Quarterly Commentary 3rd Quarter 2015

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The vast majority of U.S. stocks began to form a broad, rolling top back in November 2014. Historic price volatility has marked the months since then, as the world’s major central bankers have intervened with verbal or monetary support whenever market prices threatened an uncomfortable decline. Slowing economic fundamentals, however, limited subsequent rallies to the area of prior trading ranges. The S&P 500 peaked in May at 2134. In mid-August, prices broke support dramatically with the widely watched Dow Jones Industrials plummeting by more than 2200 points in just four trading sessions, taking prices back to the levels of May 2013. More frenetic volatility characterized the remainder of the quarter, with the S&P 500 shedding 6.4% over the full three-month period and registering a 5.3% loss for the year-to-date.

Notwithstanding still abundant central bank stimulus, most world markets have been weaker than those in the U.S. Even after the rally that opened the fourth quarter, the vast majority of world markets remain down for the year and virtually all are trading beneath their 200-day moving averages. It was striking to note at quarter-end that the MSCI All Country World Index (excluding the U.S.) was at the same level as in March 2000, despite the powerful market rally since 2009. Longstanding Mission clients may well remember our counsel as we entered the new century that we were likely entering a long weak cycle that could last for two decades. It remains highly likely that the U.S. and the rest of the world will ultimately see stock prices below their March 2000 levels before this long weak cycle ends.

In my September 8 blog (Worldwide Bear Market? Probably), I outlined numerous reasons why it is probable that a significant bear market has begun. Fundamental as well as technical conditions continue to point to the same conclusion.

The domestic and world economies are weak and weakening. The Organization for Economic Cooperation and Development and the International Monetary Fund have both recently lowered their U.S. and global economic forecasts. The IMF believes there to be a 50% chance of global growth declining below 3% next year – “equivalent to a global recession.” Citigroup’s research team raised the odds of such a global recession to 55%. Former Treasury Secretary and ex-presidential economic advisor Larry Summers describes the danger facing the global economy as more severe than at any time since the Lehman Brothers bankruptcy in 2008. He makes his case for no near-term rate rise by stating that many industrialized economies are barely running above stall speed and can ill afford a negative global shock. He sees monetary policymakers lacking the tools to respond if a recession were to unfold.

The weak macro picture is compounded by erosion at the micro level as well. Third quarter corporate earnings are expected to decline year over year, and early reporting companies are offering weak forward guidance. Goldman Sachs recently warned that deterioration of balance sheet health is “increasingly alarming” and will only worsen if earnings growth continues to stall amid a global economic slowdown. According to Bloomberg, corporations have loaded up on debt. In the aggregate they owe more interest than ever before, with interest coverage at its lowest since 2009. Major corporations such as Hewlett Packard, Deutsche Bank, Caterpillar and Halliburton have all recently announced intentions to lay off many thousands of employees. Such announcements are likely to multiply.

Since the end of the 1990’s, I have pointed to excessive debt as the primary threat to the domestic and world economies. The debt problem is so severe that seven years of unprecedented central bank stimulus has failed to promote growth even approximating the historic norm. Growth of real per capita U.S. GDP is less than half the normal growth over the past two centuries. To promote even that meager result, the Fed has built a balance sheet debt mountain more than four times what it was just seven years ago. Following the Fed’s lead, other central bankers have similarly attempted to boost their economies on the back of more debt. In the last two decades, overall worldwide debt has grown from $40 trillion in 1995 to $200 trillion last year, while global GDP grew by a far more modest $45 trillion over the same years. Worldwide debt now far exceeds the 2007 crisis level. As became clear in the 1920’s and 1930’s, when all major economies face severe debt overhangs, no single country can serve as the world’s engine of growth. It’s an environment that spawned destructive currency wars in the 1930’s, and we are seeing the early signs of such beggar-thy-neighbor policies today. History demonstrates clearly that there is no easy escape from extreme debt levels.

All debt, of course, is not created equal. In a zero interest rate environment, desperate investors hunt far and wide for yield. In recent years, vast amounts of relatively free borrowed money found its way into emerging economies. When money is essentially free, massive misallocations are likely with serious mispricing of risk assets. Emerging markets have experienced huge asset inflation despite commodity disinflation. With the prospect of rising U.S. interest rates making those investments more expensive, hundreds of billions of dollars have been fleeing those emerging economies in recent months. Very likely, banks have lent trillions that will never be repaid. Defaulted loans obviously penalize both debtors and creditors, and widespread defaults can spiral into a worldwide crisis.

