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The Humility Of Rates And The Arrogance Of Equities

Tyler Durden's picture




 

Submitted by Michael Lebowitz of 720Global

The U.S. economic growth rate has been trending lower since 1950. The current growth cycle, as illustrated in the chart above, reflects further deterioration of this trend as today’s economic growth rate is merely peaking at levels that were previously deemed recessionary (compare current growth rates with prior troughs in growth). This is troubling when one considers the unprecedented lengths to which the Federal Reserve (Fed) has gone to reverse this trend. It is not by any measure unfair to say that the monetary policy approach taken since the great recession introduces serious doubts about the efficacy of the central banks actions and leaves a lot of unanswered questions about the ultimate consequences of their actions.

We are certainly better off, so the argument goes, given the measures the Fed has taken, than we otherwise would have been. The flaws in this justification are two-fold. First, it abjectly fails to consider what might have been in the longer term had we not taken the easy route or as some say “kicked the can down the road”. Second, it does not respect the risks the economy has assumed and the potential repercussions yet to manifest.

Are we comfortable with unemployment data given that the participation rate sits at 38-year lows? Should the gargantuan and growing income disparity that historically has threatened the stability of so many social, economic and political systems concern us? What should we make of the massive unproductive debts our society is accumulating? Why shouldn’t we question the wisdom of a decision-making authority that has introduced and aggravated these instabilities? The United States has brushed against such imbalances in the past but has always been willing to eventually, take actions which we know to be right and proper.

What appears to have evolved in the U.S. and around the world is that the practice of economic discipline has been lost, and traded for the transitory benefits of debt and quick fixes. Promoted by the intellectual glitterati of the central banks, our economic system has become addicted to all forms of debt, much of which has been unproductive. As a result the economy experiences short bursts of unsustainable economic activity instead of healthy, organic and lasting economic growth. Economic prosperity occasionally requires the sacrifice of short term gratification and progress in exchange for the promise of longer term benefits built upon that sacrifice.

To the extent leadership, in whatever context, sets forth examples that are irresponsible and self-indulgent, it should not be surprising that those who take their cues from this leadership propagate this unfortunate behavior. Over time a collective mindset develops that conforms to the actions of poor leadership. Society loses its cognitive ability to differentiate between what we know historically has been wrong and what now appears to be right. Most are either unwilling or unable to discern that anything is erroneous with leadership’s decision-making and problem-solving.

In 2014, all but a few argued that the path of interest rates was certainly higher. Despite a steady decline beginning on January 1st of 2014 and continuing today, everyone still insists strenuously that interest rates simply have to go up. What if all the arguments about growth in the US economy and much anticipated rate hikes by the Federal Reserve hinged upon a decision-making premise that is flawed? What if instead of the standard and variety of factors informing the consensus perspective about the direction of interest rates it is actually interest rates themselves that are sending signals that should inform our perspective about all other things? This should not be such a crazy proposal given the close relationship interest rates have had with growth and inflation in the past. Ignoring the fact that interest rates stand at levels only seen twice in American history dating back to 1790 (2012 and 1946) maybe be a mistake.

Since 2009 investors have pushed prices, valuations and earnings multiples higher for many assets. Part of the justification is based on very low interest rates and the benefits that accrue to companies and asset prices from these low interest rates. Included in this rationale are:

  1. Decreased interest expense
  2. Cheaper debt prompted many corporations to conduct stock buy backs, therefore reducing equity supply and giving the appearance of better earnings
  3. Lowered discounting factors for forecasted earnings which increased present values
  4. A perceived penalty for holding cash or very low yielding bonds which “forced” investors to riskier, higher returning assets

While the reasons are valid, the benefits of low interest rates are relatively short-lived. The dominant, lasting factor in corporate valuations, and any asset valuation for that matter, is future earnings potential. Corporate earnings are directly tied and highly correlated to the size of the economy. Historically, corporate profits have cycled in a tight band of 4% to 10% of GDP. Earnings typically reach the upper band, as they are now, when the economic cycle peaks and the lower band when it troughs. Many factors can cloud investors’ judgment, but understanding GDP growth and the cycle of profits within the economic trend is crucial.

Investor sentiment tends to mirror economic cycles, oscillating between pessimism and optimism. This is typically reflective in current earnings multiples and forecasts for future earnings as well as prices. The most recent rally is no different, having progressed from outright fear to the euphoric state which pervades most domestic markets today. The table below compares the current bullish cycle to the ten others which have occurred since 1949.

Optically today’s rally appears similar in many respects to the average rally over the last 65 years. The duration of the market move and the annual price gains are slightly higher than average but in both instances do not stand out as anomalous.

