It will not shock you when I say we live in confusing times. Odd, seemingly inconsistent events, and decisions don’t bring the expected results. Once-reliable rules don’t work. This makes it hard to chart a personal and business path forward.

At the same time, truly nothing is new under the sun. Almost everything we see happened before at some point in human history, though of course with different details and magnitude. So, we can’t throw out precedent completely. Well, except for negative interest rates. That really is something new under the sun.

Negative rates are like the event horizon around a black hole. Once you cross the event horizon, all known mathematical models and descriptions of the universe change. Negative interest rates are creating the same chaos in the world as black holes do in space.

Here is more from Ray Dalio, Bridgewater Associates, August 28, 2019:

The most important forces that now exist are:

  • The End of the Long-Term Debt Cycle (When Central Banks Are No Longer Effective) +
  • The Large Wealth Gap and Political Polarity +
  • A Rising World Power Challenging an Existing World Power =
  • The Bond Blow-Off, Rising Gold Prices, and the Late 1930s Analogue

In other words, now

  1. central banks have limited ability to stimulate,
  2. there is large wealth and political polarity, and
  3. there is a conflict between China as a rising power and the US as an existing world power.

If/when there is an economic downturn, which will produce serious problems in ways that are analogous to the ways that the confluence of those three influences produced serious problems in the late 1930s.

There are four important influences that drive economies and markets:

  1. Productivity
  2. The Short-Term Debt/Business Cycle
  3. The Long-Term Debt Cycle
  4. Politics (Within Countries and Between Countries)

There are three equilibriums:

  1. Debt growth is in line with the income growth required to service the debt,
  2. the economy’s operating rate is neither too high (because that will produce unacceptable inflation and inefficiencies) nor too low (because economically depressed levels of activity will produce unacceptable pain and political changes), and
  3. the projected returns of cash are below the projected returns of bonds, which are below the projected returns of equities and the projected returns of other “risky assets.”

And there are two levers that the government has to try to bring things into equilibrium:

  1. Monetary Policy
  2. Fiscal Policy

The equilibriums move around in relation to each other to produce changes in each like a perpetual motion machine, simultaneously trying to find their equilibrium level. When there are big deviations from one or more of the equilibriums, the forces and policy levers react in ways that one can pretty much expect in order to move them toward their equilibriums.

For example, when growth and inflation fall to lower than the desired equilibrium levels, central banks will ease monetary policies, which lowers the short-term interest rate relative to expected bond returns, expected returns on equities, and expected inflation. Expected bond returns, equity returns, and inflation themselves change in response to changes in expected conditions (e.g. if expected growth is falling, bond yields will fall and stock prices will fall).

These price changes happen until debt and spending growth pick up to shift growth and inflation back toward inflation. And, of course, all this affects politics (because political changes will happen if the equilibriums get too far out of line), which affects fiscal and monetary policy. More simply, and most importantly, said, the central bank has the stimulant, which can be injected or withdrawn and cause these things to change most quickly.

Fiscal policy, which changes taxes and spending in politically motivated ways, can also be changed to be more stimulative or less stimulative in response to what is needed, but that happens in lagging and highly inefficient ways.

 

Looking At What Is Happening Now In Context Of That Template

Regarding the above template and where we are now, in my opinion, the most important things that are happening (which last happened in the late 1930s) are:

  • We are approaching the ends of both the short-term and long-term debt cycles in the world’s three major reserve currencies.
  • The debt and non-debt obligations (e.g. healthcare and pensions) that are coming at us are larger than the incomes that are required to fund them.
  • Large wealth and political gaps are producing political conflicts within countries that are characterized by larger and more extreme levels of internal conflicts between the rich and the poor and between capitalists and socialists.
  • External politics is driven by the rising of an emerging power (China) to challenge the existing world power (the US), which is leading to a more extreme external conflict and will eventually lead to a change in the world order. (Ian Bremmer calls this the return of a bi-polar world but with significant differences in the goals of the powers.)
  • The excess expected returns of bonds is compressing relative to the returns on the cash rates central banks are providing.

As for monetary policy and fiscal policy responses, it seems to me that we are classically in the late stages of the long-term debt cycle when central banks’ power to ease in order to reverse an economic downturn is coming to an end because:

  • Monetary Policy 1 (i.e. the ability to lower interest rates) doesn’t work effectively because interest rates get so low that lowering them enough to stimulate growth doesn’t work well.
  • Monetary Policy 2 (i.e. printing money and buying financial assets) doesn’t work well because that doesn’t produce adequate credit in the real economy (as distinct from credit growth to leverage up investment assets), so there is “pushing on a string.” That creates the need for…
  • Monetary Policy 3 (large budget deficits and monetizing of them), which is problematic especially in this highly politicized and undisciplined environment.