Further complicating life for investors is the second factor that contributed greatly to both of this century’s stock market crashes – extreme overvaluation. TV’s talking heads continually refer to current valuation levels as “fair” or “not too bad.” While valuations are not as extreme as those of the dot.com mania at the turn of the century, any honest evaluation of a broad array of the most commonly used measures of value shows stocks to be selling at or above the levels at the 2007 market peak and all other market highs throughout U.S. history but for the 2000 fantasy level from which prices were more than cut in half over the next two and a half years. The valuation work of such renowned market historians as Nobel Prize winner Robert Shiller, John Hussman and Jeremy Grantham point to probable annualized equity returns over the next 10 to 12 years ranging from negative to positive by very low single digits. Intermittent serious declines are highly probable.

Despite seriously deteriorating economic and corporate conditions, stocks have rallied off the September 29 price lows. In fact, the deteriorating conditions, both here and throughout most of the world, seem to have emboldened stock traders. European and Japanese central bankers remain committed to Quantitative Easing. Negative economic and market conditions appear to have the Federal Reserve afraid to raise short-term interest rates even to a minimal 0.25%. The IMF and others are counseling the Fed to delay any rate rise at least until 2016, some warning of panic in emerging markets with any rate increase. Cherishing the fuel of free money, traders have taken the perverse position that bad news is good news. Some of the recent rally’s strongest days have accompanied the worst economic announcements. Traders apparently value the medicine more than they fear the disease. While there is no way to know how long such a condition can prevail, we can maintain with certainty that it cannot continue indefinitely. Markets are left vulnerable to severe declines–even panics like the 1100 Dow point decline on August 24. The most profound danger is that investors lose confidence in central bankers remaining willing and able to keep market prices elevated. The 50% and 57% stock market declines in the earlier years of this century both unfolded despite aggressive attempts by the Fed to support the economy and markets. The Fed doesn’t always win, and we remain firmly convinced that it’s just a matter of time before investor confidence in the Fed wanes again. For now, however, traders appear ready to celebrate the prospect of more free money, no matter how severe the underlying conditions necessitating such rescue efforts.

Nevertheless, the potential for a more significant near-term market decline has increased. In the U.S., the quality of market rallies over the last several quarters has weakened. Fewer stocks are rising and, at quarter-end, more than half of all U.S. stocks were down more than 20% from their recent highs. Only 37% of common stocks are trading above their individual 200-day moving averages. Trading volume is increasingly concentrated in declining stocks; and the internal characteristics of the current rally are far weaker than those in 2010 and 2011 that both eventually led to new price highs. It looks far less likely that the current rally will see prices move back to earlier highs.

Traditional investment alternatives are similarly not very attractive. Thanks to Fed policy, risk-free returns remain near zero. Investment quality fixed income securities continue to trade near historic low yields. At current levels, a mere 50 basis point rise in rates would create a negative full-year return on a 10-year U.S. Treasury note.

With debt levels as elevated as they are–both here and abroad–severe accidents can happen. Maintaining a portfolio with a traditional asset allocation is a bet that serious accidents will not happen, despite conditions that have historically penalized portfolios. Mission has long believed that a more flexible, strategically allocated portfolio will better protect and grow assets in such a highly uncertain environment.


Worldwide Bear Market? Probably

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My most recent blogs – August 10 and August 11 – highlighted the unprecedented volatility that has characterized the U.S. stock market over the past year. I concluded that “…the potential for a major market collapse increases.”

The market took out a down payment on such a collapse with its 1100 Dow point freefall in the opening minutes of Monday, August 24. The opening hardly marked the end of the excitement, however, as prices rocketed back and forth until the closing bell. In total, there were 17 moves in opposite directions ranging from 100 to 1100 points. On average, the market changed direction every 23 minutes, with each price move averaging 335 points. That action would have constituted a busy quarter, but it unfolded in a single day. High frequency traders must have had a field day.

While that frenetic pace couldn’t continue, even the reduced volatility remained extreme by virtually any other yardstick. Tuesday through Friday, August 25-27, saw 26 additional alternating price moves ranging from 100 to 450 Dow points. For the four-day period, prices moved an average 263 points in alternating directions every 36 minutes. Although volume was the highest in four years, there were probably not a lot of long term investors. Perhaps more long-term investors should have been involved. With equity holdings very close to their maximum levels seen before the perilous market collapses beginning in 2000 and 2007, serious damage to shareholder wealth will unfold if a bear market has in fact begun. Numerous conditions indicate that a bear market has probably begun. The depth and duration remain to be seen.

Substantial publicity attended last week’s “death cross” on the S&P 500, with that index’s 50-day moving average dipping below its 200-day moving average. As always, when such a phenomenon occurs, naysayers emerge to point to instances in which the cross did not predict a severe market decline. What is more important to recognize, however, is that more often than not, such a cross does introduce a significant market decline.

The Dow Jones Industrial Average demonstrated the same pattern a few weeks earlier than did the S&P. Around the world, the picture is convincingly the same. We follow activity in 46 world markets. Every one of them is trading below its 50-day moving average, and only four are trading above their 200-day moving averages. Most world markets show losses for the year-to-date, and their moving averages are declining. Price destruction is widespread.

