STALL SPEED : Any Geo-Political, Economic or Financial Event Could Trigger a Market Clearing Fall
As we reported last month, Global Economic Risks have taken a noticeable and abrupt turn downward over the last 60 days. Deterioration in Credit Default Swaps, Money Supply and many of our Macro Analytics metrics suggested the global economic condition is at a Tipping Point. Though we stated "Urgent and significant actions must be taken by global leaders and central banks to reduce growing credit stresses" nothing has occurred even after the 19th disappointing EU Summit to address the EU Crisis. Some event is soon going to push the global economy over the present Tipping Point unless major globally coordianted policy initiatives are undertaken. The IMF recently warned and reduced Global growth to 3.5%. This is just marginally above the 3% threshold that marks a Global recession. This would be the first global recession ever recorded. The World Bank is "unpolitically'projecting 2.5%. The situation is now deteriorating so rapidly, as to be impossible to hide anylonger.
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MONETARY MALPRACTICE : Moral Hazard, Unintended Consequences & Dysfunctional Markets - Monetary Malpractice has had the desired result of driving Investors into becoming Speculators and are now nothing more than low-odds Gamblers. There is a difference between investing, speculating and gambling. At one time these lines were easy to comprehend and these distinctive groups separated into camps with different risk profiles in which to seek their fortunes. Today investing has become at best nothing more than speculating and realistically closer to outright gambling.
The reason is that vital information is either opaque, hidden or manipulated. Blatant examples such as: the world of off balance sheet debt, Contingent Liabilities, Derivative SWAPS, Special Purpose Vehicles (SPV), Special Purpose Entities (SPE), Structured Investment Vehicles (SIV) and obscene levels of hidden leverage make a mockery out of public Financial Statements. Surely if we get our ego out of this for a moment we can see that stockholders are now nothing more than gamblers? What is worse is that the casino is rigged. With Monetary Policy now targeting negative real interest rates, it is forcing the public out of interest bearing savings and investing, and into higher risk vehicles they would have shunned historically. They have no choice as the Monetary Malpractice game is played against them.
There is an old poker player adage: "when you look around the table and can't determine who the patsy with the money is, it is because it is you." MORE>>
The market action since March 2009 is a bear market counter rally that has completed a classic ending diagonal pattern. The Bear Market which started in 2000 will resume in full force when the current "ROUNDED TOP" is completed. We presently are in the midst of of a "ROLLING TOP" across all Global Markets. We are seeing broad based weakening analytics and cascading warning signals. This behavior is typically seen during major tops. This is all part of a final topping formation and a long term right shoulder technical construction pattern. - The "Peek Inside" shows the detailed coverage available this month.
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Latest Public Research ARTICLES & AUDIO PRESENTATIONS
“To treat your facts with imagination is one thing, but to imagine your facts is another.”
Yesterday I published the assets/liabilities of the European Central Bank as provided by them. I provided some analysis that I thought was relevant as I also asked all of you to look at the numbers yourself. To be quite open; I was stunned by the data they provided and shocked by the implications. I had not seen the data in any other source or commented about by anyone and the subject, while admittedly complex, and perhaps made more complex by design, is a huge wake-up call for anyone investing in Europe.
The ECB lists, as of the end of the 1st quarter of 2012, 16.304 trillion Euros ($ 21.032 trillion) in assets and 17.334 trillion Euros ($22.631 trillion) in liabilities. It is right there in black and white as I showed in the ECB provided data that I presented yesterday. However when you get to their consolidated balance sheet you find the numbers they bandy about in public to be a ledger of 3.240 trillion Euros ($4.00 trillion) and you catch your breath and pause. Utilizing normal American accounting practices this variance would be impossible and yet here it is; staring us all right in the face.
“Europe has put a ‘stop payment’ on our reality check!”
I can report that I did hear from a number of large institutions yesterday that also looked at the numbers themselves and were stunned. Conversations were held, questions were asked and I think an accurate summation of the conversations was that everyone was in some state or another of astonishment. The numbers were not my numbers after all and while many good issues were raised in terms of how to properly analyze the data that was presented there was a clear sense that we were being duped by the European Central Bank and played for suckers.
“Reality is the leading cause of stress amongst those in touch with it.”
Forget that the liabilities are greater than the assets and forget that that both have increased rather appreciably in the last several years and just concentrate on the size of the numbers presented and then ask the central questions; who is responsible for these assets and liabilities and where are they counted? We know that they are not counted at the ECB as they are not a part of their consolidated balance sheet. You may ask how this is possible and I re-print, once again, the applicable note from the ECB:
“Recognition of assets and liabilities
An asset or liability is only recognized in the Balance Sheet when it is probable that any associated future economic benefit will flow to or from the ECB, substantially all of the associated risks and rewards have been transferred to the ECB, and the cost or value of the asset or the amount of the obligation can be measured reliably.”
So there is the rationale, like it or not, but then where are these assets/liabilities counted? We are talking about $21.032 trillion in assets here and $22.631 trillion in liabilities which are larger numbers that all of the GDP of Europe. We can surmise that the ECB does not count these loans, securitizations and collateral as they belong to a given nation or a bank guaranteed by the nation or the securitization is guaranteed by some country but the rub is the country doesn’t count them either. When a European nation reports out its debt to GDP ratio I knew that they did not count
Contingent Liabilities and I knew that
Government Backed Bank Bonds (Ponzi Bonds) were not included and I knew that
Regional Debt guaranteed by the government was not included
but this, and the sheer size of it, had lain underneath everyone’s radar.
