John Mauldin, Editor
Outside the Box
Special Report: Chinese Sunset
Reveling in Success
A Federal Reserve Oblivious to Its Effect on Financial Markets
The Federal Open Market Committee last month didn’t even mention risk from persistent low rates.
By Martin Feldstein
The sharp fall in share prices last week was a reminder of the vulnerabilities created by years of unconventional monetary policy. While chaos in the Chinese stock market may have been the triggering event, it was inevitable that the artificially high prices of U.S. stocks would eventually decline. Even after last week’s market fall, the S&P 500 stock index remains 30% above its historical average. There is no reason to think the correction is finished.
The overpriced share values are a direct result of the Federal Reserve’s quantitative easing (QE) policy. Beginning in November 2008 and running through October 2014, the Fed combined massive bond purchases with a commitment to keep short-term interest rates low as a way to hold down long-term interest rates. Chairman Ben Bernanke explained on several occasions that the Fed’s actions were intended to drive up asset prices, thereby increasing household wealth and consumer spending.
The strategy worked well. Share prices jumped 30% in 2013 alone and house prices rose 13% in that year. The resulting rise in wealth increased consumer spending, leading to higher GDP and lower unemployment.
But excessively low interest rates have caused investors and lenders, in their reach for yield, to accept excessive risks in equities and fixed-income securities, in commercial real estate, and in the overall quality of loans. There is no doubt that many assets are overpriced, and as the Fed normalizes interest rates these prices will fall. It is difficult to know if this will cause widespread financial and economic declines like those seen in 2008. But the persistence of very low interest rates contributes to that systemic risk and to the possibility of economic instability.
Unfortunately, the recently released minutes of December’s Federal Open Market Committee meeting made no mention of financial-industry risks caused by persistent low interest rates for years to come. There was also no suggestion that the Fed might raise interest rates more rapidly to put a damper on the reach for yield that has led to mispriced assets. Instead the FOMC stressed that the federal-funds rate will creep up very slowly and remain below its equilibrium value even after the economy has achieved full employment and the Fed’s target rate of inflation.
Fed officials say that macroprudential policies should be used to prevent financial instability.
But there are few such policies in the U.S. beyond the increased capital requirements for the commercial banks. Nothing has been done to limit the loan-to-value ratios of residential mortgages or the leverage in commercial real-estate investments. Moreover, the commercial banks supervised by the Fed represent only about one third of the total capital market. The Fed has no ability, for example, to reduce risks in the shadow banking or insurance industries.
The Dodd-Frank law imposed restrictions on bank portfolios and increased banks’ capital requirements, which have created new problems by reducing liquidity in financial markets.
When bond investors and bond mutual funds look to sell, there may be no ready buyers to prevent sharp falls in bond prices. The resulting rise in long-term interest rates could then reduce equity prices as well.
Moreover, the Fed is planning a path for short-term interest rates that is likely to raise the rate of inflation too rapidly in the next two years. The December FOMC minutes show that members expect to have a negative real federal-funds interest rate until sometime in 2017, much too low for an economy already at full employment. The danger is that very low interest rates in this environment would lead to a higher rate of inflation and higher long-term rates.
The Fed could prevent that faster rise in inflation by increasing the federal-funds rate more rapidly this year and next.
Fed officials also make the case that stimulating the economy by continued monetary ease is desirable as protection against a possible negative shock—such as a sharp fall in exports or in construction—that could push the economy into a new recession. That strategy involves unnecessary risks of financial instability. There are alternative tax and spending policies that could provide a safer way to maintain aggregate demand if there is a negative shock.
The Fed needs to recognize that its employment goals have essentially been reached and that the inflation rate will reach its target of 2% in the foreseeable future. The economy would be better served by a more rapid normalization of short-term interest rates.
Mr. Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of the Journal’s board of contributors.
Market Correction Could Become a Full-On Bear
Technical indicators such as support levels and market breadth suggest it is nearly time to hunker down.
By Michael Kahn
I consider there to be two indicators that tell us when a bear market has begun. The first is when the benchmark index violates both long-term trendlines and key support levels. In November, I discussed here that the charts looked remarkably similar to those seen at the last market top in 2007. I followed that up in December showing the same condition, complete with confirming technical indicators, at the 2000 peak.
At both of those peaks, the major trendline drawn from the start of each bull market was clearly broken to the downside. That is the case today for the Standard & Poor’s 500 (see Chart 1). The trendline from 2009 is broken and the October rally successfully tested that breakdown. Part one – the trend break – is in play.
Standard & Poor’s 500
The important point to make is that it will be about 11.5% below the last peak, seen in November, and more than 12% below the all-time high, set in May.
The second condition needed for a bear market is confirmation in the broad market. After all, the benchmark S&P 500, while tracking about 80% of the country’s market value, only looks at about 8% of the 6,000 stocks trading on the New York Stock Exchange and Nasdaq combined.
