About Stocks and Bonds

          The stock market highs of November have not yet been taken out and my long-term trend-following indicators continue to become more bearish.  At this point, a “Santa” rally looks less likely especially given the Fed’s recent statements about accelerating the taper or slowing the rate of currency creation.

          As the longer-term readers of “Portfolio Watch” are aware, I believe the Fed’s taper talk is just that.  The math doesn’t lie; the federal government cannot fund its deficit spending without currency creation.  While the Fed may taper officially, liquidity will have to be made available in order to close the budget gap.

          Of course, common sense dictates that this process of currency creation will have to cease at some future point.  When it does, it is my belief that a reset will have to occur that will affect many assets including stocks and real estate.

          Both stocks and real estate are in a bubble in my view.

          David Stockman, former budget director, penned an article last week that examines just how extended stocks likely are.  Here is a bit from Mr. Stockman’s piece (Source:  https://internationalman.com/articles/david-stockman-reveals-the-truth-about-the-stock-market-and-what-it-means-for-you/)

The fundamental consequence of 30 years of Fed-fueled financial asset inflation is that the prices of stocks and bonds have way overshot the mark.

That’s why what lies ahead is a long stretch of losses and investor disappointment as the fat years give way to the lean.

These will hit hard the bullish investor herd and aggressive buyers of calls who can’t imagine any other state of play. They will be shocked to learn — but only after it is way too late — that the only money to be made during the decades ahead is on the short side of the market by buying puts on any of the big averages: the FANGMAN, S&P 500, NASDAQ 100, the DOW and any number of broad-based ETFs.

The reason is straightforward. The sluggish, debt-ridden Main Street economy has been over-capitalized, and it will take years for company profits and incomes being generated to catch up to currently bloated asset values. Accordingly, even as operating profits struggle to grow, valuation multiples will contract for years to come, owing to steadily rising and normalizing interest rates.

We can benchmark this impending grand reversal on Wall Street by reaching back to a cycle that began in mid-1987. That’s when Alan Greenspan took the helm at the Fed and promptly inaugurated the present era of financial repression and stock market coddling that he was pleased to call the “wealth effects” policy.

At the time, the trailing P/E multiple on the S&P 500 was about 12X earnings — a valuation level that reflected a Main Street economy and Wall Street financial markets that were each reasonably healthy.

The US GDP in Q2 1987 stood at $4.8 trillion and the total stock market was valued at $3.0 trillion, as measured by the Wilshire 5000. Back then, Wall Street stocks were stably capitalized at 62% of Main Street GDP.

Over the next 34 years, a vast unsustainable gulf opened up between the Main Street economy and the Wall Street capitalization of publicly traded stocks.

During that three-decade period, the Wilshire 5000 market cap rose by 1,440% to $46.3 trillion. That’s nearly four times the 375% gain in nominal GDP to $22.7 trillion.

Accordingly, the stock market, which was barely three-fifths of GDP on Greenspan’s arrival at the Fed, now stands at an off-the-charts 204% of GDP.

If we assume for the moment that the 1987 stock market capitalization rate against national income (GDP) was roughly correct, that would mean that the Wilshire 5000 should be worth $14 trillion today, not $46 trillion. Hence, the $32 trillion of excess stock market valuation hangs over the financial system like a Sword of Damocles.

In fact, we believe that the gulf between GDP and market cap has been growing wider and more dangerous since the Fed sped up money printing after the Lehman meltdown. To wit, since the pre-crisis peak in October 2007, the market cap of the Wilshire 5000 is up by nearly $32 trillion, while the national income to support it (GDP) is higher by only $8 trillion.

The stock market’s capitalization should be falling, not soaring into the nose-bleed section of history. After all, since the financial crisis and Great Recession, the capacity of the US economy to generate growth and rising profits has been sharply diminished. The real GDP growth rate since the pre-crisis peak in Q4 2007, for instance, is just 1.5% per annum, which is less than half its historical trend rate of growth.

Back in October 2007, the stock market’s capitalization was 106% of GDP and in just 14 years it has soared to the aforementioned 204%. So even as the growth rate of the US economy has been cut in half, stock market capitalization has doubled.

Given that the stock market has gotten way, way ahead of the economy, the longer-range implication is a long spell during which financial asset prices will stagnate or even fall until they eventually recover the healthy relationship to national income.

Looking at this from a different angle, the current $46 trillion market cap of the Wilshire 5000 would not return to 62% of GDP until US GDP reaches $75 trillion. At an average of 3.3% per annum increase in nominal GDP since Q4 2007, it would take 38 years to get there!

That’s right. The massively over-valued stock market is currently capitalizing on an economy that might exist by the year 2060… if all goes well.

            Mr. Stockman offers a terrific perspective on where stock valuations have moved since the Fed began the ‘temporary’ policy of currency creation.

          Real estate has followed a course similar to the course tracked by stocks.

          The Case-Shiller Housing Index is the commonly used metric of housing values.  The chart illustrates housing values for the past 25 years.

          Looking at the chart, one can see the decline in housing values at the time of the financial crisis.  The index fell from 200 to about 150. 

          Notice that housing values began to increase in earnest after the Fed began quantitative easing.  Since that time, housing prices have nearly doubled.

          And, as inflated as housing prices were at the time of the financial crisis, they are far more inflated presently – they are about 50% higher than they were prior to the collapse that began in 2007.

          Of course, as we have demonstrated many times in the past if real estate and stocks were priced in gold rather than depreciating US Dollars, one gets a completely different perspective.  In 2007, gold was about $650 per ounce.  Today, the spot price of gold is about $1800.  That’s an increase of about 275%.  Priced in gold, both stocks and real estate have declined in value which one would expect given the massive levels of debt that exist.

