Eddie Ghabour, Co-Owner of Key Advisors Group shares his thoughts on the potential of a recession in the next 12 months while also balancing US market moves. Even though Eddie does not see a recession in the next year he is shifting his clients into a more defensive position for their portfolio by focusing on dividend stocks and shifting into cash. We also discuss how the election could play a roll in delaying a major recession.
Ed Moya, Senior Market Analyst at OANDA joins me to share his thoughts on the US markets and all the recession fears that are on investors minds. Most importantly for this week we look ahead to major events that could drive markets, these include the Jackson Hole meeting and the G7 summit over the weekend.
Sean Brodrick, Editor over at Weiss Ratings joins me to address the growing fears for a recession. While we have heard a recession is right around the corner for a couple years but now more factors are lining up that support this argument. We discuss the places Sean is viewing as the best investment opportunities.
This post Free-Riding Investors Set up Markets for a Major Collapse appeared first on Daily Reckoning.
Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition.
The best example is a parasite on an elephant. The parasite sucks the elephant’s blood to survive but contributes nothing to the elephant’s well-being.
A few parasites on an elephant are a harmless annoyance. But sooner or later the word spreads and more parasites arrive. After a while, the parasites begin to weaken the host elephant’s stamina, but the elephant carries on.
Eventually a tipping point arrives when there are so many parasites that the elephant dies. At that point, the parasites die too. It’s a question of short-run benefit versus long-run sustainability. Parasites only think about the short run.
A driver who uses a highway without paying tolls or taxes is a free rider. An investor who snaps up brokerage research without opening an account or paying advisory fees is another example.
Actually, free-riding problems appear in almost every form of human endeavor. The trick is to keep the free riders to a minimum so they do not overwhelm the service being provided and ruin that service for those paying their fair share.
The biggest free riders in the financial system are bank executives such as Jamie Dimon, the CEO of J.P. Morgan. Bank liabilities are guaranteed by the FDIC up to $250,000 per account.
Liabilities in excess of that are implicitly guaranteed by the “too big to fail” policy of the Federal Reserve. The big banks can engage in swap and other derivative contracts “off the books” without providing adequate capital for the market risk involved.
Interest rates were held near zero for years by the Fed to help the banks earn profits by not passing the benefits of low rates along to their borrowers.
Put all of this (and more) together and it’s a recipe for billions of dollars in bank profits and huge paychecks and bonuses for the top executives like Dimon. What is the executives’ contribution to the system?
Nothing. They just sit there like parasites and collect the benefits while offering nothing in return.
Given all of these federal subsidies to the banks, a trained pet could be CEO of J.P. Morgan and the profits would be the same. This is the essence of parasitic behavior.
Yet there’s another parasite problem affecting markets that is harder to see and may be even more dangerous that the bank CEO free riders. This is the problem of “active” versus “passive” investors.
An active investor is one who does original research and due diligence on her investments or who relies on an investment adviser or mutual fund that does its own research. The active investor makes bets, takes risks and is the lifeblood of price discovery in securities markets.
The active investor may make money or lose money (usually it’s a bit of both) but in all cases earns her money by thoughtful investment. The active investor contributes to markets while trying to make money in them.
A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery.
The benefits of passive investing have been trumpeted by the late Jack Bogle of the Vanguard Group. Bogle insisted that passive investing is superior to active investing because of lower fees and because active managers can’t “beat the market.” Bogle urged investors to buy and hold passive funds and ignore market ups and downs.
The problem with Bogle’s advice is that it’s a parasitic strategy. It works until it doesn’t.
In a world in which most mutual funds and wealth managers are active investors, the passive investor can do just fine. Passive investors pay lower fees while they get to enjoy the price discovery, liquidity and directional impetus provided by the active investors.
Passive investors are free riding on the hard work of active investors the same way a parasite lives off the strength of the elephant.
What happens when the passive investors outnumber the active investors? The elephant starts to die.