And that does not count penny stocks trading over-the-counter on the pink sheets and bulletin board.
Admittedly, this condition is subjective. There is no real research on what percentage of stocks needs to be falling, for how long and how much they need to lose. Even if we slap an arbitrary figure of 50% for the percentage of stocks falling and use the irksome 10% price decline threshold, it is easy to see how this condition has been met in today’s market.
Just take a look at the NYSE advance-decline line (see Chart 2). It peaked in April of last year.
And the Nasdaq advance-decline peaked in March 2014, although to be fair this indicator has a natural downward bias. The Nasdaq is home to some highly speculative companies that are more prone to failure.
For me, almost everything is in place for the third cyclical bear market in the 21st century. And that also follows the road map of the 18-year secular market cycle I’ve seen in place since a century ago. If that is a correct assessment, then 2016 is year 16 in the secular bear market that began when the technology bubble burst in 2000.
A secular or long-term bear market can contain several cyclical or short-term bull and bear cycles. The 1970s is the last great example of a secular bear. And the 1982-2000 rally was the last great secular bull.
Some analysts say that a secular bull market began in 2013 when the S&P 500 breached the highs of 2000 and 2007, but I disagree. That said, I have no evidence that any coming cyclical bear market will be as severe as the prior bears or last as long. To me, a 16-year secular bear market is close enough to satisfy the requirement of the “average” 18-year cycle.
The bottom line is that the last straw will likely be breakdowns by the big-cap S&P 500, Nasdaq and Dow Jones Industrial Average below their summertime lows. At that point, it will be hard to argue for anything other than a significantly lower market later this year.
The Return of Public Investment
Have the BRICs Hit a Wall? The Next Emerging Markets
The FBI’s Worst Nightmare
The bloodbath in oil continues.
Yesterday, oil dipped below $30/barrel for the first time since December 2003. Just 18 months ago, a barrel of oil cost $106.77.
Oil is off to a horrible start in 2016. The price of oil has fallen every day this year, shocking many Wall Street analysts who called a bottom in the $35-40 range.
On Monday, The Wall Street Journal reported:
Morgan Stanley issued a report this week describing an environment “worse than 1986” for energy prices and producers, referring to the last big oil bust that lasted for years. The current downturn is now deeper and longer than each of the five oil price crashes since 1970, said Martijn Rats, an analyst at the bank.
Global investment banks Goldman Sachs (GS) and Citigroup (C) now expect oil to drop below $30.
And Morgan Stanley (MS) warned earlier this week that oil could fall as low as $20 a barrel.
• The world has too much oil…
New technologies such as “fracking” have unlocked huge reserves of oil. Since 2008, U.S. oil output has jumped 74%. And last spring, U.S. production reached its highest level since the 1970s.
The Organization of the Petroleum Exporting Countries (OPEC), a cartel of major oil-producing countries, is also pumping at record levels. OPEC produces 40% of the world’s oil.
• Low oil prices have crushed U.S. oil companies…
Shares of Exxon Mobil (XOM), the largest U.S. oil company, have fallen 26% since June 2014. Chevron (CVX), the second-largest U.S. oil company, is down 37%.
The companies that sell equipment to the oil industry are down big, too. Schlumberger (SLB) and Halliburton (HAL), the two largest oil services companies, are down 39% and 55% since June 2014.
• Oil companies have drastically cut spending…
The global oil industry has already cut 250,000 jobs. And more job cuts are likely coming. Energy consulting company Wood Mackenzie estimates that $1.5 trillion worth of oil projects in North America can’t make money even at $50 oil.
• Many U.S. oil and gas producers can’t pay their bills…
The Wall Street Journal explained on Monday:
As many as a third of American oil-and-gas producers could tip toward bankruptcy and restructuring by mid-2017, according to Wolfe Research. Survival, for some, would be possible if oil rebounded to at least $50, according to analysts...
More than 30 small companies that collectively owe in excess of $13 billion have already filed for bankruptcy protection so far during this downturn…
• U.S. oil companies borrowed nearly $200 billion between 2010 and 2014…
Industry debt levels jumped by 55% during the “boom times” when oil was over $100/barrel.
With oil at $30 today, many companies can’t pay their debts. According to The Wall Street Journal, North American oil and gas producers are losing $2 billion each week due to low energy prices.
Like most commodities, oil is cyclical. It goes through big booms and busts. Right now, the industry is going through its worst downturn in decades.
Eventually, oil will bottom out. We’ll get an amazing opportunity to buy the best oil stocks at bargain prices.
But for now, oil is still in a sharp downtrend. The world simply has too much oil. We recommend avoiding oil stocks for now.
• Louis James, editor of International Speculator, has a way to profit from the oil…
Louis is our resource investing guru. His specialty is finding small miners with the potential to return five or ten times your initial investment. Today, Louis thinks the plunge in oil is creating an opportunity to profit.