          The reality is that the US Dollar and every other fiat currency around the world is no longer an accurate metric when examining economic data and asset pricing.

If you or someone you know could benefit from our educational materials, please have them visit our website at www.RetirementLifestyleAdvocates.com.  Our webinars, podcasts, and newsletters can be found there.

Artificial Markets

         On numerous occasions, I have made the case that, financially speaking, we live in a land of make-believe.  In other words, many financial markets are artificially inflated.

          The base cause of artificially inflated markets is the devaluation of the US Dollar.  Dollar devaluation, stated another equally accurate way, is price and asset inflation.  Anything measured in US Dollars has increased in price or value as the US Dollar has been devalued, something that continues and is intensifying despite indisputable evidence of inflation.

          David Stockman, former congressmen representing Michigan’s 4th District and former Director of the Office of Management and Budget under President Reagan, wrote a piece last week that examines this phenomenon from a unique perspective.  I’m including an excerpt here and a link to the entire piece that is worth a read.  (Source:  https://internationalman.com/articles/david-stockman-on-the-feds-socialist-monetary-policies-and-what-comes-next/)

Socialist central planning has been elevated to a new art form based on control of the economy from the commanding heights of finance.

Central banks were once in the money business, in the sense of securing its availability, liquidity, and stable value. But the contemporary Fed never says a peep about the place where money arises and dwells — the financial markets — while gumming endlessly about the Main Street economy and the condition of and its targets for the components and constituents of GDP.

During the last 43 years, total financial assets held by the household sector have increased by a staggering $100 trillion. And that’s just a proxy for the massive levels of bank deposits, money market funds, bonds, publicly traded shares, and private equities that flow through the warp and woof of the nation’s $21 trillion GDP.

The Fed spent the last 13 years capping and smothering the money market rate.

That’s socialism by any other name.

Ironically, it’s leading to the same outcome as in the old Soviet Union: a failing economy for the masses and a concentration of wealth and privilege among the few elites who are close to the levers of control.

The chart (left) shows the real federal funds rate, calculated by subtracting the year-over-year trimmed mean-CPI increase from the Fed’s target rate. During the last 169 months (since March 2008) the rate has been deeply negative for 96% of the time and just a tad positive for a grand total of 7 months, all in 2019. And now, after last year’s money-printing orgy, the real federal funds rate stands at –2.37%, nearly the deepest level ever.

Never in a million years would participants in voluntary exchange on the free market lend money — even overnight — at a negative real rate. It defies economic logic and sanity itself.

          Stockman makes the point of artificial markets extremely well.  As you read the article excerpt, keep in mind that the real Fed Funds rate was calculated using the manipulated Consumer Price Index which is the official measure of inflation.  Stockman calls it the “year-over-year trimmed mean-CPI”.

            If one adjusted the Fed Funds rate chart for the real inflation rate rather than the officially reported inflation rate, the already profoundly negative real Fed Funds rate goes even more negative.

            Stockman points out that smart, savvy investors operating in a free market would never accept real returns that are negative. 

            This simple example demonstrates just how artificial financial markets have become.  We can take Stockman’s real Fed Funds rate calculation and apply it to stocks as well.

            The chart is a chart of the S&P 500 since calendar year 2000.  Notice that over that time frame the S&P 500, a broad stock market index has moved from about 1400 to about 4200.  That’s an increase of 300%, right?

            Not so fast.  To determine the real return, one must adjust it for US Dollar devaluation.  As price inflation makes the price of essentials like food, fuel, lumber, and automobiles increase, the same price inflation causes stock values to move nominally higher.  But that doesn’t mean they are higher on a real basis.

            In my view, the best way to determine the real value of stocks is to price them in a consistent metric.  That doesn’t begin to describe the US Dollar which is a pure fiat currency.  Since gold has been used as money for most of history, let’s see what happens when we price stocks in gold.

            The simplest way to do that is to take the value of the S&P 500 in 2000 and divide it by the price of gold per ounce.  If we take 1400 and divide by the approximate price of gold per ounce in 2000 of $28, we arrive at a real value of the S&P 500 priced in gold of 5.  To make the point clear, in calendar year 2000 it took 5 ounces of gold to buy the S&P 500.

            Fast forward to calendar year 2021.  The S&P 500 is at 4200 and the price of gold per ounce is about 1800.  Doing the same calculation today finds that the S&P 500 can be purchased with 2.3 ounces of gold or less than half of what it took to buy the S&P 500 20 years ago.

            So, are stocks really 300% higher than 20 years ago?

            Nominally yes, but on a real basis no.  On a real basis, stocks are lower than they were 20 years ago.  And, despite that fact, stocks are arguably incredibly overvalued.

            If we take the total value of stocks (also known as market capitalization) and divide that number by economic output (Gross Domestic Product) we get a more realistic valuation than simply measuring the nominal value of stocks.

            Since both market capitalization and Gross Domestic Product are priced in US Dollars, inspecting this relationship can be useful.

            Notice from the chart that at the tech stock bubble peak in calendar year 2000 market capitalization was 159% of GDP.  Today that number has been inflated to an all-time high of 209%, nearly 1/3rd higher than at the nosebleed levels of 2000.            

          On a real basis, in my view, stocks will go lower, even if they rise on a nominal basis due to additional money creation.

If you know of someone who could benefit from our educational materials, please have them visit our website at www.RetirementLifestyleAdvocates.com.  Our webinars, podcasts, and newsletters can be found there.