Think of it; twenty-two trillion dollars worth of assets and liabilities and accounted for nowhere. No need to worry anymore about Target2; a mere tuppence at one trillion dollars, a decimal point. Just exactly what these assets and liabilities might be is anyone’s guess. Just which nations generated them is also anyone’s guess as no data or explanation is provided. Just what any country’s real debt to GDP ratio might be if these assets/liabilities were included in the equation is also anyone’s guess but I think it is safe to assume that the numbers would be off the charts; far off the charts.
“Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.”
You know, these are not blue fairies or gnomes or elves that have gone missing. These are twenty-two trillion dollars ($22 trillion) of loans and securitizations and mortgages that are found and accountable for by no one. These are real assets and real liabilities that have been turned into cash by the ECB and it causes me to wonder just how accurate the Money Supply numbers are for Europe with this amount of cash being pumped into the system. I also wonder what anyone’s real balance sheet looks like and I wonder what kinds of losses are being incurred and by whom. To be quite forthright, and in my opinion, this seems to me not just the rigging of the game or the gaming of the system but something far past that; something out beyond the realm of the credible and of real world experiences.
This is what we are investing in when we buy European bonds? This is where we are putting our client’s money? I don’t know; they may have gone mad but I have not.
“An error does not become truth by reason of multiplied propagation, nor does truth become error because nobody sees it.”
1- EU Banking Crisis
IMF CAUTIONS - 10 Year To Fix The Current Financial Crisis
"It will surely take at least a decade... for the world economy to get back to decent shape" is the somewhat shockingly honest (and at the same time hopeful that ECOpocalypse does not happen before) outlook that the IMF's Olivier Blanchard offers in a recent interview with Hungary's Portfolio.ru via Reuters. His diatribe of expectations that Germany would have to accept higher inflation, the US had to fix its fiscal problem, "Japan is facing a very difficult fiscal adjustment too" is more an understatement of facts than a forecast but on the bright-side he thinks China has turned the corner on its asset boom (but faces slower growth ahead). The reality is that, as he also notes, debt reduction (via default or deleveraging) is unavoidable and while he believes that this can be done without stifling growth in this credit-fueled world in which we have lived (though no mention of the tooth fairy). Dismissing the idea of inflation-targeting, he warns "You can have an economy in which inflation is stable and low, but behind the scenes the composition of the output is wrong, and the financial system accumulates risks." It seems the IMF is waking to the new reality - perhaps as evidenced by their actual disagreement with Greece over fantasy GDP data - though we fear what another decade of this will do to global instability.
The world economy will take at least 10 years to emerge from the financial crisis that began in 2008, the International Monetary Fund's Chief Economist Olivier Blanchard said in an interview published on Wednesday.
But even though the focus was on Europe's troubles now, he said, the United States also had a fiscal problem which it had to resolve.
"It's not yet a lost decade... But it will surely take at least a decade from the beginning of the crisis for the world economy to get back to decent shape," Blanchard said.
"Japan is facing a very difficult fiscal adjustment too, one which will take decades to solve. China has probably taken care of its asset boom but has slower growth than before, but we do not forecast any really hard landing," he added.
Blanchard said that adjustment in the euro zone required a decrease in prices in the bloc's indebted southern half and a rise in core countries.
"A somewhat higher inflation rate in Germany should simply be seen as a necessary and desirable, relative price adjustment," Blanchard said. "Given overall demand conditions and the ECB's strong mandate to ensure price stability, this is not the beginning of hyperinflation," he said.
On the debt crisis, Blanchard said that debt reductions were unavoidable but it should be done without stifling growth, walking on a "narrow middle path."
"If you do it too slow, the market thinks you're not serious, if you do it too fast, you kill the economy. For each country you have to find the right path of consolidation," he said.
He said inflation-targeting had serious limitations and using just the main policy rate was not enough.
"You can have an economy in which inflation is stable and low, but behind the scenes the composition of the output is wrong, and the financial system accumulates risks."
What's to worry about? The world is engulfed in a liquidity tsunami from Japan's QE expansion to the ECB's bond buying program and the Federal Reserve's QE3. Bond yields have fallen for Spain and Italy pulling them out of the danger zone, the flames of the Eurocrisis have died down to smoldering embers and there is a general belief that the world will somehow shortly reignite the engines of economic growth just any day now. With October starting the seasonally strong "best months of the year" there seems to be nothing but clear sailing ahead.
Of course, as Bob Farrell's rule #9 so eloquently states "When all the experts and forecasts agree - something else is going to happen." While the media focuses their attention on all the things that could go "right" to keep the rally going - investors should focus on the things that could possibly go "wrong" which could result in significant, unexpected, capital reductions. Therefore, as we look forward into the final quarter of 2012 here are the three big risks that could crack the markets.
The "Fiscal Cliff"
The fiscal cliff is looming larger as we rapidly approach the end of the year. The simultaneous collision of expiring tax cuts, automated budget and job cuts, and the implementation of 22 new, or higher, taxes from Obamacare will weigh not only the economy but the markets as well. If Congress does not address this issue, and very soon, the fear of a jump in tax rates will induce a market liquidation as investors sell postions to realize capital gains at 2012 rates of 15% before they jump to 23.8% in 2013. Furthermore, those investors that have been pouring money into high yielding dividend investments may begin to rethink their strategy as dividends jump from 15% to 43.4% next year.
However, it is not just the hike in investment related taxes that will cause a burden on the markets. The impact of the entire "fiscal cliff," should it go unchecked, will impose an estimated 4% clip to economic growth, and ultimately corporate earnings, pushing the U.S. into a deep recession next year. The financial markets are currently pricing in strong economic growth in 2013, as high as 4%, versus the current paltry 1.25% as of Q2-2012.
Historically, stocks have lost roughly 30% of their value on average during a "normal" economic recession.
