Lance Robert's weekend review provides a solid reminder that the Fed's happy talk and the market's giddy heights are dangerous illusions. But this particular chart in his presentation drives the message home loud and clear.
The Fed has become a serial bubble machine over the last two decades, and cheap debt is the driving force. Note that before each cyclical peak of the S&P 500 that junk bond yields plunge into new cyclical lows as measured by the dotted boxes. And during each of the three bubble cycles shown here the boxes dip lower in absolute terms, meaning that junk bonds and risk have been increasingly mis-priced owing to central bank financial repression.
Thus, with the Merrill high yield index nearing an all-time low yield of 5%, the implication is astonishing. Namely, that with the CPI having just clocked in at 2.1% y/y, the real yield on junk bonds is barely 3%! Yet history proves losses can reach double digits when the bubbles crashes. During the 2008-2009 meltdown, for example, yields rose from 7% to 23%, implying devastating losses for speculators on leverage and bond funds managers subject to redemption. Needless to say, those categories encompassed most of the bond holders at the time.
And that's the evil of the Fed's financial repression at work. It creates a frenzied scramble for yield that results in a double deformation. First, debt gets way too cheap, causing companies to borrow wildly in order to fund financial engineering maneuvers such as massive stock buybacks, LBO's and cash M&A deals. That massive inflow of debt-based share buying, in turn, drives the stock market into its final blow-off phase as is evident in the chart.
But secondly, the full economic losses on the vastly over-priced junk bonds are never realized by investors and issuers due to the Fed's post-crash reflation maneuvers. Rather than avoid bubbles or pricking them once they begin inflating uncontrollably, the Fed's policy every since Greenspan has been to keep its head in the sand until the bubble crashes on its own weight. It then flood the financial markets with liquidity to prevent the resulting wring-out of debt and speculative excess from running its course.
Nothing could be more perverse than this morning after monetary flood syndrome. It allows speculators to front-run the central bank's now predictable monetary expansion. Instead of incurring losses, they scoop up busted securities for cents on the dollar and ride out the bubble reflation as the Fed cranks up the printing presses.
This pattern has been repeated consistently since the late 1980's S&L crisis. Chasing busted securities, loans and other financial instruments in the wake of periodic boom-bust cycles has now become a major operating division of the Wall Street casino.
Even more perversely, issuers of high yield debt and other risky securities frequently dodge the bullet. Rather than suffer permanent losses on their equity, LBO sponsors and other highly leveraged companies are able to "refinance" their maturing debts, kicking the can down the road for often another 5-10 years.
After the 2008-2009 crash, for example, there were massive debt maturities scheduled for 2012-2015, but thanks to $3.5 trillion of money printing and deeply sub-economic interest rates from the Fed, nearly all of these junk issues and leveraged loans have been refinanced. The debt maturity bulge is now in the trillions, but sits out beyond 2015.
Effectively, the Fed is operating a giant financial snow-plow, putting the American economy in harm's way by encouraging speculators and leverage artists to turn more and more American businesses into serial refi machines.
These refi'd companies have essentially become debt mules. They function to pay the interest and scalp all available cash to service the debt. Accordingly, real investment in productive plant and equipment is at an all-time low and the prospects for feature sustainable growth steadily diminish.
Given these perverse impacts, it is not surprising that the American economy continues to struggle and that "escape velocity" has become a jingle mouthed by Wall Street stock peddlers, not a viable prospect for the Main Street economy. Worse still, the Fed is setting up the financial markets for another devastating collapse, yet our monetary central planners remain as bubble blind as ever.
By Lance Roberts at STA Wealth Management
This past week the Janet Yellen, and her band of merry men, concluded their two day FOMC meeting with little surprise or fanfare. For the most part, there were few changes to the overall tone of the press conference as the Fed revised down its forecast for economic growth and nudged up their projections for short-term interest rates.
Here are some of the more important highlights from the Fed statement:
“Information received since the Federal Open Market Committee met in April indicates that growth in economic activity has rebounded in recent months.”
“Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated.”
“Inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.”
“The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.”
“The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. “
“The Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month.”
The markets primarily expected as much. However, as shown in the chart below, with the economy “struggling” in the first quarter, the overriding “fear” by market participants has been the extraction of “accommodation” from the markets.