Since 2009, over $2.5 trillion of equity investment has been added to passive-strategy funds, while over $2.0 trillion has been withdrawn from active-strategy funds.
The active investors who do their homework and add to market liquidity and price discovery are shrinking in number. The passive investors who free ride on the system and add nothing to price discovery are expanding rapidly. The parasites are starting to overwhelm the elephant.
There’s much more to this analysis than mere opinion or observation. The danger of this situation lies in the fact that active investors are the ones who prop up the market when it’s under stress. If markets are declining rapidly, the active investors see value and may step up to buy.
If markets are soaring in a bubble fashion, active investors may take profits and step to the sidelines. Either way, it’s the active investors who act as a brake on runaway behavior to the upside or downside.
Active investors perform a role akin to the old New York Stock Exchange specialist who was expected to sell when the crowd wanted to buy and to buy when the crowd wanted to sell in order to maintain a balanced order book and keep markets on an even keel.
Passive investors may be enjoying the free ride for now but they’re in for a shock the next time the market breaks, as it did in 2008, 2000, 1998, 1994 and 1987.
When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.
Passive investors will be looking for active investors to “step up” and buy. The problem is there won’t be any active investors left or at least not enough to make a difference. The market crash will be like a runaway train with no brakes.
The elephant will die.
for The Daily Reckoning
The post Free-Riding Investors Set up Markets for a Major Collapse appeared first on Daily Reckoning.
Mike Larson, Editor of The Safe Money Report shares his thoughts on why he remains in safe assets even when the Fed and other central banks are going down the easy money road. We also discuss the potential scenario where markets do not breakdown but rather these safe assets outperform all the high flaying stocks.
Bloomberg captures the mood on Wall Street:
“Traders Take Fed Message as License to Buy Everything.”
Jerome Powell had his telegraph out yesterday… and wired a message of approaching rate cuts.
Federal funds futures give the odds of a July rate cut at 100%.
They further indicate three are likely by January.
And like sugar-mad 8-year olds amok in a candy store… traders are out for everything in sight.
Yesterday they drove the S&P past 3,000 for the first time. And today, freshly inspired, they sent the Dow Jones running to virgin heights.
The index crossed 27,000 this morning — timidly and briefly at first.
Comments by the president sent it temporarily slipping.
China is “letting us down,” Mr. Trump informed us.
Evidently China has not purchased satisfactory amounts of American agriculture — as it had agreed to at last month’s G20 summit.
And so the trade war menaces once again.
But the Dow Jones recalled Mr. Powell’s communique, rediscovered its gusto… and lit out for 27,000 once again.
It ended the day at 27,088.
Is Dow 30,000 Next?
We next await rabid and delirious shouts for Dow 28,000… 29,000… 30,000!
And who can say they will be wrong?
Dow 27,000 sounded plenty handsome not far back.
Yet here on July 11, Anno Domini 2019… Dow 27,000 it is.
Don’t fight the Fed, runs an old market saw. It has proven capital advice…
The Fed does not box fairly.
It strikes beneath the belt. It bites in the clinches. It punches after the bell has rung.
Those unfortunates battling the Fed lo these many years have absorbed vast and hellful pummelings.
Justice may have been with them. But the judges were not.
“The Bears Have Been Damnably, Comedically, Infamously… Wrong”
With the displeasure of quoting ourself…
The frustrating thing about bears is that they make so much sense.
They heave forth every reason why stocks must collapse — all sound as a nut, all solid as oak.
Chapter, verse, letter, they’ll explain how the stock market is a classic bubble…
And how it has been inflated to preposterous dimensions by cheap credit.
P/E ratios haven’t been so high since the eve of the Crash of ’29, they’ll insist.
Market volatility has returned — and history shows trouble is ahead, they’ll warn.
Or that today’s sub-4% unemployment is a level historically attained only at peaks of business cycles.
And that recession invariably follows.
Et cetera, et cetera. Et cetera, et cetera.
But despite their watertight logic and all the angels and saints…
The bears have been damnably, comedically, infamously… wrong.