With such a wide disparity between the current price of the S&P 500 index and the underlying economic and fundamental realities - the potential reversion could be as brutal as seen during the last two recessionary cycles in 2000 and 2008.
Euro-crisis And Euro-recession
Other than a lot of promises, hope and hand shaking - there has actually been very little progress made in resolving the issues that plague the Eurozone. While bond buying programs, monetary assistance, and continuous "talk" has kept quieted the news flow from the Eurozone in recent weeks - the debt, deficits and economic struggles still weigh on countries unwilling to implement spending controls and debt reduction programs.
The bond buying program that has been put forth by the ECB as the solution to saving the Eurozone is really nothing more than a regurgitation of the SMP Program which was tried, and failed, in 2011. The reality is that the program doesn't attack the root problems at the base of the Eurocrisis which is a complete lack of a constitutional union, and central banking system, under which the countries have collectively agreed to operate. The current union is destined to fail simply due to a lack of a unified structure - "all chiefs and no indians."
However, the recession in the Eurozone is just as big of a risk to the 4th quarter as a return of the crisis. The continued recessionary drag across the Eurozone is dampening revenues and slowing demand for exports from the U.S. Recent corporate reports from key transportation related companies have all warned of weaker outlooks due to slowdowns in the Eurozone.
Since the end of the last recession exports have made up roughly 40% of corporate profitability. The chart below shows exports as a percentage of GDP. Historically, when exports turn down the economy was slipping into recession. The recent drop in durable goods orders and industrial production are warnings that this could already be occurring.
While the media continues to discuss how the U.S. is faring well despite the drag from the Eurozone - the reality is that it just takes time for the slowdown across the ocean to migrate its way west. The chart below shows the Eurozone versus the U.S. economy and the close relationship that exists between the two. It is unlikely that the domestic economy will be able to avoid the drag of a continued recession in Europe for long.
Another risk to the 4th quarter comes down to the impact of the deteriorating economic environment on corporate earnings. Stock prices have been rising solidly over the past several months to get in front of the anticipated QE3 operation by the Fed. However, that rise in price comes at a time without an increase in the underlying fundamentals. This detachment of price from earnings puts the markets at risk of reversion in the months ahead.
The chart below shows Gross, EBIT and Net Profit Margins for the market. What is clearly evident is that each has peaked and began to weaken. Falling margins and year-over-year revenue growth (topline sales) becomes a real concern as analysts continue to estimate a sharp rise in revenue (dashed line for the last half of 2012) in the months ahead. These overly optimistic assumptions will have to be negatively revised in the coming months given the ongoing weakness in Europe and China.
Unlike the 2008-2009 recession when revenues fell at the same time as the cost of sales - we are currently witnessing a far more disturbing development of falling gross margins in recent quarters. This suggests, unlike the last recession, that costs are rising relative to topline growth which will rapidly impact profit margins more than currently estimated.
Not Just 3
These are just three of the risks that we see going into the 4th quarter that could well limit the impact of the recently announced QE3 bond buying program. While the Fed may state that the program is in place to boost employment - the reality is that the program was implemented to stave off the impact of the recession that is slowly sweeping the globe. The coordinated efforts of the ECB, Japan, China and the U.S. make this clear.
The biggest threat to the financial system is another sharp recession that could potentially lock up the financial system. The debt burdens that currently clog the system have not been dealt with and the systemic risks are still very present throughout the system. With economic growth faltering any shock to the system, such as the "fiscal cliff", could well be the domino that begins a sharp unwinding of the risks that have once again built up in the system.
With the current markets overbought, extended and overvalued combined with overly optimistic future expectations - the components of the next mean reversion are already in place. The only question is what triggers the next decline?
So the Fed is pinning its hopes on stimulating the economy via the wealth effect again, as it did when it revived the post-tech-wreck asset bubble in housing and credit in that now infamous 2003-07 period of radical excess. But here's the rub. While there is a wealth effect on spending, the correlation going back to 1952 is only 57%. But the correlation between spending and after-tax personal incomes is more like 75%. The impact is leagues apart. And that is the problem here, as we saw real disposable personal income decline 0.3% in August for the largest setback of the year. The QE2 trend of 1.7% is about half the 3.2% trend that was in place at the time of 0E2. Not only that, but the personal savings rate is too low to kick-start spending, even if the Fed is successful in generating significant asset price inflation. The savings rate now is at a mere 3.7%, whereas it was 6% at the time of QE1 back in 2009 and over 5% at the time of QE2 2010 — in other words, there is less pent-up demand right now and a much greater need to rebuild rather than draw down the personal savings rate. This is a key obstacle even in the face of higher net worth.
What is fascinating is that the rise in net worth looks fairly tenuous. Yes, home prices have risen on the back of tighter supplies but the builders have ramped up production by nearly 30% over the past year. And the first-time buyer is dormant, which means that the key source of demand in the food chain is still missing, and investor-based buying will only go so far in terms of sustaining any further home price appreciation.
But it is the action in the equity market that is most telling. This is the first time after any major central bank incursion — QE1, QE2, Operation Twist and LTRO — that 13 (trading) days after the announcement, the stock market is lower. The S&P 500 has dropped 1% since the day of the Fed meeting whereas it was up an average of 4% at this juncture following the other four announcements. I had said earlier that the Fed has likely established a firm floor but it looks clear that the more ominous global economic backdrop has also established a ceiling — I mean, weren't the lagging hedge funds supposed to have been piling in by now? And all of the cyclical sectors are lower which again is highly atypical—all down around 2%. And if there was a group that the Fed was really trying to support it was the Financials and this sector is down 3% along with basic materials. Go figure. The more defensive areas like Health care, Utilities and staples have outperformed, which is very rare after a QE announcement out of the Fed.
