February 5, 2016
By Steve Blumenthal
“Clearly, QE has not worked. We have not had one year of 3%+ growth since the Great Recession and are barely averaging 2%. Yes, if your measure is the stock market and other financial assets that have inflated, then QE has worked quite well. But the boost QE was supposed to deliver just hasn’t reached Main Street.
One of the basic tenets of QE and other related policies is that if you want to increase consumption, you lower the cost of borrowing. But if out-of-control borrowing was the original problem, then QE as a solution is kind of like drinking more whiskey in order to sober up.
And if you reduce the earnings of those who are savers so that they are no longer able to spend, the whole purpose of the original project – to foster economic growth – is defeated.
But we (central bankers) can’t acknowledge that, because if we did, we’d have to admit that our theories don’t work. And we all know, because God knows, that our theories are correct.”
John Mauldin, Thoughts from the Frontline – Tokyo Doubles Down
U.S. recession signals are intensifying. The QE boost that hasn’t reached Main Street will be taken away from Wall Street in the next recession.
I wrote a piece this week for Forbes entitled, U.S. Recession Signals Intensify . The hard reality is we are due (some say overdue) for a recession and evidence suggests the next one is heading our way. Equity market declines are at their worst during recession as you’ll see in the following chart. View the next chart with a stiff drink in hand. To this, as advisors, we must defend!
Take a look at the “Market Price – Peak to Trough” column. The largest market declines come during recession when your starting points are high valuations (like today).
Source: Advisor Perspectives
The last two recessions saw market declines of -56.8% and -49.1%. Many panicked out near the market lows. Portfolios can be defended and do not need to take that hit. It is the opportunity those dislocations create that we want to position for. A buy when everyone else around us is in panic mode. Recessions follow expansion. Expansion follows recession. Markets cycle.
A brief commercial. Our relative strength tactical strategies are defensively positioned in bonds (which are performing well) and utilities (up nearly 5% in January vs. near -5% for the S&P). Many managed futures strategies are higher year-to-date. Take a look at some of the funds in the Morningstar Multi-Alternative and Managed Futures categories. In my view, recession is a 79% probability and I believe one may have just started (more on that in the charts below). My point is and has been that portfolios can be positioned for both growth and protection. Overweight tactical and managed futures. And hedge that equity exposure. Let’s not be surprised, let’s be prepared.
Look, the debt mess is global in scope and in many places simply unmanageable. Some form of debt restructuring is ahead. “If out-of-control borrowing was the original problem, then QE as a solution is kind of like drinking more whiskey in order to sober up.” Amen, Brother John. The global central bankers are stuck, as my old man used to say, “between a rock and a hard place”.
“Why is this happening? Simply, savers are scared. Lower interest rates have wrecked their retirement plans. Say you were doing some financial planning 10 years ago and plugged in 3% from your savings account. Now its 0%. You still have to plan for your retirement. Plug in 0%. What happens to your planning now? 0% compounded for X years is 0%. The math is simple. So in order to have your target savings at retirement, you need to save more, not spend more.
But for some reason, the economists that run central banks around the world can’t see this. They are all stuck in their offices talking to one another and self-reinforcing this myth that they can drive spending up by reducing the rate of return on investments. Want to see consumer spending go up? Don’t wreck their savings plans so that they are too scared to spend. But that’s too simple. Instead, central banks use a chain of causation that doesn’t exist to try to create change 3 or 4 steps down the line. It hasn’t worked, and it won’t work. It isn’t in an individual’s self-interest to go out and spend their money on more “stuff” in order to spur economic growth.” From Negative Interest Rates – Won’t You Take Me To Funkytown?
Yet for now it is with heads bowed towards the central bankers that we pray, but let’s be clear, we are witnessing an unprecedented economic experiment that is not working and confidence is waning. We are now deeper in debt and absent the hoped-for growth. The next recession will be trickier for the Fed and others to manage.
So what are the tea leaves telling us about recession? Let’s take a look at the January month-end data. The signals are intensifying. Let’s also take a look at what is going on with margin debt. Total margin debt peaked mid last year and remains higher than it was in March 2000 and at the peak in 2007. When margin debt begins to unwind, we should take notice. Margin calls, forced selling, would-be buyers step aside, etc. The “unwinding” of investment leverage causes markets to over-react to the downside (aka a “crash”). I think you’ll like the chart I share with you below.
Grab your coffee or a nice glass of wine (it’s Friday) and jump in. There are a lot of charts but it is a pretty quick read; however, if you are 100% invested in equities skip the coffee and down some whiskey. High valuations, excessive investment leverage and periods of recession are a bad mix. It’s gonna get bumpy.
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Included in this week’s On My Radar:
- Margin Debt at Record High
- Equity Market Valuations
- Recession Watch Chart
- Trade Signals – Margin Debt Flashes Warning
Margin Debt at Record High
Let’s first take a look at margin debt, then valuations and then the probability of recession.
One of the indicators I like to watch and post in Trade Signals from time to time is margin debt. Simply put, markets dislocate when leverage unwinds (would be market makers and buyers step aside). I’ve been concerned for some time about the record high level of margin debt but, in general, most of the time, margin is not a bad thing. It is when it declines below its moving average trend line (“smoothing”) that our concern should grow.
The following chart looks at Margin Debt as a Percentage of GDP and is updated quarterly. It then looks at the current level and compares it to a 15-month smoothing. Risk is elevated when the current reading is below its smoothing. Note the red arrows and the line I drew between them (1987, 2000, 2008 and today). The yellow circle highlights the most recent reading.
Hedge that equity exposure!
Equity Market Valuations
This next chart is my favorite valuation metric. It