Since 2009, the Dow Jones has continually thumbed a mocking nose at them.
First at 10,000, then 15,000, at 20,000… then 25,000.
Each point supposedly marked high tide — and each time the water rose.
It now rises to 27,000.
But is there some hidden pipe that could suddenly rupture, some unappreciated vulnerability that could send the Dow Jones careening?
Perhaps there is. But what?
The Dow’s Problem Child
Put aside the general hazards of trade war for now.
And turn your attention to Boeing…
Boeing has made the news in recent months — as you possibly have heard.
But its battering may continue yet. Explains famous money man Bill Blain:
Boeing has just announced its H1 [first half] deliveries in 2019 are down 54%. It has only delivered 90 new aircraft this year. Yet it is producing 42 new B-737 MAX’s each month and is having to store them on airport parking lots! It isn’t getting paid for these aircraft, but it still has supply chain commitments to meet. Boeing is hemorrhaging cash to build an aircraft no one can fly…
Boeing is trying to rush deliveries of other aircraft types to buyers to make up for the B-737 MAX cash slack. But there have been problems with B-787 Dreamliners built at its state-of-the-art Charleston factory — “shoddy production and weak oversight” said The New York Times. At least one airline is said to be refusing to accept aircraft built outside Seattle. The U.S. Air Force stopped deliveries of new KC-46 tankers for a while when they found engineers had left hammers and other tools in wing and control spaces — a clear indication of “safety standards gotten too lax” said Defense News… This has massive implications for Boeing.
It may have massive implications for the stock market as well.
The Dow Jones is a price-weighted index.
Its components are weighted according to their stock price — not market capitalization or other factors.
And Boeing is the largest individual component on the Dow Jones. It presently enjoys an 11.6% weighting.
When Boeing goes up, the index often goes with it. When Boeing goes down, the index often goes with it also.
“The Likely Trigger for a Market Shock Will Be a ‘No-see-em’”
The bullet that fetches you is the bullet you don’t detect… as legend puts it.
And according to Blain,“The likely trigger for a market shock will be a ‘no-see-em.’”
He believes Boeing could be the “no-see-em” that knocks market flat:
I am concerned the market is underestimating just how bad things could go for Boeing, and when it does, the whole equity market will knee-jerk aggressively, triggering pain across all stocks… The crunch might be coming.
But perhaps Mr. Blain is chasing a phantom menace, a false bugaboo.
Scarcely a day passes that a fresh crisis-in-waiting does not invade our awareness.
Yet they all blow on by… “harmless as the murmur of brook and wind.”
We cannot argue Boeing will be different.
Hell to Pay
Perhaps we should raise a cheer today for Dow 27,000.
Yet the Lord above did not bless us with a believing or trusting nature.
Instead, we take our leaf from Mencken:
When we smell flowers… we look around for a coffin.
And as we have argued previously:
All things good must end, including bull markets — especially bull markets.
One day, however distant, there will be hell to pay.
And it won’t be the bears doing the paying…
Managing editor, The Daily Reckoning
How far might markets plunge next time around?
And will you be able to recover your losses rapidly?
Answers — possibilities, rather — shortly.
And is one of Wall Street’s oldest chestnuts of investment wisdom tragically wrong?
This question too we will tackle.
But first to that vicious den of sin and iniquity — the stock market.
The Dow Jones roared 353 points today. The S&P rallied 28 points and the Nasdaq… 109.
For reasons we turn to the president’s comments this morning:
Had a very good telephone conversation with President Xi of China. We will be having an extended meeting next week at the G-20 in Japan. Our respective teams will begin talks prior to our meeting.
That G-20 meeting transpires June 28-29.
We shall see.
But how much value can you expect the stock market to shed in the next bear market?
The United States economy has endured recession every five years since World War II — on average.
Yet the present economic expansion runs to 10 years. It will be crowned history’s longest next month.
How much longer will the gods of chance be put off, cried down, ridiculed and shooed away?
10-year Treasury yields have slipped beneath 3-month Treasury yields.