At the same time, the yield on the 10-year T-note. which is usually steady around this time following a post-QE announcement, has fallen more than 10 basis points this time around. The TSX has turned in a similar though less dramatic swing this time - Financials and Materials, which had cheapened up far more going into this than their U.S. counterparts, have actually hung in, as has the overall Canadian market (though to be fair, it is usually up 2% by now).
As the accompanied charts illustrate, one obstacle for the equity market of late has been sentiment and positioning. The Market Vane Bullishness index is at the high end of the range and as the latest CFTC (Commodity Futures Trading Commission) data indicate, the net speculative long positions on the S&P 500 and Nasdaq on the CME have already surged to record high levels. In other words, a lot of the buying power that pundits were expecting has already been exhauisted.
The pace of economic activity is weakening, with all deference to ISM. With profits faltering and wage earnings slowing down, we have a situation where Gross Domestic Income softened to a mere 1.7% annual rate in Q2 from 6.1% in Q1 and 4.6% in Q4 of last year. This was the weakest performance since the third quarter of 2009 just as the worst recession in seven decades was ebbing. In real terms, GDI actually stagnated — up a mere 0.16% annual rate, a buzz-cut from the 3.8% pace in Q1 and 4.5% in Q4, again the weakest tally since Q3 last year and the second weakest since Q2 2009. This puts the GDP slowdown in Q2 into perspective. GDP is all about spending. GDI is all about income. And it is income that drives confidence, spending, and ultimately prosperity — not the other way around.
SOCIAL UNREST - Stems from Shrinking Disposable Income. Jobs are the central issue.
In order to avoid social unrest and absorb the world's young people entering the global workforce, the World Bank Development Report states that 600 million jobs must be created from 2005 to 2020. As Bloomberg BusinessWeek reports, jobs should be at the top of governments' agendas or they could face further uprisings such as toppled leaders in Egypt and Tunisia. "Demographic shifts, technological progress, and the lasting effects of the international financial crisis are reshaping the employment landscape in countries around the world," World Bank President Jim Yong Kim said in a foreword to the report. "Countries that successfully adapt to these changes and meet their jobs challenges can achieve dramatic gains in living standards, productivity growth, and more cohesive societies." However, those countries that don't adapt, face the kind of social unrest we have warned of again and again - and are starting to see in more and more civilized Western nations. So - a mere 600 milion jobs and all is well - amazing!!!
Their findings:- 90% of jobs are created in the private sector and so Governments must create an environment that encourages investment - especially in small- and medium-sized business.
90 second clip summary on Private Sector Job Creation:
2 minute clip on Joblessness and Social Cohesion:(link)
Following HSBC's PMI data, China's official Manufacturing PMI just printed well below economists' expectations and is now signaling contraction for the second month in a row. Critically the expectation was for a return to expansion at 50.1 but the data came at 49.8 - still marginally higher MoM. Most sub-indices improved modestly from August but of most interest was the fifth month-in-a-row that the employment index dropped. For all the iron-ore-recovery believers, the Inventories of Raw Materials index also jumped by its most in three months as Input Prices also surged for the second month in a row. So contraction confirmed, a CCP in 'leadership' turmoil, and a PBOC stymied by inflationary concerns and the need to push through structural reform.
We have in the past attempted to take on the gargantuan task of exposing the multi-trillion Chinese Shadow Banking system (not to be confused with its deposit-free, rehypothecation-full Western equivalent), most recently here. Alas, it is has consistently proven to be virtually impossible to coherently explain something as decentralized and as pervasive as an entire country's underground economy, especially when the country in question is the riddle, wrapped in a mystery, inside an enigma known as China. Today, however, courtesy of AsiaFinanceNews we get a report as close as possible to the most comprehensive overview of what may soon be (especially if rumors of tumbling Chinese municipal dominoes are correct) the most talked about subject in the financial world: China's Shadow Banking empire.
From Chinese Shadow Banking System
China presently has five state-controlled megabanks operating within the supervision of the central government, of which the government is a majority shareholder, and seventeen additional “shareholder banks.” Because China’s state banking sector operates as a direct subsidyfunding channel for state-owned enterprises (as opposed to acting in the capacity of risk analytics based credit institutions), the largest state-owned banks have required periodic recapitalization every decade over the past sixty years as the constant generation and cumulative exposure to non-performing loans exceeds the banks’ total equity. The circumstances comprising the present situation, however, will include monetary exposure by international asset management firms which have acquired both direct equity-stakes in the banks as well as exposure to Hong Kong-listed shares.
State Control and Politically Mandated Loans
The banking system is generally considered to represent the weakest link in China’s political economy. Loans are typically a form of direct subsidy by the central government to the various state-owned enterprises. According to Victor Shih, a professor at Northwestern University who specializes in China’s political economy and is considered an expert on China’s banking system, prior to 1997 there had been no comprehensive audits, nor general ledgers, nor any capital stock at any of the five largest banks, as such was considered unnecessary. The central government, which controls 98% of China’s financial sector, maintains control over the banks in order to finance various political and socio-economic policy objectives, maintain capital controls and set fixed interest rates, comprising in effect a self-referential sector, resulting in inefficient capital allocation which deprives China’s small and medium-sized enterprises (“SMEs”) of access to credit through the supervised banking system
Rejection of Western Credit Practices: Global Financial Crisis Doomed Reforms
The government halted and subsequently reversed reforms, and began moving away from western banking practices in late 2008 in response to the global credit crisis, ordering banks to originate loans to both local and centrally-planned investment projects in order to prevent a rapid slowdown in growth. The credit expansion undertaken by banks in 2009 at the direction of Chinese president Hu Jintao resulted in approximately $3.1 trillion in new loans created by the end of 2010.5 The National Development and Reform Commission (“NDRC”) fast-tracked and granted approval of virtually 100% of all fixed-asset investment projects submitted for funding by local governments. The NDRC was created to address the response to a survey by the central government asking local government officials to identify those projects for they had been unable to obtain credit financing. The role of the NDRC is to approve the projects rejected by the banks, thus in essence having approved the worst projects for financing in 2009 and continuing to approve such projects through the present
Just as we had suspected for months, Bernanke's attempt to herd cats and to drive retail investors into equities is now a complete and unmitigated catastrophe. According to just released ICI data, in the week ended September 26, the second full week after the announcement of QE3,
retail investors pulled $5.1 billion from domestic equity funds, following a massive $4.8 billion outflow the week prior, and the most in 2 months.