But Louis isn’t buying oil companies. He likes airlines, as he explained in the December issue of International Speculator...
The airline business is very sensitive to oil prices. Airline stocks often move up when oil drops…
Going long on a great, profitable airline with lots of growth on tap is a virtual way to short oil, without risk of being forced to cover if oil rises.
Jet fuel, which is made from oil, is a major operating expense of airlines. From the third quarter of 2013 to the third quarter of 2014, revenues for Louis’ favorite airline stock jumped 17%. And its quarterly profits more than doubled.
• On December 23, we warned you of the biggest threat to your wealth in 2016…
At Casey Research, one of our key goals is to warn you about anything that can affect your finances.
That’s why we investigated a serious danger that no one else is talking about...
This threat is far more dangerous than a stock market collapse, a severe economic depression, or even a currency crisis. And it’s much more likely to happen.
We’re talking about a financial terrorist attack…an attack that could wipe out the money and stocks you own in an instant.
Think about it…if you have $50,000 in the bank, what do you really have? These days, it’s certainly not a claim to hard assets like gold or silver. And it’s certainly not real cash in a vault.
What you have are digital bytes in a computer. A cyberattack could erase these in seconds…causing your money and stocks to vanish.
• Hundreds of cyberattacks have happened in the U.S....
Here are a few:
➢ In 2013, a team of Russian hackers stole $1 billion from more than 100 U.S. banks.
➢ In April 2015, hackers broke into President Obama’s personal email.
➢ In May 2015, hackers breached the Internal Revenue Service database and lifted information from 300,000 private tax returns.
Hackers have also broken into “secure” databases of government agencies. The Federal Reserve, Department of Defense, and CIA have all been hacked.
• Recently, we learned of a cyberattack on America’s infrastructure…
Iranian hackers infiltrated a dam in Rye, New York. Rye is a small town located just 20 miles northeast of Manhattan.
The cyberattack remains classified. We don’t know all the details. But, according to The Wall Street Journal, the hackers gained access to the dam’s control system.
• A major cyberattack in the U.S. is inevitable…
Cybersecurity expert Mary Galligan recently told Bloomberg News that a U.S. cyberattack is “the FBI’s worst nightmare.”
Unfortunately, it’s a matter of when, not if, a major financial terrorist attack will happen. It’s a no-brainer for America’s enemies to launch a cyberattack against our financial system…
Think about it…funding and organizing a large-scale terrorist attack takes months or years of planning. It can require coordinating dozens of people. It can cost an enormous amount of money.
Or you could take a handful of very smart people, get them a few computers, and launch a major cyberattack...one that could shut down entire industries, cause a stock market crash, and cause an explosion of inner-city violence.
• We recommend moving a significant amount of money outside the digital financial system…
Keep enough paper cash to cover three to six months’ worth of living expenses. You can store your cash in a safe or public storage unit. You could even bury it in a waterproof container in your backyard.
Some might call us crazy for recommending this. But remember, America’s financial system is almost entirely digital. Your money and stocks are just digital entries. They could vanish in a cyberattack.
Holding a significant amount of physical cash will allow you to take care of yourself and your family should the “unthinkable” happen.
Chart of the Day
Louis’ favorite airline stock is racing higher…
Today’s chart shows the performance of Louis’ favorite airline stock since oil prices peaked in June 2014. This stock is up 61% since then. The S&P 500 is down 1% over the same period.
As long as oil stays low, this company should continue to earn big profits. And, as we mentioned earlier, the global economy still has far more oil than it needs.
Bull Economy 2
by: The Nattering Naybob
From Martin at Macronomics: "Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you. From a "risk-reversal" perspective, we think, the current sizable "short positioning" from the "Leveraged crowd," offers a good contrarian punt, given the "weaker" outlook as of late of the US economy."
"The deceleration in real GDP in the third quarter primarily reflected a downturn in private inventory investment and decelerations in exports, in PCE, in nonresidential fixed investment, and in state and local government spending that were partly offset by a deceleration in imports." - Q3 2015 GDP Report
From Jeffery P. Snider: "When looking back at that catalog of increasing financial and economic carnage, the pattern should be immediately recognizable to economists as "shrinking" or "tightening" money supply; all the symptoms are there and apparent. It is the classic replay of that condition, as reductions in money supply lead to monetary deflation (commodities and certain markets, including stocks that have, for almost a year and a half, gone, at best, nowhere, and for a great many places have already sunk quite significantly) and depressive economic conditions. To the orthodox economist, however, that just cannot be since ZIRP and QE are both "stimulative" while the latter is sold as "money printing."
"But even as the macro picture is hopelessly obscured by the mischievous tinkering of bureaucrats, the county-level data reveals the dismal truth: according to a new study by the National Association of Counties, 93% of America's counties have not yet recovered from the recession." - Zero Hedge