Signs of the Top

By John Mauldin

Aug 17, 2013

The investment media seems obsessed with the question of whether the Fed will taper. The real question should be not about "tapering" but about credibility. What happens when fundamentals become the narrative as opposed to what the central bank is doing? What happens if the Federal Reserve throws a liquidity party and nobody comes? Today we look at some of the fundamentals. The market is in fact overvalued, but that doesn't mean it can't become more overvalued. Is this August 1987 or August 1999?

Signs of the Top

We are told they don't ring a bell when bull or bear markets start. That may be true, but it does seem that there are similar signs as we approach turning points. This week in my reading I have been struck by a number of signs that suggest that, if we haven't reached a top in the latest bull market cycle, at least a pause may be in order. Let's review a few of them. The first comes from Charles Gave, who notes that margin debt is now back to extremes.

I started in the fascinating business of trying to understand why markets go up and down in February 1971. The old money manager in the French bank which had hired me straightaway said:

"Charles, you will never get rich in this business using other people's money. Do NOT leverage your positions. Leverage might be all right for fellows who deal in real estate, but for those in stock markets, it only brings misery."

Being young and smart (or so I thought), I assumed this advice could not conceivably apply to me. A few margin calls later, accompanied by quite a string of sleepless nights, and I came to realize that the old gentleman had a point.

Now that I am quite old myself and certainly not as smart as I thought I was in 1971, I find myself tracking the moves of the poor souls who believe they can leverage profitably. Then I do the opposite. This is why Charles the 70-year-old is watching what Charles the 30-year-old is doing—to do the reverse. Have a look at the graph.

The red line at the top is New York Stock Exchange margin debt as a multiple of US GDP per capita, the black line on the bottom pane is a ratio between US stocks and (government) bonds. It seems that the fellows using other people's money to get rich have an uncanny ability to leverage up when shares become overvalued vs. bonds. They also seem to get most enthusiastic just before a recession, usually after a prolonged outperformance of equities against bonds.

They leverage in order to participate as much as possible in what looks like a free ride, with no downside risk. There are always a number of good reasons why the stock market cannot change direction. Take your pick: "technology has created a new type of economy," or "house prices never go down," or "we have recently discovered an infinite source of wealth called QE." These reasons can be added to a long roster of other excuses such as, "I can get insurance against the next market decline" (1987) or "the Fed will never, ever allow for positive real rates to appear" (1979) or "oil prices cannot quadruple" (1974).

The rise in the stock market this past year has not been because of fundamentals. Earnings in the nonfinancial sector have been flat. Mark Gongloff writes on the HuffPost site:

Bloomberg figures that bank earnings rose 27% in the second quarter, which was the only thing keeping the S&P 500 from reporting a net drop in profits for the quarter. With the banks, S&P 500 profits were up 3.3% in the quarter, Bloomberg estimates. Without them, S&P 500 profits would have been down 1.2%.

Lousy profits have not kept the S&P 500 from gaining nearly 19 percent so far this year. But even that performance trails the financial sector, which is up 26 percent this year. The banks topped the broader market last year, too, doubling the broader market's gain. And banks have managed all this despite never-ending scandals, onerous regulations and the scorn of an angry nation.

The Wall Street Journal suggests that non-financial companies might have finally reached the limit of how much profit they can squeeze out of a dour economy by laying off workers and cutting costs. Banks, on the other hand, have the useful ability to skim rent from even the lamest economy. They're proving it now and finding profits in innovative ways, like moving aluminum around in warehouses to create a sense of scarcity and drive up prices." (Huffington Post)

This lack of profits is showing up in the economy. Nominal GDP growth over the past year was the slowest ever recorded outside of a recession, as the following chart from the London Telegraph demonstrates.

And because the rise in the stock market has not been accompanied by an increase in earnings, price-to-earnings ratios have risen back to levels that suggest the market is getting closer to stalling out. I post the following tables from the Wall Street Journal. While the Dow and the S&P 500 are not at nosebleed levels, they are certainly pricey. The Russell 2000 and the NASDAQ, on the other hand, are seriously overpriced in terms of earnings.

What Are They Smoking?

What I find most fascinating in the table is the estimate from Birinyi Associates of the forward 12-month earnings of the Russell 2000. On a trailing 12-month basis, the P/E ratio is nearly 48.

However, Birinyi estimates that earnings are going to grow so much in the next 12 months that the forward P/E ratio will be merely 19. Yes, merely. They come up with that number by shifting from as-reported earnings for the previous 12 months to operating earnings for the next 12 months. I've written letters in the past demonstrating that "operating earnings" should be characterized as earnings before interest and hype. Call me a skeptic, but I just don't see any way you can publish a number like that with a straight face.