This is also the sixth largest weekly outflow in 2012 to date, a year in which over $100 billion has already been pulled from equity mutual funds.
And since we now know that Bernanke's only motive for QE3 is to stimulate a wealth effect and to push everyone into the broken casino, where such trading farces as Kraft's flash smash today, as Knight Capital's implosion a month ago, and FaceBook's IPO, not to mention the virtually daily Flash Crash in at least one name, have killed every last shred of faith in equities, it can be safely said that QE3 has failed three short weeks after being launched.
As to where the money did go: why taxable bonds of course - not even the "dumb money" is that dumb to go where the Fed tells it to, and instead merely does what the Fed does: it keeps on frontrunning the Fed's monetization of the US deficit, which is now going on for the 3rd year in a row.
Eventually "this time may be different." But not yet.
21 - US Stock Market Valuations
VALUATIONS - Over Next Year Trailing PE to be Below Generational Norm.
To determine whether the stock market is expensive or cheap, some experts use aggregate valuation ratios, either trailing or forward-looking, such as price-earnings ratio (P/E) and price-dividend ratio. Operating under a belief that such ratios are mean-reverting, most imminently due to movement of stock prices, these experts expect high (low) future stock market returns when these ratios are low (high). Where are the ratios now? Using the S&P 500 Index level as of the close on 9/28/12 and the most recent actual and forecasted earnings and dividend data from Standard & Poor’s, we find that:
The following chart shows variations in valuation ratios based on 12-month trailing earnings/dividends from the end of 1989 through the the second quarter of 2012. Solid lines show the behavior of the ratios, and dashed lines of the same color show their respective averages over the past 22 years. All data are actuals (earnings 99% reported for the second quarter of 2012). Operating P/E and as-reported (GAAP) P/E are well below “normal” values, while the price-dividend ratio is slightly below “normal.”
Operating P/E derives from corporate earnings sources expected by management to continue contributing to future earnings. As-reported P/E includes contributions to earnings from discontinued operations and anomalous (as judged by management) conditions. Operating earnings are arguably more forward-looking and optimistic. As-reported earnings are arguably more manipulation-free and realistic (sustainable).
Note that stock buybacks began augmenting/displacing dividends in the mid-1980s.
The next chart is a shorter-term view of 12-month trailing operating P/E for June 2008 through June 2012. The chart also shows the trajectory of operating P/E for the current Standard and Poor’s bottom-up operating earnings forecast through September 2013, assuming the S&P 500 Index persists near its level of 1441 as of the close on 9/28/12. If the Standard & Poor’s earnings forecast is accurate and the S&P 500 Index remains near 1441, 12-month trailing operating P/E will remain well below its 22-year mean of 19.2 shown in the chart above.
The final chart presents a shorter-term view of 12-month trailing as-reported P/E for June 2008 through June 2012. The chart also shows the trajectory of as-reported P/E for the current Standard and Poor’s top-down as-reported earnings forecast through September 2013, assuming the S&P 500 Index persists near its level of 141 as of the close on 9/28/12. If the Standard & Poor’s earnings forecast is accurate and the S&P 500 Index remains near 1441, 12-month trailing as-reported P/E will remain well below its 22-year mean of 25.6 shown in the top chart above.
In summary, current S&P earnings data forecast 12-month trailing price-earnings ratios below generational“normal” over the next year.
● The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
● The Q Ratio, which is the total price of the market divided by its replacement cost (more)
● The relationship of the S&P Composite price to a regression trendline (more)
To facilitate comparisons, I've adjusted the two P/E ratios and Q Ratio to their arithmetic means and the inflation-adjusted S&P Composite to its exponential regression. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I'm using as a surrogate for fair value. Based on the latest S&P 500 monthly data, the market is overvalued somewhere in the range of 33 percent to 51 percent, depending on the indicator. This is an increase over the previous month's 31 percent to 48 percent range.
I've plotted the S&P regression data as an area chart type rather than a line to make the comparisons a bit easier to read. It also reinforces the difference between the line charts — which are simple ratios — and the regression series, which measures the distance from an exponential regression on a log chart.
Click to enlarge
The chart below differs from the one above in that the two valuation ratios (P/E and Q) are adjusted to their geometric mean rather than their arithmetic mean (which is what most people think of as the "average"). The geometric mean weights the central tendency of a series of numbers, thus calling attention to outliers. In my view, the first chart does a satisfactory job of illustrating these four approaches to market valuation, but I've included the geometric variant as an interesting alternative view for the two P/Es and Q. In this chart the range of overvaluation would be in the range of 43 percent to 61 percent, an increase over last month's 41 percent to 57 percent.