This yield curve inversion has preceded each and every recession 50 years running.
And last week the yield curve inverted to its steepest degree since April 2007.
Meantime, Morgan Stanley’s Business Conditions Index just endured its largest-ever monthly plummet.
It presently languishes at its lowest level since December 2008 — the teeth of the financial crisis.
In Morgan Stanley’s telling, the American economy may already be sunk in recession.
But today or 18 months from today… a bear market will likely come dragging in on recession’s coattails.
Thus we arrive at the inevitable question:
How much value might the stock market lose in the next bear market?
Financial journalist Mark Hulbert interrogated the history since 1900 (based on data from research firm Ned Davis).
Investors have withstood 36 bear markets in these 119 years.
Hulbert then zeroed in on stock market valuations.
In particular, to the cyclically adjusted P/E ratio (CAPE) hatched by Yale man (and Nobel winner) Robert Shiller.
At 30.2, CAPE is mountain-high — that is, stocks are vastly expensive by history’s standards.
Today’s valuations rise even above 1929’s — and put 2008’s in the shade.
Only during the dot-com delirium were stocks dearer than today.
Hulbert’s research reveals bear markets tend to greater severity when stock valuations are elevated.
And so given today’s wild valuations, how far might the Dow Jones drop next time?
The answer, says Hulbert… is 35.3%:
A simple econometric model whose inputs are past bear markets and CAPE values predicts that, if a bear market were to begin from current levels, the Dow would tumble 35.3%. Though that’s less severe than the 2007–09 bear market, it still would sink the Dow below 17,000.
Hulbert concedes his findings do not rise to the 95% confidence level he seeks. But can you safely throw them aside?
Assume the Dow Jones does go tumbling 35.3% — beneath 17,000.
Worry not, says Wall Street.
Hold on for the long pull. Buy and hold is the way.
The stock market always comes back, the learned gentlemen assure us.
The magic of annually compounding returns will ultimately leave you in easy waters.
But have another guess, says analyst Lance Roberts of Real Investment Advice…
Perhaps you seek 10% compounding annual returns for five years.
Ten percent is handsome — but not extravagant.
Assume 10% is precisely what you receive the first three years. But you lose 10% the fourth.
What then happens to your gorgeous five-year 10% compounding?
You would need to haul in a ludicrous 30% return the fifth year… to catch up.
The “power of compounding” ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required.
If you are approaching retirement — or already in retirement — can you afford to stagger 10%?
You must further consider today’s extreme valuations.
The higher the valuation… the lower returns you can expect over the next several years.
At today’s valuation extremes…
Would you be better off placing $3,000 into the stock market each year — or wedging it under your mattress?
Roberts has given the numbers a good, hard soaking. At 20x valuations, he finds…
Your stock market money would finally exceed your snoozing cash… in twenty-two years.
“Historically, it has taken roughly 22 years to resolve a period of overvaluation,” affirms Roberts, adding:
Given the last major overvaluation period started in 1999, history suggests another major market downturn will mean revert valuations by 2021.
And recall — today’s CAPE is 30.2%. Perhaps stocks must wait even longer to break ahead.
But can you afford to wait?
for The Daily Reckoning
What are the three elements of the perfect political and market storm I see coming together this fall?
The first is an effort by the Democratic House of Representatives to impeach President Trump. The second is the socialist-progressive tilt in the 2020 presidential election field. The third is the fallout from the Mueller report and the Russia collusion hoax — what I and others called “Spygate.”
These components are independent of each other but are at high risk of convergence in the coming months. Let’s look more closely at the individual elements of impeachment, electoral chaos and Spygate that comprise this new storm with no name.
The first storm is impeachment. Impeachment of a president by the House of Representatives is just the first step in removing a president from office. The second step is a trial in the Senate requiring a two-thirds majority (67 votes) to remove the president. Two presidents have been impeached, but neither was removed. Nixon resigned before he could be impeached.