What is unique about this rally is the excessive premium being placed on future earnings and economic growth. Here are three takeaways from the table:

  1. Stock prices in the current rally increased much more than economic growth would typically dictate. The gain in stock prices versus the gain in GDP is almost twice the average.
  2. On a similar note the Market Capitalization to GDP ratio has reached a level that has only been attained one other time. It currently stands at 50% above the average of the prior bull markets. Excluding the 1990’s technology bubble, this is clearly unique.
  3. Cyclically adjusted price-to-earnings (CAPE 10) and other valuation methods not listed here, stands in exclusive company as well. CAPE 10 is now equal to the multiple present on the eve of the great recession in 2007 and is only surpassed by the 1990’s bubble and the 1930’s Great Depression (32.56 -not shown above).

Historically, the combination of high valuations and weak economic growth have had dangerous implications for stock prices. The two tables below show the subsequent annualized two year performance of the S&P 500 given various combinations of valuations and economic growth rates. The first table compares CAPE 10 to the average GDP over the next two years (example: the CAPE10 observation on January 2000, is compared to the average GDP for all of 2000 and 2001). The second table compares the ratio of U.S. market capitalization to the average GDP over the next two years. There are two important takeaways from the tables:

  1. When high valuation measures occurred and subsequent GDP was weak, the stock market posted substantial losses
  2. As one might expect, slow economic growth, except in the instances of very cheap valuations, has led to significant losses.

 

The Fed, and a consensus of Wall Street economists continue to forecast “resilient” economic growth in the coming quarters. These so called “green shoots” are seemingly always getting ready to sprout. Since 2010, GDP growth projections by the Federal Reserve have been overly optimistic with GDP forecasts running 1.1% higher, on average, than actual results.

Such rosy predictions require a confidence that a change in the secular economic trend is forthcoming and ignores the relationship interest rates have with economic growth and inflation. One should be circumspect of that thesis given that the predominant forces driving those secular trends have not changed, and in fact are still adding to future economic headwinds.

If the expectation of “resilient” trend growth is a fallacy and interest rates continue to send signals confirming that notion as they have throughout this secular period, investor concerns should be heightened. The level and term structure of interest rates are not confirming the broad logic behind equity market valuations, they damn that logic. The same equation using low interest rates as a discount factor should also properly consider weaker earnings cash flows implied by that very same discount rate. The conclusion we draw is that the selective application of low interest rates as a key driver of currently high equity valuations is the same input that will drive equities lower revealing a risk hidden in plain sight.

"It is not the beauty of a building you should look at; it’s the construction of the foundation that will stand the test of time."

-David Allan Coe

 

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Tue, 04/21/2015 - 16:37 | 6015857 weburke
weburke's picture

as I drive around, the young like starbucks, the old like cvs.

Tue, 04/21/2015 - 23:03 | 6016973 golden torch
golden torch's picture

I'm making over $7k a month working part time. I kept hearing other people tell me how much money they can make online so I decided to look into it. Well, it was all true and has totally changed my life. This is what I do... www.globe-report.com

Tue, 04/21/2015 - 16:39 | 6015864 disabledvet
disabledvet's picture

I mean seriously...the collapse in the commercial paper market this past Winter was friggin EPIC.

 

"Nothing Total War in the Middle East can't solve!" of course...

Tue, 04/21/2015 - 16:56 | 6015875 knukles
knukles's picture

Lesson 1.)  The bond market is a far superior discounting mechanism than any other market.
Lesson 2.)  Every single financial crisis first manifests itself in the short term markets, a la lack if liquidity, insolvency, etc.
Lesson 3.)  Liquidity as in Ability/Access to Financing is NOT the same as Liquidity as in Marketability of Obligations (Albeit oft closely related)

Tue, 04/21/2015 - 16:52 | 6015894 Arthur Schopenhauer
Arthur Schopenhauer's picture

I see the Lemonade, hot dog, and hamburger stands is doin' pretty good.

Tue, 04/21/2015 - 17:21 | 6015996 main1event
main1event's picture

You need to have a permit for those.  

Tue, 04/21/2015 - 17:01 | 6015930 Clowns on Acid
Clowns on Acid's picture

"It is not the beauty of a building you should look at; it’s the construction of the foundation that will stand the test of time."

-David Allan Coe

" Quoth the Raven - Nevermore"

Edgar Allan Poe

Tue, 04/21/2015 - 17:04 | 6015946 Weaponized Innocense
Weaponized Innocense's picture

Precarious would be an understatement.

Tue, 04/21/2015 - 17:40 | 6016070 ZH Snob
ZH Snob's picture

it's true.  the rates are like, whatever, while the stocks are all about the paparazzi and scoring models.

