The Fed seeks “stable” inflation targets of 2%.  For many goods the price is nowhere near “stable.”

 

 

Healthcare costs are a problem in this country.  For illustration, let’s apply a hypothetical self-employed person making $100,000 a year. The $1,286/month premiums add up to $15,432 annually. But you get no benefits (except a basic wellness exam) until you’ve spent another $12,500. That totals $27,932, or 27.9% of your gross income that will go to healthcare if anyone in your family gets even a minor illness.

Let’s take that a little further. This self-employed person is paying $12,000+ in Social Security plus another $3,000 in Medicare, plus federal income tax, in addition to state and local taxes. Which means that if someone in that hypothetical family gets sick, the family has to figure out how to make all of their payments on maybe as little as $45,000 net, after taxes and healthcare.

The irony is that much of the country thinks you are rolling in cash, and might be inclined to vote for someone who would raise your taxes.

 

 

Based on our research on various price reporting services, we think the real consumer inflation rate is probably about 5 to 6%.

What About Education Costs?

Does it pay off? Sometimes, but far from always. The chart below breaks down the change in college graduate wages since 2000 by percentile. In most cases, after that 2% average inflation the Fed thinks is too low, real wages actually dropped over this period. And note this only looks at those who actually earn degrees. Millions drop out before getting that far (but not before racking up debt).

 

 

So not only is college more expensive, the economic benefit you get from it may well be negative. This is inflation on steroids.

Let’s think about that for a moment. You graduated in 2000 at age 22, got married, had kids, and right about now you’re facing college costs. What’s happened to the price of college? Up over 130% in 20 years. A tad more than 2% inflation.

The average price of a new car is $34,000 and median household income is $64,000, and it’s that high only because millions need those cars to commute to underpaid jobs far, far away from the distant suburbs where they can afford to live.

 

MegaTrends

 

“Megatrends” are profound, long-lasting changes in society’s status quo. Investing in them is fundamentally different but potentially rewarding. Neils Jensen of Absolute Return Partners identifies eight megatrends he follows.

  • Investing in megatrends offers a better shot at long-term wealth than investing in the latest fad because megatrends always survive difficult market conditions.
  • A true megatrend will have a global theme rather than a specific regional focus.
  • For instance, the debt supercycle is making banks everywhere downsize their loan books, forcing small borrowers to look elsewhere for their financing needs.
  • Megatrends spawn smaller trends. The digital revolution is fueling the growth of non-fossil energy and urbanization.
  • Current equity valuations suggest low and possibly negative returns will prevail in the years to come for Buy and Hold strategies.
  • The portfolio construction approach that worked well over the last 35-40 years may not keep doing so. (Buy and Hold asset allocation)

Bottom Line: We often hear how US markets are the world’s strongest. Jensen says it may not be the US per se, but simply that we have more exposure to the strongest megatrends. They unfold slowly but hold great power.

The 8 megatrends:

  1. The End of the Debt Supercycle
  2. Retirement of the Baby Boomers
  3. Declining Spending Powers of the Middle Classes
  4. Rise of the East
  5. The Age of Disruption
  6. Running Out of Freshwater
  7. Electrification of Everything
  8. Mean Reversion of Wealth-to-GDP… with #8 effectively being the aggregate result of the other seven megatrends.

Over the past 120 years, US equities have moved in a very well-defined market valuation channel, and that we are currently bumping against the ceiling of that channel

 

 

Inverted Yield Curve Graph

 

 

Debt

 

DoubleLine’s Jeff Gundlach suggested that trouble is brewing in debt markets as interest rates hover around zero. Decades of can-kicking would finally stop in the 2020s, and the US will have to face realities relating to its debt situation.  “[We’re] going to have to face Social Security, health care, all of these things, deficit-based spending — all of that is going to have to be resolved during the 2020s because the compounding curve is just so bad,” he said. The billionaire investor said interest costs on the debt would soar from 1.25% to at least 3% by 2027. “That’s a big, big increase. And that’s coming,” he warned.

The last financial crisis was about debt and debt levels have increased substantially since 2008. The entire “recovery” was built on debt.

Global debt-to-GDP ratios have increased. Companies and governments have piled on more debt than before. Emerging-market debt, led by China, is also at a record. The big banks are even bigger, and remain “too big to fail.”

Now, ten years after the financial crisis, there are major complications building with the deluge of debt created on the back of central bank quantitative easing policy.

Eliminating all that debt is the ultimate solution for avoiding another crisis. But now that the central banks are cutting rates again and making more cheap credit, or “dark money” available, the problem’s only getting bigger.

Loans to companies with large amounts of outstanding debt, known as leveraged lending, grew 20% last year alone. The growing corporate debt problem has even prompted the Federal Reserve to identify it as a potential risk to the financial system.

The share of new, large loans that have been going to comparatively risky borrowers exceeds peak levels reached previously in 2007 and 2014.