More specifically, central bank policies will push short-term and long-term real and nominal interest rates very low and print money to buy financial assets because they will need to set short-term interest rates as low as possible due to the large debt and other obligations (e.g. pensions and healthcare obligations) that are coming due and because of weakness in the economy and low inflation.

Their hope will be that doing so will drive the expected returns of cash below the expected returns of bonds, but that won’t work well because

  • these rates are too close to their floors,
  • there is a weakening in growth and inflation expectations, which is also lowering the expected returns of equities,
  • real rates need to go very low because of the large debt and other obligations coming due, and
  • the purchases of financial assets by central banks stays in the hands of investors rather than trickles down to most of the economy (which worsens the wealth gap and the populist political responses).

This has happened at a time when investors have become increasingly leveraged long due to the low interest rates and their increased liquidity. As a result, we see the market driving down short-term rates while central banks are also turning more toward long-term interest rate and yield curve controls, just as they did from the late 1930s through most of the 1940s.

As a result, there is a lot to be learned by understanding the mechanics of what happened then (and in other analogous times before then) in order to understand the mechanics of what is happening now. It is also worth understanding how paradigm shifts work and how to diversify well to protect oneself against them.

 

My Comments About Ray’s Comments Above

The coming, difficult times will be somewhat less difficult if we recognize them for what they are, and prepare accordingly. That is what I’m trying to do with these weekly emails.

 

gold is usually positive during recessions

 

Another Bear Market Indicator

This chart is based on a bear market probability model produced by Goldman Sachs. The model uses five data categories to calculate the probability: US unemployment, the P/E ratio, the ISM manufacturing index, the inflation rate, and the yield curve. One drawback with the model is that it can stay high for years before a bear market actually arrives.

 

 

The reading, however, has dropped over 12% during the last five months, and that has not been a good sign for the markets. When this has happened in the past, the markets struggled over the long term.

 

China

China posted the steepest decline in factory gate inflation in at least three years in August, suggesting manufacturers are having to slash prices in order to win new orders and offset the impact of tariffs on goods imported into the United States. New car sales in China, the world’s biggest automobile market, also declined, falling 9.9% from last year and notching the 14th drop in the past 15 months.

 

Government Jobs Have Declined Over The Years

 

 

China’s Exports To The US Have Declined 16% In The Last 12 Months

 

 

This Is What An Inverted Yield Curve Looks Like

 

 

Coming 5 And 10 Year Returns

The first chart looks at the long-term trend of the S&P 500 Index. It looks busy, but hang in there with me. Here’s how to read it:

  • Ned Davis Research (NDR) plots the long-term trend line of returns since 1928 (red dotted line in the middle section of the chart).
  • They measure each month-end price, and compare it relative to the long-term trend line (again, since 1928). They sort the data into five quintiles ranging from “Top Quintile” (most overpriced relative to the long-term trend) to “Bottom Quintile” (most underpriced).
  • Then, they look at each data point and calculate what the actual subsequent 5- and 10-year total return turned out to be. Then, they calculate the average return in each quintile.
  • The data box in the upper left shows the difference. I’ve added the data box in the upper middle, so you can see both the total return after 5 and 10 years and what that means in terms of annualized gains.
  • Bottom line: The average annual gain is just 1.80% when in the top quintile (see 8/31/19 “We are Here” arrow), and it is greater than 15% per year when in the bottom quintile (see green “We’d be better off Here” arrow).

 

 

The buy-and-hold investor, according to this NDR chart, will have low average returns in the next 10 years due to current high market valuations. Our models give us more options with Gold, Silver, Bonds, Oil, and a two-sided strategy on equity and other markets.

 

Current Market Valuation

 

 

Here is another Chart on market valuation from Shiller:

 

 

Debt

With corporate debt to GDP levels now at record levels, it is only a function of time until something breaks.

 

 

Market Data
  • On Monday, many momentum traders likely had their worst day in a decade. Stocks that showed the best gains year-to-date suffered some of the worst losses, and stocks down the most so far in 2019 showed some of the best gains.
  • September has a bad reputation as being the worst for stocks.
  • “Safe” stocks are expensive. After their recent surge, the trailing P/E ratio for the S&P 500 utilities sector is above 20, and the forward ratio is above 19, both the highest since 1990.
  • The S&P 500 is nearing a fresh high for the first time in 30 days, yet fewer than 10% of its members are hitting new highs. That’s not too surprising since nearly 40% of them were still in correction territory a few days ago.