Is always instructive to pay attention to what Jeremy Grantham at GMO thinks about the prospects for future returns. Grantham manages over $100 billion and is an intellectual force in the investment community. Here are his recent expected returns for various asset classes relative to their valuations. They do not bode well for pension funds that are projecting 7 to 8% compound returns for the next seven years. This problem is magnified in public employee pension programs, some of which are already massively underfunded.

Finally, let's look at two charts that my good friend John Hussman has posted in the past few weeks. John is arguing that stocks are now overvalued, overbought, and overbullish.

His second chart looks at two measures of valuation for the S&P 500 and compares them to the price level. One measure is a function of revenues, and the other is the smoothed Shiller earnings, which is an average of inflation-adjusted earnings from the previous 10 years. Note that the stock market is not at the bubble levels of 2000 in terms of valuation, but it is certainly getting close to 2006-07 levels.

This is not to say the stock market can't continue to go up from here. The belief that one should not fight the Fed has become the dominant paradigm for the market. The fingerprints of QE3 are all over the recent rise in the stock market.

As Didier Sornette put it, writing about central bank responses to the crises of the past few decades, "Each excess was felt to be 'solved' by measures that in fact fueled following excesses; each crash was fought by an accommodative monetary policy, sowing the seeds for new bubbles and future crashes."

How will it all end? Faith in central banks today is equivalent to faith in the word dot-com in 1999 or faith in the eternal rise of housing prices in 2006. With the support of a powerful narrative—that central banks can support asset prices and effectively backstop financial crises (eliminating tail risk)—sentiment is driving the markets higher in the face of cyclically improving but historically weak and unstable fundamentals (plagued by debt deleveraging and aging demographics).

Ultimately, the stability of the system depends on central banks' credibility, markets'sentiment, and policy responsiveness to prevent minor drawdowns from becoming full-blown crashes. My friend Mohamed El-Erian has written extensively on the importance of the central bank "brand" and warned of the danger of a broken narrative. Markets tend to overshoot in both directions and will most likely fall even farther than fundamentals warrant when and if central banks lose control of popular sentiment.

It is not only the credibility of sovereign nations burdened with debt that can reach a Bang! moment. The credibility of and faith in central banks is just as fragile. Today we see humorous images of dollar bills with Ben Bernanke's face on them, with the words "In Ben We Trust." Unfortunately there is truth in that jest. Whether it is Mark Carney at the BOE or Mario Draghi at the ECB or the future chairperson of the Fed, central bankers are in the hot seat when it comes to global stability.

The world no longer worries first and foremost about the products corporations make or the services they perform. Rather, it is focused on the amount of easy money the central banks can dish out.

What happens when that amount is no longer enough and market forces turn? With central banks already in a hyper-easing mode, what can they do then, in the face of the next real crisis, to convince the markets that they have things under control? And there are any number of potential trigger points for the next crisis. One that comes to mind is a political shock such as a southern European country's refusing to submit to further austerity (if Italy or will Spain is forced into early elections, that could do it) or a change in Germany's tune. What if the ECB actually has to follow through on its commitment to use OMT (outright monetary transactions) to buy unlimited amounts of short-term Italian, Spanish, and/or French bonds. Draghi simply cannot follow through without expanding the ECB's balance sheet, and it is not crazy to think that the German Constitutional Court could respond by limiting the size of OMT, as it did with EFSF. That kind of blow would mean game over for Draghi's sentiment-supporting bluff.

If the narrative of the power of central banks changes, then it is a whole new ballgame for investors. Fundamentals will once again rule. What a concept. You might want to consider raising a little cash in your portfolio or buying some volatility insurance. Just a thought

Join Me at the World Premier of Money For Nothing

I am extremely pleased to be able to announce the world premiere of the extraordinary new documentary on the Federal Reserve, called Money for Nothing. The screening will be in Dallas on Friday, September 6, at 7 PM at AMC NorthPark 15. The movie will then begin to open in various cities around the country the following week, starting with New York and Washington, DC. I was privileged to see the full film last week in Maine with many of my economist friends, and everyone was impressed. This is a movie that I hope everyone in the United States will watch so they can understand the history behind the Federal Reserve and what is happening now.

Producer Jim Bruce was able to interview dozens of luminaries from both inside and outside the Federal Reserve system, including Paul Volcker, Janet Yellen, numerous regional presidents, and former Federal Reserve members. You can see a trailer by clicking here and learn when the movie is coming to a city near you, or you can arrange for it to do so, by going to I hope you can join me at the world premiere in Dallas. It will be a special evening.

