the deepest economic decline that we have experienced since the 1930s. The steepness of the decline has produced a commensurate response by governments and their central banks in the form of massive fiscal and monetary injections into the economy.
When central banks create liquidity through massive monetary injections, the money has to flow somewhere. It can go into the economy—boosting economic growth—or it can flow into the financial markets—creating higher asset prices. Money and credit are the main drivers of bull and bear markets. They also drive the business cycle. Unfortunately, when new money is created, the government doesn't control its path. Traditionally the first destination of newly created money is the financial markets, not the economy. Since this newly created money did not come from saving but instead from the government printing presses, it becomes a force of instability and distortion that is reflected by asset booms and economic anomalies—think tech stocks in the 1990s and real estate and mortgage assets in this decade.
This tsunami of money is what is fueling today's rise in asset prices. What you are seeing reflected in the financial markets is what Jens O Parsson called the good effects of an early inflation: "The effects at the beginning of an inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the latter inflation, on the other hand, the effects are all bad."[2] The latter effects may be postponed or kicked further down the road but they eventually arrive. When the effects of the most recent inflation do, we'll experience another bust. The next bust will be even bigger than the last one, reflecting the immensity of the monetary and fiscal stimulus now being administered by governments around the globe. More about the bust latter; for now investors need to take advantage of the boom. As J Anthony Boeckh warns in his new book "The Great Reflation," "Investors, unfortunately, do not have the luxury of riding out this turbulent period by sitting in short-term deposits and money market funds. After taxes and inflation, capital will erode."[3]
For now, it's "eat, drink, and be merry, for tomorrow [the markets] will die." In his latest quarterly letter, famed value investor Jeremy Grantham discusses the possibility that the S&P 500 could advance or exceed its former high in the 1500 to 1600 range during the next 18 months. Grantham cites that the excessive market response has occurred due to the sensitivity of stocks to low interest rates and the promise by the Fed that rates are likely to remain low. Grantham believes that if we experience a weak economic recovery—a high probability in my opinion—we could face a very real danger of a third stock market bubble.[4]
In the meantime, the markets should continue to benefit from this tsunami of money while monetary and fiscal injections create distortions in the U.S. economy, leading to a bifurcated economic recovery. The job market is slowly improving, as shown in the graphs below (courtesy of my friend Brian Pretti at Contrary Investor from his 29 April newsletter). Notice the drop in unemployment claims and the positive turn in the unemployment rate.
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Barry Bannister at Stifel Nicholaus posits that the next catalyst for the markets could be an improvement in the unemployment rate and net positive job creations. This event, along with positive earnings and economic growth, could take markets much higher than most investors and lamenting bears are thinking. In a world of near-zero interest rates, money has to flow somewhere. It would appear—barring some unforeseen mishap and occasional corrections—that financial markets have further room to grow.
Economic Recovery, or Prep for a Relapse?
Traction in the economy seems to be picking up, courtesy of the American consumer. This can be seen in the graphs below showing a drop in the personal savings rate and the pick up in retail sales.
Data Source: U.S. Census Bureau, BEA
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Most of the increase can be attributed to a rise in asset prices and government relief efforts aimed at distressed homeowners. The top 20% of income earners account for nearly 60% of all retail sales. With asset prices rising again and the economy stabilizing, the wealthy are spending again. This can be seen below in the graphs of Nordstrom Inc (JWN), Coach Inc (COH), and Tiffany & Co (TIF) versus Wal-Mart (WMT).
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In a recent move Wal-Mart announced it is cutting prices on about 10,000 items.[5] The announcement comes in the wake of a recent quarterly report showing year-over-year same-store sales at Wal-Mart U.S. were down two percent.[6] This is a big change for a retailer that experienced strong sales throughout the financial crisis. While the Ned Davis graphs above indicate a strengthening in the trend in retail sales, especially in discretionary categories like fashion, it is doubtful that consumers are moving back up the retailing food chain. It is more likely that the top 20% of income earners are contributing the bulk of these gains as asset prices have risen substantially over the last 15 months.
While things have perked up for some high-end retailers, the Wal-Mart sales numbers may indicate their customer base is still hurting. For now high-end retailers are enjoying the side effects of an asset boom on high-end wage earners. That could change next year when those high-end consumers become the target of tax hikes which could remove some of that discretionary spending. The unintended consequences of higher income and investment taxes could be another double-dip recession and a higher unemployment rate down the road when the asset bubble bursts.
Continuing the theme of a bifurcated economy: on the surface the economic indicators tell us the economy is improving. This can be seen in the graphs of the LEI and ISM manufacturing report below.
Data Sources: Standard & Poor's, ECRI, ISM
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The graphs indicate continued economic growth over the next few quarters. However, as Brian Pretti at Contrary Investor points out in his April 29th missive, the ISM numbers reflect large big manufacturing and service companies—the type of companies that make up the S&P 500. The NFIB (National Federation of Independent Business) surveys reflect an entirely different story. Small business retailers, manufacturers, and service companies aren't as optimistic. Normally when the economy recovers both large and small businesses see their conditions improve. Not this time around.