Tue, 04/21/2015 - 18:07 | 6016190 DonutBoy
DonutBoy's picture

WTF? Interest rates don't discount anything when CB's buy all available paper with fresh digital money.  Interest rates on 10-year German sovereign debt are NEGATIVE.  It's insane to pretend this is a market signal.

Here's the signal - in case you're missing it:  There is a ginormous debt bubble that should have popped and taken 10-20 mega-banks with it in 2008.  Rather than allow that - the CB's have elected to re-flate the bubble by destroying the current monetary system, finishing what Nixon started by taking the dollar off the gold standard.

 

 

Tue, 04/21/2015 - 19:28 | 6016435 falak pema
falak pema's picture

Absolutist Capitalism is the new model now being sold by the US Oligarchs as in the TIPP agreement. The inalienable rights of a few to make profits like it were their bill of rights come what may! 

It would make them the transnational masters of surplus profits of export trade model that benefits its own local capitalist class by allowing it to invest this surplus according to the international labour arb mechanism beyond their national borders (via tax free havens).

This is why Greece is a basket case as it would be the fate of all countries who don't generate the trade surpluses their capitalists make using local and hired cattle/sheeple workers (In Greece's case its been a pure robbery straight and simple all sitting in Swiss accounts). 

Of course in a world of absolutist capitalism we would all end up like Greece and our elected could not fight the oligarchy, as the international arbitration courts mechanism would make their national laws obsolete and irrelevant.

So how do the Oligarchs perpetuate their profit cycle ad nauseum?

Simple. You can only generate trade/capital surpluses if your bonds and debts are deemed as being worth as  pure "gold"; aka your absolutist capitalism has to have as co-conspirator the Reserve status of monetary hegemony (or co hegemony like $/Euro) for US/Germany today.

All others end up one day like Greece.

Thats what is being negotiated currently by the US and japan/Australia as well as USA/EU.

Only a few win and even then with the level of debt today they have screwed up the game beyond redemption. Give em all the rope they need! 

Tue, 04/21/2015 - 19:50 | 6016509 OC Sure
OC Sure's picture

"The U.S. economic growth rate has been trending lower since 1950. The current growth cycle, as illustrated in the chart above, reflects further deterioration of this trend as today’s economic growth rate is merely peaking at levels that were previously deemed recessionary (compare current growth rates with prior troughs in growth). This is troubling when one considers the unprecedented lengths to which the Federal Reserve (Fed) has gone to reverse this trend."

What may be overlooked in the author's line of reasoning is accepting the premise that the Federal Reserve's actions are an attempt to reverse the trend of lower, multi-generational, growth. The monopoly on "banking" is the cause of the declining  growth. It cannot be otherwise.

Better off to stop staring at a totem pole and just chop it down.

Tue, 04/21/2015 - 20:07 | 6016552 Wild Theories
Wild Theories's picture

but everyone likes poles(not the ones in Poland), they are nice and phallic

Tue, 04/21/2015 - 20:03 | 6016542 RaceToTheBottom
RaceToTheBottom's picture

The chart would look a whole lot worse if we were using Shadowfacts data...

Tue, 04/21/2015 - 20:11 | 6016559 razorthin
razorthin's picture

You can't buy MOAR rates, only MOAR bonds (debt).  Rates are the casualty.  Humility my ass.

Tue, 04/21/2015 - 20:10 | 6016561 Clesthenes
Clesthenes's picture

“The US economic growth rate has been trending lower since 1950.”

Well, yes, that’s a good place to start: the first sentence.  It will usually tell you if the article is based on facts of reality… or just plain wishful thinking.

The “economic growth rate” is then defined as the rate of change of the GDP: an index that, upon examination, is found to be based on wishful thinking.

The federal government publishes ‘Financial Reports of the United States Government’ on an annual basis, as of September 30 of each year.  The latest available is the one for 2013 (for purposes of my examination).  It, like several before it, declares that “current government policies are unsustainable”.  It arrives at this conclusion with language and concepts designed to mislead any reader, from the casual reader to, it seems, the most experienced financial analysts.

There is much confusion to unravel: ‘What is a “present value” dollar… a “primary deficit (surplus, gap)”?  The frusg makes use of the Gross Domestic Product (GDP); which supposedly measures gross production of the nation for a year; and is comprised of ten components.  At least two of those components represent a decrease of production, and are added to the level of production.  Government accountants make financial projections over the next 75 years; ‘Are they realistic… or pure nonsense?’

As we make sense of the Report, we come up against the question, ‘Are all these confusions part of some kind of training exercise for a planned major shock to the financial system… on a global scale?’

How can an index, comprised of a soup of contradictions and wishful thinking, be employed by men to measure anything?  And, why has it taken 85 years for someone to discover that it is little more than a collection of economic fairy tales?  (Please read more)

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