It is time to hit the send button. I'll be home for two weeks and trying to catch up on a hundred details, as well as to get into the gym and drop a few pounds. And I get to catch up with my kids and grandkids, too. Have a great week and enjoy the final month of summer.

Your ready to be home for a while analyst,

John Mauldin

Copyright 2013 John Mauldin. All Rights Reserved.

Other Voices


Don't Ignore the Greek Problem


The ECB has put off a euro-zone crisis by printing bailout and bond money as fast as it can.The final cost: higher interest rates and tanking bonds.

                                             Tim Foley

Have you read anywhere that the Greeks will soon be requesting a third bailout? Probably not. Thus far this summer, the euro-zone leaders and the European Central Bank have successfully papered over the real problems in the south of Europe.

If only denial, smoke, and mirrors could solve the euro-zone crisis. The euro wasn't a bad idea, but the euro zone should have been limited to those countries that can make it without bailouts. That list probably does not include Greece, Ireland, Portugal, Spain, Italy, and Cyprus. Those countries will have to leave the euro, default on at least some of their debts, and institute their own devalued currencies. Then they can reform and hope to rejoin the euro at some future date.

In the middle of 2011, I published a book, Euro: How to Save It, in which I predicted that the first Greek bailout would not succeed, and that the Greeks would run out of money in early 2012. That's exactly what happened. I also predicted that the euro zone would collapse because of the Greek default. I was wrong on that one—so far.
Compare Korea and similarly sized Spain. Korea sells cellphones, cars, ships, and electronic chips to the world, while Spain sellswhat?
What I completely underestimated was the willingness of the stronger European countries to bail out every troubled country. They operate on classic Keynesian assumptions: If you can just throw in a little more money, demand will increase, and everyone will live happily ever after. It's not working out that way, not even in Greece, which has received huge bailouts.

IN THE GREEK CRISIS IN mid-2010, the country had a gross domestic product of about $320 billion, a national debt of $390 billion, and a yearly budget deficit of $30 billion. The first Greek bailout was for $143 billion for over three years. It was easy to predict that the country would fail again, in early 2012, because the Greeks had to roll over about $40 billion a year in existing debt, plus cover the $30 billion annual budget deficit. Sure enough, the Greeks went through $140 billion in two years, and they were insolvent again by the first half of 2012.

The Greek debt had grown to about $490 billion, but the European Central Bank, the International Monetary Fund, and the European Union (often called the troika) let the Greeks default on 25% of it, a loss of roughly $137 billion to private bondholders. Then the troika gave the Greeks another, even larger bailout of $220 billion that all sides said should last until 2020. How much of that $220 billion is left? Just $14 billion, barely enough to get the Greeks past the German elections in September. Few things in finance are more likely than a request from the Greeks for a third bailout.

The trend is not good. Consider:

Bailout 1: $143 billion
Default 1: $137 billion
Bailout 2: $220 billion
Total: $500 billion

Nearly half a trillion dollars has gone down the Greek drain in three years—the three years during which the Greeks were supposed to restructure their economy and return to the private capital markets. In those three years, the Greek GDP has shrunk from $320 billion in 2010 to about $250 billion in 2013, a drop of nearly 25%. Unemployment has gone up, from 10% in 2010 to 25% in 2013. These numbers are just about the same as the numbers for the U.S. in the worst year of the Great Depression.

Unfortunately, Greece is not the only problem country in Europe. Ireland and Portugal have national debts at 120% of GDP, and they continue to run big budget deficits. There's little chance they will be off bailouts and back to the bond market by Christmas. A second bailout is on the horizon for both countries.

Italy has a national debt of 132% of GDP, a continuing budget deficit, and a divided government. Its bond rating is two notches above junk, but somehow its 10-year bond rates are just 4.2% (versus U.S. rates of 2.7%). The inconsistency may be explained by some kind of sub rosa purchasing of Italian bonds by the European Central Bank.

Spain has a national debt that is in control, a budget deficit that is not in control, and a real-estate bubble that is about to pop. Spanish real estate tripled when U.S. real estate was doubling. What happened to our real-estate prices and our banks has only just begun to play out in Spain.

Thus far, ECB Chairman Mario Draghi has postponed a euro-zone crisis by printing bailout and bond money as fast as he can. When it becomes obvious to investors in Europe that this can't continue, money will flee to safer places. To get that money back, the ECB will have to allow interest rates to rise—a lot. That is what governments have to do when their debts become unsustainable. As everyone knows and nobody remembers until it's too late, bond prices fall when rates rise.

Even the bonds that survive the crisis will be cut in value. The principal losses and the losses from default could total $4 trillion, or even more if the Europeans continue to put off their days of reckoning.