Large companies, who may get a larger portion of their sales overseas, seem to be doing well, as reflected in recent earnings and cash flow statements.
Small businesses continue to struggle, beset by approaching higher taxes, increased regulation, and limited access to credit (generally not a problem for big companies). Large corporation tax rates remain the same. For small business owners tax rates will be going up next year when the Bush tax cuts are allowed to expire. They will go up again with new surcharges against investments as a result of healthcare reform in 2013. Large companies with a global sales base can more easily absorb the cost of higher taxes and regulation. Small companies aren't as fortunate. The burden of high taxes and regulation and a loss in sales revenue impose a disproportionately larger burden on the small business owner.
Small businesses represent the largest employer base in this country. They have created the bulk of new jobs in our economy over the last three decades. The fact that they aren't optimistic and are not hiring does not bode well for the unemployment picture over the next few years. One has no further to look than the daily headlines. They tell a story of large companies laying off workers, closing down plants, outsourcing jobs, or moving production offshore. If large companies are cutting back and moving offshore, that leaves small business and government as the only source of new job creation in this country. Even there it is a mixed picture. Small businesses aren't hiring, or in many cases, are going out of business. The federal government is creating new jobs but those jobs are being offset by layoffs by state and municipal governments.
Data Sources: ISM, NFIB
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Since most of the economic growth we have seen over the last three quarters has been the result of an inventory build and massive fiscal stimulus from government, future economic growth is likely to be anemic. The economy will be plagued by an unemployment rate that will remain high for years. Small businesses aren't hiring; neither is big business. That leaves only government. The graph below shows the percentage increase of government as a percentage of GDP over the last few decades.
Data Source: BEA
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As the graph illustrates, government is becoming bigger and that translates into bad news for the economy. Bigger government means bigger budget deficits, higher taxes rates, slower economic growth, lower productivity, and higher inflation rates.
Not good news for the economy, but it could be good news for nominal asset prices. As expressed by Jeremy Grantham in his April quarterly report:
If, however, the economy only limps along, which seems more likely to me, then we run a very real danger of a third dangerous bubble in stocks and in risk-taking in general. For in that event, Bernanke will definitely keep rates low quarter after quarter and speculation will surely respond…It is hard to work out where the resources would come from to resuscitate the economy if a real shock were to be delivered by another collapse of a major asset class. The key problems here are the Fed's refusal to see risks embedded in asset class bubbles and the willingness of both the Administration and Congress to tolerate this dangerous policy.[7]
What's an Investor to Do?
Since the U.S. economy is being propped up by artificial means, this leaves investors in an unenviable position. Remain in cash and risk the erosion of capital to the ravages of taxes and inflation that most assuredly are coming, or become more knowledgeable and adept at tactical asset allocation. The economic pillars of the economy will remain weak for many years and asset prices won't rise indefinitely. Because the sources of asset gains are being fueled by central bank liquidity, the financial markets likely will become more unstable and volatile. Investors will increasingly need to monitor liquidity conditions and changes in the business cycle. When either of those conditions changes, an equal change in portfolio allocation will be warranted. If there is one lesson that can be learned from the last decade it is that when liquidity expands, all asset classes rise—some more than others. Equally, when liquidity is withdrawn, all asset classes can fall, with a few exceptions. The trick is knowing what to hold and what to fold and when.
What should be understood by every investor is that these are not ordinary times and we are not experiencing a normal economic recovery. What was safe in the last downturn, cash and treasuries, may not be safe in the next bust. As the folks at The Bank Credit Analyst (BCA Research) have observed the debt supercycle has morphed into a government debt supercycle which portends a different outcome during the next downturn.[8] Low-yielding treasuries, cash, and money market funds may not be as safe as the majority of investors think. During the credit downturn in 2008, the Fed had to backstop money market funds to keep a run on the funds from occurring. It took over trillion in bailouts and guarantees to keep our large banks, insurance companies, and auto companies from going bankrupt. Even then a few big ones went bust. We're still experiencing bank closures as shown in the graph from the FDIC below.
Data Source: FDIC
While the last downturn caused a brief whiff of deflation, the next round of inflation is already beginning. To quote Tony Boeckh, "the Age of Inflation will continue with new twists that will have implications for all asset markets."[9]
A Strategy for a New Market
So how will ordinary investors know when it is time to raise sail or when it is time to head toward safe harbors? No one can know the exact timing of the next bust. It can come suddenly, or, more likely, there will, like the credit crisis, be plenty of advance warnings. There are a number of indicators that can alert us to changes in the economy and changes in the financial markets.
Track the LEI
One of my favorites is the LEI (leading economic indicators). The index is made up of 10 indicators, three are monetary and seven relate to the economy. As you can see below the percentage change in the LEI relates very closely to the change in the stock market. As the LEI began to turn up in March of last year, it coincided with a turn in the financial markets.