As I've frequently pointed out, these indicators aren't useful as short-term signals of market direction. Periods of over- and under-valuation can last for many years. But they can play a role in framing longer-term expectations of investment returns. At present market overvaluation continues to suggest a cautious long-term outlook and guarded expectations. However, at the today's low annualized inflation rate and the extremely weak return on fixed income investments (Treasuries, CDs, etc.) the appeal of equities, despite overvaluation risk, is is not surprising.
21 - US Stock Market Valuations
EMERGING MARKETS - Export Growth Looks Similar to pre-2008
While the 'Misery' Index in Iran reaches exceptional levels, and the US aggregate of inflation and unemployment peaked last October, Europe's misery has continued to rise in the face of an ever-easing ECB and political jawboning. As SocGen notes today, the UK's misery has turned back higher and the Euro-zone's Misery Index has never been higher. These misery indices clearly reflect deteriorating economic performances in the main G10 countries, with some unsurprisingly weaker performances in Spain and Greece, leading the eurozone index higher. Given recessionary situations expected in some eurozone countries next year, the misery index is unfortunately quite unlikely to edge south significantly.
Eurozone: a record misery index. The situation in the eurozone deteriorated further during the summer: the unemployment rate hit a record 11.4% in August, while inflation increased from 2.4% yoy to 2.6% yoy, pushing the eurozone misery index to a record high (14%). With an unfortunately dark employment outlook, the index is unlikely to reverse course sharply anytime soon. This will force the ECB to keep an ultra-accommodative stance for some time to come.
US misery index: keep a close eye. The decrease (from 8.3% to 8.1%) in the unemployment rate in August was not enough to offset the increase (from 1.4% yoy to 1.7% yoy) in the inflation rate. As a result, the US misery index has increased slightly. Is it merely a passing cloud or the first sign of a more worrying storm? The September NFP report, to be released on Friday, will give us more of a clue. Although the US job situation is clearly less worrying than the eurozone’s, it remains a risk factor for the outlook for the US misery index, and could force the Fed to embark on QE 3.5 with Treasury purchases early next year.
UK misery index edging north. Although we only know the July results for now, we also note the first signs of a deterioration in the UK misery index; based on both employment and inflation. This provides a quandary for the BoE; our economists expect it to increase its QE programme in November.
Spain and Greece: converging misery indices. Spain’s misery index overtook even Greece’s in Q2, and is now about twice the eurozone’s (25.93 versus 13.7). With 24% unemployment rates in both countries, it is clear where the underperformance by both Spain and Greece comes from. Inflation is much more satisfactory, with 1.3% yoy in June in Spain and Greece versus 2.4% yoy in the eurozone. Unfortunately, looming austerity budgets in both countries next year will weigh on domestic demand and thus unemployment rates, leading to still elevated misery indices.
33 - Public Sentiment & Confidence
MACRO News Items of Importance - This Week
GLOBAL MACRO REPORTS & ANALYSIS
US ECONOMIC REPORTS & ANALYSIS
US RECESSION - Reliable Indicators Gives early Signal
In his latest Breakfast with Dave note, David Rosenberg points to one sub-component of the durable goods report that sent a particularly scary signal. The three-month moving average of core capex orders (i.e. nondefense capital goods excluding aircraft) was -4.1 percent in August.
"History shows when the trend weakened to the level we see today, the economy was in recession 100% of the time," wrote Rosenberg. "So stick that in you pipe and smoke it!"
This is also bad news for jobs. According to Rosenberg's data, this measure has an 83 percent correlation with private employment.
Rosenberg also notes that durable goods orders has an 86% correlation to the stock market.
CENTRAL BANKING MONETARY POLICIES, ACTIONS & ACTIVITIES
"QE-whatever has created artificial numbers that the underlying won't support" is how Sam Zell sums up his view of the Fed's actions, adding that the Dow should be more like 9000, not 14000. The typically optimistic bottom-feeding real-estate magnate says he is not buying here, is gravely concerned about liquidity needs, and in his assessment "everything is massively too expensive." This epic CNBC interview-fest, where the less-than-cheer-leading Zell was allowed to speak, includes his views on a pending recession (as he sees capex planned projects being delayed) and while trying not to play the political card too strongly, he asks that we "stop this class warfare crap" and that the animal spirits are unleashed - as the game is being stacked against him. "We're kicking the can down the road... and with QE, there is now too much capital chasing too few opportunities - even when nobody has confidence in the future!"
How does QE3 help?
We're seeing too much capital chasing too few opportunities and consequently i think number one the effect of qe3 is nothing more than pushing up the stock market and yet the stock market is being pushed up at record levels of limited trading. we have low volumes and the market goes up, which is manipulation but it's a function of the fact, what's anybody going to do with money and nobody has any confidence in the future,
We're on the cusp of going back in a recession
How many years have we been kicking the khan down the road. that's a wake-up call for rip van winkle,
have you ever solved a problem without going to the edge?
Unleash the animal spirits, unleash people like me - the game is being stacked against me.
Stop this class warfare crap
We're watching liquidity like a hawk because there's great sense tomorrow morning it could go the other way, in effect you don't invest as much, you don't take as much risk.
Show me any country in the world that has progressed successfully without engaging the animal spirits of their people, and without creating opportunity for their people to excel and push the envelope
There are always structural issues...
Delays in capex spending is usually a sign we are headed into recession
Not optimistic about consumer spending into the end of the year
I am normally an optimist - buying when everything has dropped - but my assessment is that "Everything is massively too expensive"
Stock market should 9000 not 14000
QE is creating artificial numbers that I dont think the underlying will support
The Net Long Interest in S&P 500 Futures (the most liquid equity trading vehicle in the world) is now at its highest since December 2008. The last time investors were this 'net long', the S&P 500 fell over 25% in the next two months.
