We've been conservatively positioned in Servant Financial managed investment portfolios for quite some time now. Meanwhile the domestic stock market has generally been inclined towards further speculative gains despite increasing risk in all its forms - valuation, economic, monetary, and political. The domestic stock market in particular is looking quite stretched and vulnerable.
Our tactically underweight position on portfolio risk has been fundamentally driven based on elevated valuations, particularly domestic equities. These rich valuations have been generally accepted as a necessary distortion in order for the Fed to nurse the U.S. economy back to health and move towards its goal of normalization of interest rates. Stock market dependency on low interest rates has created the risk of severe shocks from the resumption of Fed interest rate hikes. Increasing political and economic uncertainty associated with U.S. Presidential election cycle is another potential financial shock. These developments could easily change investor risk preferences and associated investment risk premiums. It seems like quite treacherous times as we converge on inflection points for two great experiments in modern history - unconventional monetary policy and the "reality TV" version of democratic elections in 2016.
We'd like to share with you some expert perspectives on these developments by taking a look at a) domestic market valuation relative to real economic activity, b) evidence on the futility of activist Fed policy, and c) the potentially violent market meltdown that may occur with the unwind of activist Fed policies.
Financial blog Zero Hedge recently featured some monthly commentary from investment firm GMO that indicated the S&P 500 is presently overvalued by 70%. GMO's assessment is primarily based on its analysis of historical Shiller PE ratios which we also closely monitor. The following is GMO's prologue for the chart above:
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness …” - A Tale of Two Cities by Charles Dickens
While all eyes were on Federal Reserve Chair Janet Yellen in Jackson Hole, we were watching something else. In August, the Shiller P/E, a well-regarded metric for measuring the valuation of U.S. equities, breached 27. Given that its normal range is something a bit above 16, valuations are looking rather stretched. Further, the last time the Shiller P/E was above 27 was in October … 2007. And we all know how that movie ended. While nobody here at GMO is saying that a crash is imminent (and there’s no law that says stocks cannot become even more expensive), we continue to maintain our bias against U.S. stocks. We will also take this end-of-summer moment to point out the yawning disconnect between fundamentals (of the U.S. economy and even corporate America) and their stocks. It really is a tale of two cities, one of mediocre fundamentals versus a meteoric rise in markets."
The chart above graphically depicts how the vertical rise in the S&P 500 over the past five years of 11.1% real per annum is strikingly at odds with numerous economic and company financial measures - real GDP growth of 1.9%, productivity growth of 0.6%, real retail growth of 1.6%, real median income decline of -0.5%, labor participation decline of -3.0%, home ownership decline of -3.0%, real S&P earnings growth of 0.7% and real S&P revenue growth of 1.2%.
As we highlighted in last blog feature "Consumer-Technology Fatigue" we believe that the American consumers are sensing this economic disconnect together with rising political uncertainty and responding by scaling back on discretionary spending and increasing savings.
Relating to measurements of the overall effectiveness of activist Fed policies, we turn to a recent weekly article from John Hussman, chief economist and portfolio manager at Hussman Funds, dated September 6, 2016 entitled, "Failed Transmission - Evidence on the Futility of Activist Fed Policy." The article and the underlying economic analysis supporting Hussman's conclusions are quite extensive. We encourage interested readers to follow the links for further details. The essential conclusions of Hussman Fund's rigorous research are as follows:
"There is no economically meaningful or reliable correlation between “activist” monetary policy departures and subsequent economic outcomes, except to produce speculative bubbles and collapses that impact the economy over a longer horizon than the Fed seems to consider."
"The essential truth is this. Most of the variation in output, employment growth, and inflation across history can be reasonably predicted using lagged values of non-monetary variables alone. Adding information from monetary variables like the Federal Funds rate, the monetary base, and even Treasury yields, provides very little additional information. Moreover, only the “systematic” component of monetary policy - the part that can be explained by lagged non-monetary variables, has any meaningful correlation at all with subsequent economic outcomes. The remaining “activist” component does very little except to cause distortions, particularly in the financial markets. Those distortions ultimately cause economic damage when they collapse, but over a much longer horizon than the Fed seems to consider."
The chart above serves to isolate the "activist" component of Fed monetary policy. The blue line represents the Federal Fund Rate (the Fed's primary monetary policy tool) while the red line represents the systematic component of monetary policy (output, employment, inflation). The gap between the red and the blue lines represents the extent of the "activist" component. This activist component has shown no historically reliable transmission effect on the real economy but instead has only emboldened yield seeking speculative behavior in financial markets. These speculative episodes are highlighted on the chart - Fed enables tech bubble, Fed enables mortgage bubble, and the current edition Fed enables the "everything" bubble.
Now that we've framed the issue from a market valuation perspective and given clear indications of the failure of Fed "activist" policies on economic outcomes, let's switch to the potential financial market aftermath of a Fed reversing course on its failed policies. So called Black Swan investor Mark Spitznagel, chief investment officer of Universa Investments had these comments in an interview with CNBC's "Power Lunch" with emphasis added in italics.
"The markets are absolutely not positioned for this. (Federal Reserve normalization of interest rate policy.) There is this sort of collective psychology that says that the Fed can keep this going, that the Fed is in control. But, in fact, central banks are not in control. In many ways central banks are the tail wagging the dog. We think that central banks are so big relative to the market, but, in fact, central banks are tiny relative to the market. Central bank balance sheets are twenty-trillion, the whole global securities and derivatives market is a half-a-quadrillion. So, in fact, central banks are minuscule compared to that. The only thing they have going for them is this collective psychology. It’s an illusion of control."
"Remember, the equity has extreme duration now. These low rates and this high valuation means that they’re extraordinarily sensitive to changes in rates, extraordinarily sensitive to changes in risk premiums and growth."
"I would argue that central banks cannot allow rates to free float. Which is a little bit of a crazy statement. ...it’s (interest rates) also an important price signal, it’s the most important price signal. And we can’t let it free-float, we can’t let the discovery process work. If we did that, the markets would be cut in half, the stock market would be cut in half." (This is on par with GMO's estimated S&P 500 overvaluation.)
To summarize the present perilous plight of financial markets, we have a) a domestic stock market that is overvalued by 70% to 100%, b) a Fed central bank that has enabled an "everything" bubble by pursuing "activist" monetary policies that have been shown to have no reliable correlation to real economic outcomes but instead in two recent market corrections have been found to encourage yield seeking speculative behavior in financial markets, and c) a Federal Reserve on an experimental flight with reckless unconventional monetary policies that is seemingly trapped in a self-imposed "coffin corner."
A coffin corner or aerodynamic ceiling is the altitude at or near which a fast fixed-wing aircraft's stall speed is equal to the critical Mach number. Mach is the ratio of the speed of a body to the speed of sound in the surrounding medium. It is often used with a numeral (as Mach 1, Mach 2, etc.) to indicate the speed of sound, twice the speed of sound, etc. At this altitude it is very difficult to keep the airplane in stable flight. Because the stall speed is the minimum speed required to maintain level flight, any reduction in speed will cause the airplane to stall and lose altitude rapidly.
Please say some prayers for the barnstorming, stunt flying members of the Fed as they delicately try to maneuver monetary policy back to normal while avoiding a stock market crash.