WHAT SHOULD HAVE the Europeans been doing the past three years to truly solve their problems? They should have been working harder, marketing aggressively, and innovating more. If they cut their cushy six-week vacations to the two-week U.S. standard, they would be working 50 weeks instead of 46 weeks. Simple math (50/46= 1.087) suggests they could potentially be growing their economies at better than 8% per year versus 1%. Of course, you have to be working on what the world wants to buy.

That's marketing. Compare Korea and similarly sized Spain. Korea sells cellphones, cars, ships, and electronic chips to the world, while Spain sells—what? Finally, the Europeans need to innovate as they once did during the first and second Industrial Revolutions. Sincé World War II, they missed the arrival of the computer, lasers, the Internet, fiber optics, oil/gas fracking, cellphones, and just about everything else. 

WILLIAM THAYER is an author and financial analyst living in San Diego.

Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved

lunes, agosto 19, 2013



China’s Reform Anxiety

Yao Yang

15 August 2013

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BEIJINGSincé 2010, global financial circles have been obsessing about China’s slowing economy. But, while the country barely met the official target of 7.5% annual GDP growth in the second quarter of this yeargenerating significant anxiety worldwideChina’s government seemingly remains calm, showing no indication that it plans to launch yet another stimulus package. Do China’s leaders really have the situation under control?
In fact, the Chinese government’s stance – based on Premier Li Keqiang’s Likonomics,” which prioritizes structural reform over rapid GDP growth – will prove to be in the best interests of China and the rest of the world. China’s structural problems – including restrictions on labor mobility, a rigid and risk-laden financial system, and excessive reliance on government investment – are threatening its stability and economic development. Given that China’s GDP growth rate remains respectable relative to the rest of the world, the need to emphasize structural reform is clear.
But, despite well-intentioned statements and narrow gestures, China’s new leadership has yet to establish a concrete, bold reform plan capable of resolving the economy’s deep-rooted problems.
For example, last February, the State Council announced plans to reform the hukou (household registration) system, which assigns legal residency according to a person’s place of birth. The system makes relocating very difficult, as those who do not manage to acquire local residency permits face major hurdles in gaining access to public services when they migrate to other provinces. Indeed, their children are even prohibited from taking college entrance exams.
The reform plan was supposed to improve the situation by allowing migrants in towns and small cities to acquire local residency permits more freely, while easing the requirements in medium-sized cities. But efforts to reform the system have been met with strong resistance, especially from local governments and residents, who fear the strain that unregulated migration to their cities will have on resources, employment, and services. As a result, a genuine hukou reform strategy remains elusive.
Similarly, the government has been slow to formulate and implement effective financial-market reforms. Hopes were high early this year, when the State Council announced a strategy aimed at liberalizing the capital account, establishing a more flexible exchange-rate policy, and opening the financial sector to domestic private capital. But the government then heeded influential economists’ warnings of the risks of relaxing capital controls too hastily.
In fact, the opposite should be happening. Narrow policies like the government’s recent credit tightening will make it difficult to direct financial resources to the real economy one of the primary objectives of “Likonomics.” Genuine progress depends on Chinese leaders’ willingness to address the structural flawsnamely, the restrictions on domestic private capital – that are impeding the financial system’s ability to channel savings to the most promising economic sectors.
Despite several rounds of deregulation, it remains very difficult to establish private banks in China, and rules on non-banking financial institutions are often unclear. As a result, shadow banking, which provides capital at triple the cost implied by the official base interest rate, is flourishing – and generating significant uncertainty and risk.

Although the government recently attempted to attract capital back to the official banking sector by eliminating the lending rate’s lower bound, more substantial reform is needed – and that will likely have to wait until the interest rate on deposits is fully liberalized and the financial sector is open to private Banks.
In many other areas, too, China’s government either remains indecisive or is offering only rhetoric and small gestures. For example, the devolution of some project-approval powers to local governments will not solve the underlying problem of excessive state intervention in the economy; on the contrary, it may even enhance the state’s role by giving local governments more freedom to carry out investment projects.
China’s leaders know what is wrong with the country’s economy. But, as their efforts over the last several months have highlighted, they are uncertain as to how to go about fixing it – a fact that is generating significant anxiety in financial markets and among the general public. As senior Chinese officials gather for their annual summer meeting in Beidaihe, a coastal resort near Beijing, they must recognize the need for a bold plan for genuine structural reform. Otherwise, anxiety will eventually give rise to mistrust, making a comprehensive reform strategy even more difficult to implement.
Yao Yang is Dean of the National School of Development at Peking University and a professor at the China Center for Economic Research.