Economic Surprise Indices have begun to drift back lower in recent days after a short-lived scurry into positive territory as anticipation of Fed/ECB action supported equity valuations over the last few months in the face of deteriorating earnings. Critically though, as Deutsche's Jim Reid notes, headline PMIs (and the ISM) are still well behind levels that are consistent with current equity markets as the disconnect between rich equity prices and poor fundamentals remains very wide. Back around May/June they were broadly in line and since then liquidity has propelled markets but with the data at similar levels, and clearly the hope is that the current fundamental weakness corrects into year-end but at current levels the S&P faces a 9% correction, Europe 22%, and China 25% - hope is indeed a powerful thing.
EARNINGS ESTIMATES - Stealth Warnings Season Not Going Well
You see, lately the slowing global economy is increasingly catching up with those S&P 500 companies who have been forced to issue disapointing earnings guidance. Meanwhile, stocks have been rallying.
"It is interesting to note that while the EPS estimate for the index for Q3 2012 declined 4.5% during the quarter, the price of the index actually increased 6.2% (to 1447.15 from 1362.16) during this same time," writes FactSet's John Butters. "While it is not unusual to see EPS estimate revisions for a quarter and the price of the market move in opposite directions (it has happened in 20 of the past 40 quarters), it is unusual to see this magnitude of change in both the EPS estimate revisions and price."
For Q3 2012, 82 companies have issued negative EPS guidance and 21 companies have issued positive EPS guidance. If the final percentage of companies issuing negative guidance is 80% (82 out of 103), it will be the highest percentage recorded for a quarter since FactSet began tracking guidance in Q1 2006.
Here's a chart from FactSet illustrating that phenomenon.
It is apparent, according to Jim Grant in this excellent discussion on CNBC, that we are living in a world where only PhDs know what is best for us all. As the Fed hides behind the political cover of its dual mandate to centrally-plan our lives, the Fed-fighter notes "we are off the common-sense-mandate and in a PhD-Standard." In the brief and wonderfully erudite segment Grant guides the erstwhile CNBC Fed-cheerleaders to a new reality of inflation not being what they think it is (i.e. not the PCE Deflator but more prosaically too much money chasing too few products exemplified in bloated real estate prices in the past and now equity prices), of a '32-inch' yard, and of a dream-like world where we "return to capitalism", and markets are finally "allowed to clear." As ever, Grant is worth the price of admission as he explains how the 'monetary mandarins' have interjected themselves between us and the public price mechanism as the Fed's 'influence' has grown exponentially since its inception.
GLOBAL FINANCIAL IMBALANCE
STUDENT LOANS - As Expected the Default Rate Is Rising
The graph below shows the default rate over the last 23 years. The sharp decline in rates in the early 90s shows the change that occurred after the Department of Education started sanctioning institutions with default rates higher than 25 percent.
For the first time ever, the U.S. Department of Education has come out with an official three-year federal student loan default rate. Until now, the agency has only looked at two-year default rates at universities, and with a wider net cast, it's clear that students only struggle to pay back loans more with time.
Two years after leaving school, students default on their federal loans at a rate of 9.1 percent, up from 8.8 percent at last count.
That figure jumps to 13.4 percent at the three-year mark, the report shows.
Though they've seen a slight decrease in two-year default rates, for-profit institutions fared the worst by far on the three-year track, with more than one in five students defaulting after three years. Public and private schools clocked in with 11 percent and 7.5 percent default rates, respectively, according to the report.
What's more, nearly 250 schools were found with a 30 percent three-year default rate, 37 of which had a rate higher than 40 percent.
Americans most of all are confounded by their own patriotism. We often embrace the ideal without knowing what it really means. There are in fact two kinds of patriotism: the concrete, and the imagined. Many Americans fall haphazardly into the fantasy of being patriotic. They define patriotism upon the exploits of the mainstream and of the government in control at the time. They become cheerleaders for the establishment instead of stalwart champions of their country’s founding principles. In fact, true patriotism is NOT about blindly defending one’s nation or leadership regardless of its trespasses; true patriotism is about defending the philosophy that made one’s nation possible and prosperous in the first place — even if that means standing against the power structure in place today.
I often hear the uneducated and unaware claim that America and its principles have been a bane to the rest of the world. They say America is at the center of the vampire squid, flailing its vicious tentacles against innocent foreign civilizations. This is an oversimplification at best. The crimes that these well-meaning but naïve activists scorn cannot be attributed to “America” because the American ideal has been completely abandoned by those in the seat of power in our modern era. We do not live in “America” — at least, not the America that the Founding Fathers and authors of the Constitution created. Therefore, the original philosophy that gave birth to America is not the issue, the abuse and neglect of that philosophy is.
America has been ransacked and deformed into a hideous lampoon of its former self. This has been done for the most part through the destruction of the guiding principles we pretend we still hold onto as a culture, but in reality have cast aside. If we are ever to undo the damage that has already been done, we have to rediscover what the original design of America was. Wailing and growling about the inadequacies of the present does nothing unless we also establish where it is that we have fallen from grace. What is America supposed to be? What did the Founders truly intend?
1- America Is Supposed To Be Controlled By The People
The concept of a Republic revolves around a reversal of the traditional narrative of power. Throughout most of history, government stood at the top of the pyramid, where the hands of a few dominated the destinies of the citizenry. The future was a matter for the elites, not the peasants, to be concerned with. The American Republic, as designed by the revolutionary colonists who defeated the old oligarchy (at least for a time), flipped the role of government to servant rather than master. The goal was to make government tangible and accountable rather than abstract and untouchable. The America of today has no such accountability anymore.