If the House impeaches Trump, the outcome will be the same. The Senate is firmly under Republican control (53 votes) and there’s no way Democrats can get 20 Republicans to defect to get the needed 67 votes needed. So House impeachment proceedings are just for show.
But it can be a very damaging show and create huge uncertainty for markets. There are powerful progressive forces in Congress and among top Democratic donors who are fanatical about impeaching Trump and will not be satisfied with anything less. One poll shows that 75% of Democratic voters favor impeachment (including almost 100% of the activist progressive base).
Speaker of the House Nancy Pelosi and House Majority Leader Steny Hoyer have both poured cold water on impeachment talk. They feel it’s a distraction from Democratic efforts to enact their legislative agenda. But some of the party’s biggest private money donors, including Tom Steyer, are also demanding impeachment.
If Steyer does not get an impeachment process, he looks to support primary challenges to sitting Democrats who don’t join the impeachment effort. This could jeopardize Pelosi’s speakership in a new Congress. So Pelosi could come under heavy pressure to go along with impeachment.
The final outcome is irrelevant; what matters is the process itself. Impeachment fever is not likely to last long into 2020, because at that point the election will not be far away. Voters will turn their backs on impeachment and insist that disputes about Donald Trump be settled at the ballot box. That’s why you can expect impeachment fever to come to a head by the fall of 2019. And that will create a lot of uncertainty for markets.
The second storm is the 2020 election.
Trump is on track to win reelection in 2020. My models estimate his chance of victory is 63% today and it will get higher as Election Day approaches. The only occurrence that will derail Trump is a recession.
The odds of a recession before the 2020 election are below 40% in my view and will get smaller with time. Meanwhile, Trump will keep up the pressure on the Fed not to raise interest rates and will ensure that the U.S.-China trade war comes in for a soft landing.
This may sound like a rosy scenario for the economy. But it’s not so rosy for the Democrats. Every piece of good economic news will cause Democrats to dial up their political hit jobs on Trump. Each one will try to outdo the next.
There are now 24 declared candidates for the 2020 Democratic presidential nomination. That’s more than the Democrats have ever had before. Currently Joe Biden and Bernie Sanders are out in front. Biden is considered the most moderate of the candidates.
But I don’t expect Joe Biden to stay in front for long, and I don’t believe he’ll win the nomination. But the only way for a Democrat to stay in the race is to stake out the most extreme progressive positions. This applies to reparations for slavery, free health care, free child care, free tuition, higher taxes, more regulation and the Green New Deal.
If Biden does fall away, then the choices are back to Sanders, Elizabeth Warren or maybe Kamala Harris. But one is more radical than the next. So, you could have a shock effect where all of a sudden it looks like the Democratic nominee is going to be a real socialist. And that would rattle markets.
This toxic combination of infighting among candidates and bitter partisanship aimed at Trump will be another source of market uncertainty and volatility until Election Day in 2020 and perhaps beyond.
But the third storm is the most dangerous and unpredictable storm of all: Spygate. It involves accountability for those involved in an attempted coup d’état aimed at President Trump.
The Mueller report lays to rest any allegations of collusion, conspiracy or obstruction of justice involving Trump and the Russians. There is simply no evidence to support the collusion and conspiracy theories and insufficient evidence to support an obstruction theory. The case against Trump is closed.
Now Trump moves from defense to offense, and the real investigation begins.
Who authorized a counterintelligence investigation of the Trump campaign to begin with? Did surveillance of the Trump campaign by the U.S. intelligence community (CIA, NSA and FBI) begin before search warrants were obtained? On what basis? Was this surveillance legal or illegal?
These are just a few of the many questions that will be investigated and answered in the coming months.
These criminal referrals will be taken seriously by Attorney General William Barr along with other criminal referrals coming from Congress. Barr will take a hard look at possible criminal acts by John Brennan (CIA director), James Comey (FBI director) and James Clapper (director of national intelligence) among many others.
At the same time Lindsey Graham, Republican senator from South Carolina, will hold hearings in the Senate Judiciary Committee about the origins of spying on the Trump campaign and lies to the FISA court. These may be the most important hearings of their kind since Watergate.