 

Stock Buybacks

 

Here’s how Wall Street on Parade sums it up:

Had JPMorgan Chase not spent $77 billion propping up its share price with stock buybacks, it would have $77 billion more in cash to loan to businesses and consumers — the actual job of its commercial bank. Add in the tens of billions of dollars that other mega banks on Wall Street have used to buy back their own stock and it’s clear why there is a liquidity crisis on Wall Street that is forcing the Federal Reserve to hurl hundreds of billions of dollars a week at the Repo problem.

 

Demographics

 

Where do you find the lowest interest rates in the world?

Generally, Japan.

Where else?

Europe, especially Germany.

What do these places have in common?

Terrible demographics. Low birth rates. In Japan, the population is actually shrinking. It will start shrinking in Europe soon. And eventually, it will shrink in the United States, too.

Interest rates have gone down for almost 40 years. So have our reproductive abilities.

Japan has negative interest rates, and its stock market is below its 1990 peak. Europe has negative interest rates, and its stock market has basically stayed flat over the last 15 years.

I’ll say this explicitly—when population growth slows, stocks don’t go up, and neither do interest rates.

The amazing thing is we’ve been blaming the Fed for negative real interest rates over the last 12 years. But it might not be the Fed. And it might not be the “savings glut,” either. It might simply be demographics. Although I do think the savings glut exists—there’s a wall of money that needs to find a home.

US birth rates are plummeting. Why? Let’s just say the internet has caused certain social and cultural changes that are isolating people. It takes many forms.

I’ve seen some interesting studies on the dating app Tinder. Crazy stuff. Basically, men swipe right on everyone—they are not picky. The women are super picky and only swipe right on the top 10 percent of men, in terms of attractiveness. The result? Some men get a lot of dates, and most get none.

 

 

We are becoming Japan. And if you think we’re becoming Japan in our reproductive habits, then we’re becoming Japan in our economics, as well.

 

 

Recession?

 

One-third of economists surveyed by The Wall Street Journal think we will see a recession next year and almost 2/3 see a recession by 2021.

 

 

On average, over the past 50 years, equity bear markets tended to occur six months before a recession.

 

 

Non-manufacturing hours worked have slowed appreciably with growth falling below 2% in the seven months ended October; the ADP report confirmed the weakness in hours worked and exhibited broad-based job declines and slowing across the full spectrum of sectors.

 

 

 

When Presidential & Decennial Cycle Collide

 

There have been quite a few articles out lately suggesting that in 2020 the 10-year bull market is set to continue because it is a presidential election year. This sounds great in theory, but Wall Street and the financial media always suggest that next year is going to be another bullish year.

However, there are a lot of things that will need to go “right” next year from:

  1. Avoidance of a recession
  2. A rebound in global economic growth
  3. The consumer will need to expand their current debt-driven consumption
  4. A marked improvement in both corporate earnings and corporate profitability
  5. A reduction or removal in current tariffs, and;
  6. The Fed continues to remain ultra-accommodative to the markets.

These are all certainly possible, but given we are currently into both the longest, and weakest, economic expansion in history, and the longest bull market in history, the risks of something going wrong have certainly risen.

 

The Presidential Cycle

 

Since 1948, there have only been two losses during presidential election years which were 2000 and 2008. In fact, stocks have, on average, put in their second-best performance in the fourth year of a president’s term. (The third year has been best as we are seeing currently.)

One thing to remember about all of this is that while the odds are weighted in favor of a positive 2020 from an election cycle standpoint – there have been NO cycles in history when the majority of the industrialized world was on the brink of a debt crisis all at the same time.

 

 

Decennial Cycle

 

The best year of the decade is the 5th which has been positive 79% of the time with an average return of 22%. The worst year is the 7th with only a 53% win rate but a negative average annual return. As noted, 2020 comes in as the second place for the worst of the annual returns.

 

 

A Lot Of If’s

 

All of this analysis is fine but whether the market is positive or negative in 2020 comes down to a laundry list of assumptions:

  • If we can avoid a recession in the U.S. 
  • If we can avoid a recession in Europe. 
  • If corporate earnings can strengthen.
  • If the consumer can remain strong.
  • If the Fed can keep the Repo market liquid.

 

2020 Earnings Estimates

 

As far as corporate earnings go – they peaked this year as the tax cut stimulus ran its course, and forward expectations are being sharply ratcheted lower.

 

 

 

This earnings boom cycle was skewed heavily by accounting rule changes, loan loss provisioning, tax breaks, massive layoffs, extreme cost cutting, suppression of wages and benefits, longer work hours, and massive share buybacks along with extraordinary government stimulus.

But when it comes to actual reported “profits,” which is what companies actually earned, reported, and paid taxes on, it is a vastly different story.

Unfortunately, estimates are still too high and have further to fall. It is very likely, particularly if “tariffs” remain in place into 2020, that the majority of expected earnings growth will be reversed.

 

 

Analysts are cautious about next year’s equity returns.

 

 

Market Valuation

 

It is ONLY because of current market valuation AND the length of this economic expansion that we bring up the possibility of “market tops” and “market blow off’s”.