As you can see, Yellen managed to assuage those fears by stating:
“However, asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.”
“The Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.”
“The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
With the utterance of those statements, the “Bernanke Put” was firmly cemented into the minds of Wall Street banks who rushed into the markets to cover short positions and chase the markets higher.
I received multiple emails asking me “why?” the markets surged following the Fed’s announcement. There are increasing tensions in the Ukraine and Iraq, the economy will show -2% growth for the first quarter next week, real retail sales declined in the latest report, and employment remains primarily contained to population growth and inflationary pressures are rising.
The answer is somewhat simple. These issues are all known. The bigger risk for money managers and investors is to be “out” of the market. The belief is that regardless of what happens the Federal Reserve will step in to support the markets, so the “real perceived risk” is underperformance by managers which equates to career risk.
This is a VERY CRITICAL point to comprehend.
- Your mutual fund manager is PAID to pace the returns of their benchmark index.
- They are not paid to worry about YOUR investment position.
- If the index rises by 10% and the fund rises by 9% - you take assets from that fund to move them to a fund that was up 10%.
- Therefore, the “risk” to a fund manager is the LOSS of assets by underperforming the benchmark index. Fewer assets under management – lower income, or loss of job, for the manager.
- However, you THINK that this manager is going to “manage” the fund to protect YOUR money when the market declines.
- However, if the manager “sells high” and misses a further rise in the markets waiting to “buy low,” you take your assets away from that manager to move it to a manager who is chasing performance.
- When the market “corrects” and you lose roughly as much as the market, you now get angry that the manager did not “get out of the market” to protect YOU – even though YOU wanted him to match the index.
See the problem here.
This massive conflict of interest between Wall Street and you requires money managers to pursue relative market returns. The problem is that the “psychological” demands of individuals has created a Wall Street machine which provides a VAST array of products to fulfill the every potential desire of an individual’s “gambling,” uh…I mean, “investing” needs today. It is HUGE business for Wall Street, not such a great environment for individuals.
This is why it is exceedingly important to remember that YOUR investment goals and objectives have nothing to do with a benchmark index. (Read:Why You Can’t Beat The Index and Why Benchmarking Your Portfolio Is A Losing Bet)
The Bigger Concern
During Yellen’s post-FOMC meeting press conference, she was asked if there is anything amiss with the S&P 500 hitting all-time highs at a time when she and other Fed presidents have discussed “froth” in the bond markets.
Her answer was simply: “No.”
Her answer should have been, however, “Yes.”
JP Morgan stated:
“Even assuming trailing earnings are valid, sustainable, and not goosed by the Fed itself (not to mention non-GAAP accounting gimmickry): the most recent median S&P 500 Price to Earnings ratio as of this moment is higher than 89% of all P/E prints in the history of the market. Said otherwise, equities have only been more expensive just about 10% in the history of the S&P.”
Furthermore, as I wrote recently in “Yield Spreads And Market Reversions:”
“Currently, the ongoing "chase for yield" has led investors to take on much more "credit risk" in portfolios than they most likely realize. When "fear" is eventually introduced into the financial markets, the subsequent "instability" will lead to far greater losses than most individuals will be prepared for.
The chart below is a comparison between "junk bond" yields, the least credit worth borrowers, versus the S&P 500.”
“Currently, loans are being made to the highest risk borrowers at an effective interest rate of just 5% as compared to the "risk free" rate of 2.6% for a 10-year Government bond.
We have seen this exuberance before. In 1999, the old valuation metrics no longer mattered as it was "clicks per page." In 2007, there was NO concern over subprime mortgages as the housing boom fostered a new era of economic stability. Today, it is the Federal Reserve ‘put’ which is unanimously believed to be a backstop to any potential shock that may occur.”
I always have to qualify these missives by stating that my portfolio models are still biased to the long side of the markets. When I discuss increasing risks in the markets, which is what leads to catastrophic and irreversible destruction of capital, it is always assumed that I am sitting in cash. This is not the case.
I too have the same conflicts with portfolio management as discussed above. I must remain invested while markets are growing or suffer career risk.