Trump will be running for reelection against this backdrop of revelations of wrongdoing by his political opponents in the last election. Actual indictments and arrests of former FBI or CIA officials will cause immense political turmoil. Such charges may be fully justified (and needed to restore credibility). They will certainly energize the Trump base.
But they are just as likely to infuriate the Democratic base. Cries of “revenge” and “witch hunt” will be coming from the Democrats this time instead of Republicans. Markets will be caught in the crossfire.
How do these three storms — impeachment, the 2020 election and Spygate — converge to create the perfect storm?
By November 2019, the impeachment process should be well underway in the form of targeted House hearings. The 2020 Democratic debates (starting in June 2019) will be red-hot. Trump’s counterattacks on the FBI and CIA should be reaching a fever pitch based on real revelations and actual indictments.
The impeachment process and Trump’s revenge represent diametrically opposing views of what happened in 2016. The Democrats will continue to call Trump “unfit for office.” Trump will continue to complain that the Obama administration and the deep state conspired to derail and delegitimize him.
The 2020 candidates will have to take a stand (even though they may prefer to discuss policy issues). There will be nowhere to hide. The bitterness, rancor and leaking will be out of control.
Any one of these storms would create enough uncertainty for investors to sell stocks, raise cash and move to the sidelines. The combination of all three will make them run for the hills. That’s my warning to investors.
The next six months will present unprecedented challenges for investors. Markets will have to wrestle with fights over impeachment, election attacks and Spygate. Trump will be trying to improve his odds with Fed appointments and an end to the trade wars. Democrats will be trying to derail Trump with investigations, accusations and leaks.
Some of this will be normal political crossfire, but some of it will be deadly serious, including arrests of former senior government officials and revelations of an attempted coup aimed at the president.
A perfect storm with no name is coming. The only safe harbors will be gold, cash and Treasury notes. And make sure you have a life preserver handy.
for The Daily Reckoning
People often refer to the “perfect storm.” A perfect storm is generally understood as two or more events that are independent but converge to produce an outcome much worse than either event alone.
The term is an overused cliché, and as a writer I avoid clichés whenever possible. But though rare, perfect storms do exist. The most common example is the devastating 1991 storm popularized by the book and movie of the same name, although it was initially known as the “Halloween storm.”
In that case, three separate weather dynamics all converged in one place on one day to produce a perfect storm. The odds of all three coming together at once were less than one in 100,000. That’s less than once in 270 years. That’s a perfect storm.
Do metaphorical perfect storms happen in politics and capital markets?
The answer is yes, provided the conditions of the perfect storm definition are satisfied. The multiple events that make up the true perfect storm must be independent and rare and come to converge in an almost impossible way.
Unfortunately, a political and market perfect storm is now on the way and may strike as early as Halloween 2019, marking a new “Halloween storm.” Get ready.
Today I’ll be discussing the components making up this perfect storm, and how I see them all coming together at the same time.
In my 40-plus years in banking and capital markets, I have lived through a number of financial fiascos that arguably qualify as perfect storms. Here’s a partial list:
- 1970: Penn Central bankruptcy, the largest in history at that time
- 1973–74: Arab oil embargo
- 1977–80: U.S. hyperinflation
- 1982–85: Latin American debt crisis
- 1987: One-day 22% stock market crash
- 1988–92: Savings and loan (S&L) crisis
- 1994: Mexican tequila crisis
- 1997: Asian financial crisis
- 1998: Russia/Long Term Capital Management (LTCM) crisis
- 2000:Dot-com crash
- 2007: Mortgage market collapse
- 2008: Lehman Bros./AIG financial panic.
I was not just a bystander at these events. From 1977–85, I worked at Citibank and dealt with inflation, currencies and Latin America from a front-row seat.
From 1985–93 I worked for a major government bond dealer that financed S&Ls and traded their mortgages.
From 1994–99, I was at LTCM and dealt in all the major international markets. I negotiated the LTCM rescue by Wall Street in September 1998.