We have a two-party system that pursues the mechanizations of globalism in tandem, not in contest. When both parties have the same desires and goals, when both parties collude to remove civil liberties rather than protect them, and when both parties are funded by the same corporate backers, there is no such thing as change through the process of elections. Anyone who claims that government corruption can be punished through the ballot box hasn’t the slightest clue how our system really functions. They think we are still living in the original “America,” one that values the voice of the people.
When the government decides to push through banker bailouts, the Patriot Act, the National Defense Authorization Act, etc., all while ignoring opposition by a vast majority of citizens, it is clear that the paradigm has shifted and the American value of representation by and for the people is lost.
2 -America Is Supposed To Prosper Through Free Markets
One of the first acts of the American Revolution in the fight against British tyranny was to decouple from British economic dominance. They stopped relying on goods produced in England and peddled by the European merchant class and began making their own. From homespun clothing to homemade rifles, Americans created a legitimate free-market environment. Free markets are systems controlled by the people, thriving on the natural functions of supply and demand. They are not administered by bureaucracies or corporate hierarchies that manipulate the economy to fit preconceived political and social ends.
Free markets are decentralized markets. Corporations, which obstruct decentralization, were never meant to exist according to Adam Smith, the architect of traditional free markets. Today’s framework operates on centralization and the removal of options and choices, which is facilitated by the imbalance and lack of accountability in the corporate legal structure.
I have to laugh every time I hear someone attack “capitalism” and free markets as the source of all our ills. America has not had the pleasure of free markets for at least 100 years (since the construction of the private Federal Reserve, a collusion between banking and government interests). No one alive today has ever seen an actual American “free market” beyond community barter, so to blame free markets for our modern failings is rather thoughtless. To summarize, the U.S. economy is nothing like what the founders envisioned and fought for.
3- America Is Supposed To Have A Reserved Foreign Policy
The Founding Fathers specifically sought to keep America out of foreign entanglements and haphazard alliances. They knew from experience that the elites and monarchies of Europe often used wars as a means of consolidating power and keeping populations in relative fear. They were well aware of the methodologies of Niccolo Machiavelli and knew that forced alliances were a trap used to ensnare nations into unnecessary conflict and financial dependency while keeping the masses subservient through false patriotism.
Today, our government has utterly violated the original principles of reserved foreign policy, especially in the past century. The excuse always used is that “we are under attack,” yet we usually discover later that these “attacks” were actually fabricated by our own leaders. From the sinking of the USS Maine, to the sinking of the Lusitania, to the Gulf of Tonkin and beyond, for the past 100 years, Americans have been presented with false flag threats used as leverage to convince us to become entangled in foreign engagements. This strategy has become so common that elitists now openly admit their intentions to commit future false flags in order to draw us into yet another war, this time with Iran.
The current policy of “exporting democracy” has not only been a complete failure (just look at Egypt, Libya, Syria, Iraq, Afghanistan, etc.), it is also a total affront to the foundation of the American dynamic. Patriotism in the name of interventionism is foolhardy and decidedly un-American.
4- America Is Supposed To Respect Individual Rights
The Founders witnessed the extreme abuses of government firsthand: invasion of privacy, invasion of property, wrongful arrest and imprisonment, loss of representation, overt and malicious taxation, thuggish law enforcement, and the targeting of those who dared to dissent in their speech. The excuse used by the British for their tyrannical behavior was, essentially, national security. In the end, though, the elites’ actions had nothing to do with security for the populous and everything to do with what they saw as opposition to their hegemony. Our government has become a mirror image of the elitist power-mongers of Britain in the days of the revolution. Absolutely everything the colonists fought against has been re-established by the globalists in our political structure today, once again, all in the name of national security.
We have seen the enslavement of our money supply and general economy by the Federal Reserve; invasive and violent taxation through the Internal Revenue Service; loss of privacy through the Foreign Intelligence Surveillance and the Patriot acts; loss of property rights through multiple agencies including the Bureau of Land Management, the Environmental Protection Agency, the IRS, the Food and Drug Administration, etc. (who claim their tightening fist is for our own safety, yet they constantly overlook corporate misdeeds that put the public in true danger while pummeling average citizens for minor or non-existent offenses); the militarization of law enforcement through the Department of Homeland Security and Federally dominated fusion centers; potential loss of Habeas Corpus through the NDAA; and even wrongful arrest against those who merely speak openly of their discontent (look into the case of Marine veteran Brandon Raub for a taste of what lay ahead).
What Have We Become?
Those who rally behind the modern concept of America rally behind a façade — an empty shell devoid of the heart and soul that gave life to this once great experiment. I do not support what America is. I support what America was and what it could be again if the truth is adequately smashed into the faces of the currently oblivious public. If this country is content to suckle from the putrid teat of globalism and forsake the moral force of conscience that gave it life, then it has become another place — an alien land.
I have heard the argument that America is meant to be a kind of chameleon built to change its stripes and adapt to the demands of the era. I have heard it argued that the Constitution and the principles of the Founding Fathers are outdated and inadequate for our new age of technological wizardry and terrorist ideologies. This is pure intellectual idiocy. The principles of freedom never expire. Individual liberty is inherent and eternal. It is the driving force of every great accomplishment in the history of mankind. The Constitution and the Bill of Rights embody the spirit of that eternal battle of individual liberty. There is no adaptation. There is only freedom or tyranny.
It is time for us to decide what kind of Americans we wish to be: the deluded rah-rah puppets of a desiccated totalitarian society, or the watchmen on the wall. Will we be the keepers and protectors of the vital core of the American identity, or will we be fly-by-night consumers of the flavor-of-the-day political carnival, eating every tainted sample from the elitist platter in an insane attempt to replace our free heritage with a sleek, sexy, rehashed form of top-down feudalism?
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