As Ned Davis noted, “Given the high valuations I see, plus these divergences between many different indices, I am aware that many bull markets have ended with a rally similar to what we have seen since August.” So buckle up and keep your risk management processes in place.

We have that in place.

Valuation Dashboard

Here’s how to read the chart:

  • Red is bad, green is good.
  • Flashing red pretty much in every metric that matters.

 

 

Normal Valuation

Bottom line: Extremely Overvalued – Look at the return box when readings are above 20. Note the returns are the total returns years later… not annualized returns.

 

 

Economic Reporting

 

While economic numbers like GDP, or the monthly non-farm payroll report, typically garner the headlines, the most useful statistic, in my opinion, is the Chicago Fed National Activity Index (CFNAI). It often goes ignored by investors and the press, but the CFNAI is a composite index made up of 85 sub-components, which gives a broad overview of overall economic activity in the U.S

The CFNAI also tells the same story with large divergences in consumer confidence eventually “catching down” to the underlying index.  This chart suggests that we will begin seeing weaker employment numbers and rising layoffs in the months ahead, if history is any guide to the future.

 

 

Currently, there are few, if any, Wall Street analysts expecting a recession currently, and many are certain of a forthcoming economic growth cycle. Yet, at this time, there are few catalysts supportive of such a resurgence.

  • Economic growth outside of China remains weak
  • Employment growth is going to slow.
  • There is no massive disaster currently to spur a surge in government spending and reconstruction.
  • There isn’t another stimulus package like tax cuts to fuel a boost in corporate earnings
  • With the deficit already pushing $1 Trillion, there will only be an incremental boost from additional deficit spending this year.
  • Unfortunately, it is also just a function of time until a recession occurs.
  • Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.

 

Everyone wants to be a Technology Company.  Why?

 

Over the past several years, we have seen an unprecedented move among companies to characterize themselves as technology companies. The reason is that the “tech” label carries with it a hefty premium in valuation on a presumption of a steeper growth trajectory and the zero marginal cost benefit. A standard consumer lending company may employ technology to convince investors they are actually a new-age lender on a sophisticated and proprietary technology platform. If done convincingly, this serves to garner a large price-to-earnings multiple boost thereby significantly (and artificially) increasing the value of the company.

From 2010 to the end of the third quarter of 2019, there have been 1,192 initial public offerings or IPOs. Of those, 19% or 226 have been labeled technology companies. Over the past two years, many of the companies brought to the IPO market have, for reasons discussed above, desperately tried to label themselves as a tech company. Using analysis from Michael Cembalest, Chief Strategist for JP Morgan Asset Management, we considered 32 “tech” stocks that have gone public over the past two years under that guise.

For example, ride share company Uber (Tkr: UBER) went public in May 2019 at a market capitalization of over $75 billion. Their formal name is Uber Technologies, but in reality, they are a cab company with a useful app and a business producing negative income.

Peloton (Tkr: PTON) makes exercise bikes with an interactive computer screen affording the rider the ability to tap in to live sessions with professional exercise instructors and exercise groups from around the world. Like Arlo, the Peloton app is available to anyone, but the experience requires an investment of over $2,000 for the stationary bike. PTON went public in September 2019 at the IPO price of $29 per share. It currently trades at roughly $23.

 

Euro GDP Numbers for 2020.  All are Sub 1%

 

 

Credit Cards and Car Loan Interest Rates

 

Interest rates on consumer credit have risen substantially over the past couple of years.

 

 

Good News for the Markets

 

  • Consumer confidence in the economy continues to strengthen.
  • The NFIB small business sentiment report showed growing optimism in November.

 

Bad News for the Markets

 

  • Demand for stocks in 2020 is expected to come from share buybacks mostly.

 

Market Data

 

  • Wall Street strategists are updating their 2020 outlooks, and so far, they’re cautious. On average, they only expect about a 4% gain for the S&P 500 next year, which is one of the smallest expected gains in 20 years.
  • For most of 2019, hedge funds employing different strategies all were seemingly avoiding stocks. Their sensitivity to movements in the S&P 500 were very low, or even negative at points during the year. That recently changed in dramatic fashion.
  • Common stocks come back. For more than a year and a half, fewer than 60% of common stocks on the NYSE have managed to close above their 200-day moving averages. That’s one of the longest streaks in nearly 30 years.
  • Leaving early. Investors have pulled hundreds of billions from equity funds in 2019, despite large gains in the funds. Because the gains have been so large, the outflows are small as a percentage of total assets.
  • The Investment Company Institute shows that US and global stock markets have had net outflows in eight of the last 10 weeks
  • Smart money’s bet on ‘Gundlach Ratio.’ A respected bond fund manager highlighted his use of a ratio of copper to gold to forecast the future path of interest rates. Currently, smart money hedgers are net long copper while being heavily short gold.
  • 13 of the 17 FOMC members expect rates to remain unchanged in 2020.
  • In recent quarters, corporate CFOs have become more optimistic after a long time expecting declining conditions. At the same time, their bosses (CEOs) have continued to edge further into cautious territory.
  • Most of the gains in the Nasdaq 100 index have been in the overnight market.