In 1999–2000 I ran a tech startup, and in 2007–08 I was an investment banker and financial threat adviser to the CIA.
That’s a lot of action for one career, but it also makes the point that financial perfect storms happen more frequently than standard models expect.
Here’s what I learned: Every one of these episodes was preceded by mass complacency or euphoria.
Before the Arab oil embargo, we expected cheap oil forever. Before the Latin American debt crisis, countries like Brazil and Argentina were “the land of the future.”
No one worried about a stock market crash in 1987 because we had “portfolio insurance.” The S&Ls could not get in trouble because they had FSLIC (Federal Savings and Loan Insurance Corp.) insurance.
Mexico could not get in trouble because it had oil. Asia could not get in trouble because it had cheap labor, high growth and “fixed” exchange rates.
Russia would not go broke because it was a “nuclear power.” LTCM would not go broke because it had two Nobel Prize winners. Dot-coms would not go broke because they attracted “eyeballs.”
Mortgages were solid because we had never seen a simultaneous nationwide decline in home values. Lehman Bros. was “too big to fail.” AIG was the Rock of Gibraltar.
In short, the fiascoes I witnessed were “not supposed to happen.” They all did. The worst panics are always preceded by a sense that nothing can go wrong.
We are there again. Stocks are approaching all-time highs again. The bond bust hasn’t happened. Mortgage interest rates are near the lows of the early 1960s. Exchange rate volatility is low.
Unemployment is at 50-year lows. Real wages are rising (at least a little). There are more job openings than job seekers. ISIS is defeated. Brexit is on indefinite hold.
It’s all good. What, me worry?
I saw a recent poll asking investors when they thought a market crash might happen. Something like 80% of the respondents answered not anytime soon.
I cannot imagine a better setup for catastrophe. No one ever sees disaster coming. That’s the point.
I believe a perfect storm is coming. It’s hard to foresee the full magnitude of it, but it will likely be dramatic. It will have a major impact on markets. How it impacts you depends on how far in advance you see it coming.
What are the three specific elements of the new perfect storm I see coming for markets? Read on.
for The Daily Reckoning
Yesterday we furrowed our brow against the latest inversion of the “yield curve.”
The 10-year Treasury yield has slipped beneath the 3-month Treasury yield — to its deepest point since the financial crisis, in fact.
Inverted yield curves precede recessions nearly as reliably as days precede nights, horses precede carts… lies precede elections.
The 10-year Treasury yield has dropped beneath the 3-month Treasury yield on six occasions spanning 50 years.
Recession was the invariable consequence — a perfect 1,000% batter’s average.
But an inverted yield curve is no immediate menace.
It may invert one year or more before uncaging its furies.
But today we revise our initial projections — as we account for the “adjusted” yield curve.
The “adjusted” yield curve indicates recession may be far closer to hand than we suggested yesterday.
When then might you expect the blow to land?
Now… you realize we cannot spill the jar of jelly beans straight away. You must first suffer through today’s market update…
Markets plugged the leaking today.
The Dow Jones gained 43 points on the day. The S&P scratched out six. The Nasdaq, meantime, added 20 points.
Gold — safe haven gold — gained nearly $7 today.
But to return to the “adjusted” yield curve… and the onset of the next recession.
The Nominal vs. the Real
We must first recognize the contrast between the nominal and the real.
The world of appearance, that is — and the deeper reality within.
For example… nominal interest rates may differ substantially from real interest rates.
Nominal rates do not account for inflation.
Real interest rates (the nominal rate minus inflation) do.
That is why a nominal rate near zero may in fact exceed a nominal rate of 12.5%…
Nominal interest rates averaged 12.5% in 1979. Yet inflation ran to 13.3%.
To arrive at the real interest rate…
We take 1979’s average nominal interest rate (12.5%) and subtract the inflation rate (13.3%).
We then come to the arresting conclusion that the real interest rate was not 12.5%… but negative 0.8% (12.5 – 13.3 = -0.8).