Data Source: ECRI, Standard & Poor's
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I like to break the LEI into its two separate components, one monetary and one economic, to get a better feel of what the separate components are doing. Monetary or liquidity conditions lead economic conditions and warn ahead of dangers to the financial markets. Separate graphs of both components can be seen below.
Data Source: Conference Board
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Track Money Supply and Credit
There are a number of other indicators that investors will find helpful in monitoring as to when an asset allocation change is warranted. Since markets are fueled by liquidity, monitoring money and credit conditions is essential. This can be done by keeping track of the yield curve, the difference between short-term and long-term interest rates. A rising yield curve is indicative of a positive environment for equities, and comes about during an economic downturn when a central bank lowers short-term interest rates. It flattens or inverts when liquidity is withdrawn. As shown below the current yield curve is positively sloped indicating ample liquidity and a positive environment for equities.
Data Source: Bloomberg
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Other money and credit conditions to monitor are credit spreads—the difference between Treasuries and high risk bonds. As shown below credit spreads have been falling. The Ted Spread is another indicator to follow regarding financial stress in the financial system. It has begun to tick up recently from its lows as a result of the sovereign debt crisis within Europe.
Data Source: Bloomberg
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The PFS Group U.S. Financial Stress Index measures the volatility in the money market, bond market, stock market, currency market, and U.S.T market, combing all the various volatilities into a master composite that measures the overall health of the financial markets.
I've also shown our own financial stress indicator (above), which remains positive.
A short note here as to money supply, which can oftentimes be deceiving. As many readers know, M-2 has been contracting while M-1 has been rising. The difference is due to the non-M-1 components: retail money funds and small time deposits. The short answer as to why this is happening is that investors have been pulling their money out of money market funds, which pay nearly nothing, and are not rolling over their CDs when they mature. The preferred destination has become bond funds which offer higher yields in a yield-starved market. Last month, 9.4 billion flowed out of money market funds (4.3 billion outflow over the last year); billion flowed into bond funds (5.1 billion inflow over the last year).[10] Over time I believe investors will realize this to be a mistake as both inflation and bond yields rise in the future.
There are other indicators that an alert investor could monitor but time does not permit covering all of them here. Suffice it to say by monitoring a few key indicators such as the LEI, the yield curve, and credit spreads the ordinary investor should be able to discern when monetary and economic conditions have changed. This should allow time to take evasive action. We'll be posting updates on these key indicators on our website's Economy page for those who wish to monitor monetary and economic conditions and be alert to when they change.
The beginning of this new decade has seen many extraordinary events. The decade began with the bursting of the TMT (technology, media, telecommunications) bubble and the events of 9-11. Subsequently, the decade has reeled during the bursting of the real estate bubble, the credit bubble, and the consumer discretionary spending bubble. These four bubbles were fueled by low interest rates and rising asset bubbles in real estate and equities. The government is making every effort to pump air back into the economic balloon through enormous reflationary policies. In my opinion this eventually will lead to the next series of bubbles to burst: the U.S. dollar and the U.S. government debt bubble. However, the dollar/debt bubble is only one of a series of storms that lie ahead. The other storm is peak oil. Both storms should collide mid-decade and lead to the formation of the next Perfect Financial Storm.
As we have been highlighting nearly every week on the Financial Sense Newshour, we have now entered the crisis window we've talked about for the last few years. The crisis window began in 2008, a year earlier than I anticipated. We're enjoying the short recovery that follows. However, beginning this year from 2010 to 2014 that crisis window will begin to intensify. I expect we will see greater asset volatility and instability in the economy and the financial markets. I expect another major terrorist attack on U.S. soil, and a series of new resource wars to follow as we transition from an age of plenty to an age of resource scarcity. I'll end with one of my favorite quotes from history.
"The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must learn to work, instead of living on public assistance."
Marcus Tullius Cicero (106-43 BC) Roman Statesman, Philosopher and Orato
Coming next: Part II of "The Great Reflation" which will deal with the twin threats of a U.S. dollar/debt collapse and peak oil.
Resources:
[1] J Anthony Boeckh, The Great Reflation: How Investors Can Profit From the New World of Money, Wiley (2010), p ix.
[2] Jens O Parsson, Dying of Money: Lessons of the Great German and American Inflations, Wellspring (1974), p 71.
[3] The Great Reflation, p xvii.
[4] Jeremy Grantham, "Playing with Fire (A Possible Race to the Old Highs)," GMO Quarterly Letter, April 2010, p 2.
[5] "Wal-Mart cuts prices on 10,000 items-WSJ," Reuters, 8 April 2010.
[6] Miriam Marcus, "Wal-Mart Draws Worry After U.S. Sales Dip," Forbes.com, 18 February 2010.
[7] GMO Quarterly Letter, p 2
[8] "Outlook 2010: The Debt Supercycle Goes Global," The Bank Credit Analyst, January 2010, Vol 61 No 7.
[9] The Great Reflation, p 121.
[10] Tom Roseen, "Money Market Funds See Record Redemptions in March, but Equity and Bond Funds Attract Net New Money," Lipper Research Series, FundFlows Insight Report, 31 March 2010.