However, the difference is that I have developed tools, as shown in the 401k model below, provide clues as to when I can more safely make contrarian bets with reduced “career” risk. Knowing when to "fold'em" is what makes the real difference to long term investment returns.
Lastly, having qualified my position, it is important to understand that it is not the DECLINE in interest rates and yield spread that is important, but it is the REVERSAL that must be watched for. I point out these issues of risk only to make you aware of them as the always bullishly biased media tends to ignore "risks" until it is far too late to matter. It is likely that it will be no different this time.
Should you trust that Janet Yellen has it all under control? I surely wouldn’t.
The Fed’s Very Poor Prediction Record
Each quarter the Fed releases their assessment of the economy along with their forward looking projections for three years into the future. (See Fed Projections Myth Vs. Reality for the December analysis) I started tracking these projections starting in early 2011 and comparing the Fed's forecasts with what eventually became reality. The problem has, and continues to be, is that their track record for forecasting has been left wanting.
The reality is that the Federal Reserve cannot verbally state what their actual concerns during each highly publicized meeting as it such “truths” would potentially roil the markets. Instead, they use their communications to guide the markets expectations towards what is occurring in hopes of reducing the risks of market dislocations.
The most recent release of the Fed's economic projections on the economy, inflation and unemployment continue to follow the same previous trends of weaker growth, lower inflation and a complete misunderstanding of the real labor market.
When it comes to the economy, the Fed has consistently overstated economic strength. Take a look at the chart and table. In January of 2011, the Fed was predicting GDP growth for 2013 at 4.0%. Actual real GDP (inflation adjusted) was just 1.86% for the year or a negative 50% difference. The estimates at that time for long run economic growth were 2.7%, which has now fallen to 2.15% and was guided down from 2.3% in September and 2.5% in June of 2013.
Unfortunately, 2014 is not shaping up very well either. At the beginning of 2013, the estimates for the full year of 2014 averaged 3.2%. With the first quarter of 2014 shaping up to be nearly a 2% decline, it would now require average growth over the next 3 quarters of 5% real growth to reach that goal. Of course, since that time, the Fed has continually lowered its estimates for 2014 from that 3.2% growth rate to just 2.3% today. In order for the economy to meet that objective, the growth rate over the next 3 quarters will need to average roughly 3% per quarter. The last time that such a surge in economic growth occurred was in early 2004. With Q2 of 2013 looking to be closer to 2% annualized growth, it is highly likely that the Federal Reserve will be reducing their goals further into the year.
We have repeatedly been stating over the last two years that we were in for a low growth economy due to the debt deleveraging, deficits and continued fiscal and monetary policies that are retardants for economic prosperity. The simple fact is that when the economy requires more than $5 of debt to provide $1 of economic growth - the engine of growth is broken.
As of the latest Fed meeting, the forecast for economic growth in 2014 was revised down to 2.3% while 2015 nudged slightly higher to 2.9% respectively as the realization of a slow-growth economy materializes. However, the current annualized trend of GDP suggests growth rates in the next two years could likely be lower than that.
With more than 60 months of economic expansion behind us; this current expansion is longer than the historical average. Economic data continues to show signs of weakness, despite intermittent pops of activity, and the global economy remains drag on domestic exports. With higher taxes, government spending cuts and the debt ceiling debate looming the fiscal drag on the economy could be larger than expected.
What is very important is the long run outlook of 2.15% economic growth. That rate of growth is not strong enough to achieve the "escape velocity" required to substantially improve the level of incomes and employment that were enjoyed in past decades.
While the FOMC is vastly hopeful that the current economic improvement will be sustained; increasing deflationary pressures, weak global growth rates and stagnant wages pose major headwinds. The problem is that the current proposed plan is an exercise in wishful thinking. While the Fed blames fiscal policy out of Washington; the reality is that the monetary policy does not work in reducing actual unemployment or interest rates. However, what monetary policy does do is promote asset bubbles that are dangerous; particularly when they are concentrated in the riskiest of assets from stocks to junk bonds.