Today’s nominal rate is between 2.25% and 2.50%. Meantime, (official) consumer price inflation goes at about 2%.
Thus we find that today’s real interest rate lies somewhere between 0.25% and 0.50%.
That is, despite today’s vastly lower nominal rate (12.5% versus 2.50%)… today’s real interest rate is actually higher than 1979’s negative 0.8%.
The Standard Yield Curve vs. The “Adjusted” Yield Curve
After this fashion, the standard yield curve may differ substantially from the “adjusted” yield curve.
Michael Wilson is chief investment officer for Morgan Stanley.
He has applied a similar treatment to distinguish the adjusted yield curve from the standard yield curve.
The standard yield curve — Wilson insists — does not take in enough territory.
It fails to account for the effects of quantitative easing (QE) and subsequent quantitative tightening (QT).
The adjusted yield curve does.
It reveals that QE loosened financial conditions far more than standard models indicated.
It further reveals that QT tightened conditions vastly more than officially recognized.
The adjusted curve takes aboard the Federal Reserve’s estimate that every $200 billion of QT equals an additional rate hike… for example.
The standard yield curve does not.
Thus the adjusted yield curve reveals a sharply more negative yield curve than the standard.
Here, in graphic detail, the adjusted yield curve plotted against the standard yield curve:
The red line represents the standard 10-year/3-month yield curve.
The dark-blue line represents the adjusted yield curve — that is, adjusted for QE and QT.
The adjusted yield curve rose steepest in 2013, when QE was in full roar.
But then it began a flattening process…
QT Drastically Flattened the Adjusted Curve
The Federal Reserve announced the end of quantitative easing in late 2014.
And Ms. Yellen began jawboning rates higher with “forward guidance” — insinuating that higher rates were on the way in 2015.
Thus financial conditions began to bite… and the adjusted yield curve began to even out.
By the time QT was in full swing, the adjusted curve flattened drastically. The standard curve — which did not account for QT’s constraining effects — failed to match its intensity.
Explains Zero Hedge:
The adjusted curve shows record steepness in 2013 as the QE program peaked, which makes sense as it took record monetary support to get the economy going again after the great recession. The amount of flattening thereafter is commensurate with a significant amount of monetary tightening that is perhaps underappreciated by the average investor.
Now our tale acquires pace — and mercifully — its point.
The Adjusted Yield Curve Inverted Long Before the Standard
After years of flattening out, the standard yield curve finally inverted in March.
Prior to March, it last inverted since 2007 — when it presented an omen of crisis.
But since March, the standard curve bounced in and out of negative territory.
The recession warning it flashed was therefore dimmed and faint — until veering steeply negative this week.
But the adjusted yield curve did not invert in March…
It inverted last November — four months prior. And it has remained negative to this day.
Adjusting the yield curve for QE and QT shows an inversion began at the end of last year and persisted ever since.
Thus it gives no false or fleeting alarm — as the standard March inversion may have represented.
We refer you once again to the above chart.
Note how deeply the adjusted yield curve runs beneath the standard curve.
A “Far More Immediate Menace”
Meantime, evidence reveals recession ensues 311 days — on average — after the 3-month/10-year yield curve inverts.
But if the adjusted curve inverted last November… we are presented with a far more immediate menace.
Here Wilson sharpens the business to a painful point, sharp as any thorn:
Economic risk is greater than most investors may think… The adjusted yield curve inverted last November and has remained in negative territory ever since, surpassing the minimum time required for a valid meaningful economic slowdown signal. It also suggests the “shot clock” started six months ago, putting us “in the zone” for a recession watch.
If recession commences 311 days after the curve inverts — on average — some 180 days have already lapsed.
And so the countdown calendar must be rolled forward.
Perhaps four–five months remain… until the fearful threshold is crossed.
If the present expansion can peg along until July, it will become the longest expansion on record.
But if the adjusted yield curve tells an accurate tale, celebration will be brief…
Managing editor, The Daily Reckoning