The problem for the Federal Reserve currently is that there are very few policy tools left, and the economic effectiveness of continued artificial stimulation is clearly waning. Lower mortgages rates, interest rates and excess liquidity served well in priming the pumps of the real estate and financial markets when valuations were extremely depressed. However, four years later, stock valuations are no longer low, earnings are no longer depressed and the majority of real estate related activity has likely been completed. More importantly, the recent surge in leverage and asset prices smacks of an asset bubble in the making.
A recent interview between Bloomberg’s Tom Keene and Komal Sri-Kumar reiterated this point:
Q: What was the key moment within the Janet Yellen news conference on Wednesday?
A: I think the key moment was at 2:47 pm. She essentially said the punchbowl is there and she’s simply not going to take it away. I don’t think they’re going to raise interest rates at the end of 2015 either because the Fed has been wrong every time on its growth forecast and overly optimistic. And as growth disappoints in the second half of the year, I think the rate increases are going to be postponed.
Q: Here is a quote from you after the FOMC meeting: ‘Why are we allowing supposedly ‘emergency measures’ introduced in 2008 to go into their seventh year? What will the Fed do when there is a true shock – increase bond purchases to 100 gazillion, to 250 gazillion?’ This was a substantial takeaway on what the Fed has gotten wrong. What’s the remedy right now?
A: The remedy is that you have to take the shock. You have to stop quantitative easing. You have to have a symbolic increase in interest rates. The Federal funds rate has to go up 1/4 or 1/2 a percent. It will cause a shock to the market. It will bring down equities. It will cause bond yields to rise. Take that medicine now or be prepared to take a much stronger medicine later on when the illness gets worse.
Q: Given the fact that we have unemployment at 6.3 percent, that’s good. We have inflation moving up in terms of the CPI, close to 2.1 percent, that’s good. Why is Yellen still keeping the punchbowl here?
A: She’s keeping the punchbowl because she’s worried about the long-term unemployed. She realizes that the 6.3 percent unemployment rate is largely because of the falling participation rate. She knows there is a lot of pain. And that’s where I think the change comes. That’s where I think the Fed is wrong in terms of its benevolence to the markets.
Q: Is this a bull market you can believe in? Or is it a house of cards developed by not just Chair Yellen but BOE Governor Mark Carney and the other central banks?
A: That’s a great question. I would say this reminds me so much of the first half of 2008. Oil prices were very high and growth prospects were said to be doing very well and everybody was feeling very complacent about the overall in May and June. The ECB raised interest rates in July of 2008 thinking inflation was the major risk. We have lots of characteristics which are similar and it worries me a lot.
Q: You have been persistent in a call for subdued global economic growth combined with a little inflation. What do the optimists get wrong?
A: The optimists expect that the monetary growth, the quantitative easing, will produce economic growth at a rapid pace. Sometimes when you take a medication and it hasn’t worked for five years, you better change your medication. But that’s essentially the error with the optimists. They’ve had five years of quantitative easing, big bond purchases, quintupling of the Fed balance sheet. And we don’t have sustainable economic growth. Why not say you need a different medication? We started out with a zero interest rate in 2008 and we have evidence again and again from Robert Mandel, Milton Friedman, that monetary policy is ineffective at very low interest rate levels. The other problem is unemployment is becoming structural. That means long-term unemployment cannot be changed via monetary policy.
Q: What kind of short-term fixes are on the table?
A: I don’t think there are any short-term fixes. Especially after five years of not having done much. I’ll go one step further beyond fiscal policy. If you’re saying just spend more money and that will create jobs, we tried doing it in 2009 and 2010. It’s just not going to happen.
There are obviously many things that you should consider. The most important of which is making sure that you expectations about future investments are aligned with reality. As I stated in “Shiller’s Cape-Is It Really Just B.S.:”
“Currently, there is clear evidence that future expectations should be significantly lower than the long term historical averages. Does the current valuation levels mean that you should be all in cash? No. However, it does suggest that a more cautious stance to equity allocations and increased risk management will likely offset much of the next "reversion" when it occurs.
While I disagree with Wade's assessment, it does not mean that I do not value his opinion. My job is to protect investment capital from major market reversions and meet investment returns anchored to retirement planning projections. Not paying attention to rising investment risks, or adjusting for lower expected future returns, are detrimental to both of those objectives.”
Have a great weekend.