When U.S. stock markets have risen intermittently over the past year, leadership has come from fewer and fewer stocks. Among operating companies, only 2% to 3% of stocks are trading within 2% of their 52-week highs. On the other hand, more than half of such companies are trading 20% or more below their 52-week highs. Far more issues are reaching 52-week lows than 52-week highs.

For many months, the number of stocks rising relative to the number declining has diminished substantially with the trend accelerating recently. The deterioration started in the small-cap area, graduated to mid-caps and has recently spread to large-caps–a classic pattern leading to a bear market.

A well-respected old saying in the investment industry is that volume confirms price. As indicated earlier, volume picked up markedly on last month’s precipitous price decline. In a process begun more than two years ago, volume going into rising stocks has deteriorated steadily relative to volume going into declining stocks. Over the past few weeks, the cumulative volume total going into declining stocks has surged above the volume going into advancing stocks. As measured by Ned Davis Research since 1981, the S&P 500 has on average declined when that condition has prevailed, and the index has performed an annualized 13.5% worse than when advancing volume has dominated.

The highly respected Lowry Research Corp., providing excellent technical analysis since the 1930s, computes buying power and selling pressure as its primary measures of supply and demand on an intermediate to long-term basis. Its current computation indicates the 6½ year bull market to be in its final phase. Two weeks ago, Lowry’s identified a condition related to buying power and selling pressure that has existed only five other times since the 1930s. All occurred in significant market declines, although two were identified toward the end of those declines and only a few percent above the ultimate bottom. The other three signals were followed by declines of 44%, 40% and 32%. Needless to say, precedent suggests that investors pay attention.

For the past year and a half, the yield on lower quality debt has been rising notably both absolutely and relative to U.S. Treasury securities. That condition has preceded some of history’s most costly equity declines.

The venerable, old Dow Theory issued a bearish signal last month, as both the Dow Industrials and Transports closed beneath their October 2014 lows. And the Elliott Wave, as interpreted by Elliott Wave International, forecasts lows in this country not seen since the 1940’s. For that to be correct, we would almost certainly have to experience a worldwide depression–an outlier call, to say the least.

Technical conditions are by no means alone in raising storm warnings. Worldwide fundamentals are similarly uninspiring. The International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) have each continued to drop their forecasts for both US and world GDP growth. They have characterized the growth rates as weak and worsening. Similarly our Federal Open Market Committee has had to drop its domestic GDP growth estimates. There are pronounced growth declines and/or outright weakness in China, Canada, Brazil, Russia, South Africa, Japan, Taiwan, Singapore and South Korea –representing many different parts of the world with very different characteristics. Economic weakness is widespread.

The European Central Bank has recently cut its outlook for inflation and growth for 2015, 2016 and 2017. Those projections were made before the most recent China problems bubbled to the surface. Just last week, ECB head Mario Draghi stressed that renewed downside risks had emerged.

Emerging markets have been increasingly distressed by U.S. dollar strength, by commodity deflation and by China’s surprise devaluation. In an attempt to defend their individual economic wellbeing, a growing number of emerging countries have devalued their currencies. The risk of widespread currency wars is expanding. The Financial Times recently reported that these currency devaluations had failed to stimulate exports and had, in fact, diminished world trade. Because so much of emerging market debt is denominated in U.S. dollars, dollar strength is exacerbating the repayment burden. And that burden will get heavier still when our Federal Reserve eventually begins its interest rate normalization process.

Domestically, corporate earnings are weak and will likely be down in calendar 2015 from 2014. Analysts have for several years been forecasting significant earnings growth for the year ahead. Those forecasts have been far too optimistic, however, and have been ratcheted down progressively as each quarter has drawn near. With S&P 500 GAAP earnings barely up in 2014, earnings by the end of this year will be approximately flat from two years earlier. If stocks were cheap, that might not be a great problem. As we have highlighted in any number of this year’s blogs, quarterly reports and seminars, however, a composite of all major valuation measures shows stocks to be more overvalued than ever before, but for the months surrounding the dot.com peak in 2000. Returns from valuation levels even far below current levels have been substantially below normal over the decades.

As we have written frequently for the better part of the past two decades, debt burdens have grown to unprecedented levels relative to the size of economies throughout the world. The debt problem was a critical ingredient in each of the two 50%-plus market collapses of the past 15 years. Today’s level of debt, far worse than in those earlier instances, raises the risk of extreme market and economic reactions should those debts begin to unravel. It creates the risk that a traditional market decline could turn into something far more severe, especially if investors should lose faith in central bankers’ willingness and ability to keep economies and markets afloat. It is instructive to reflect on the June warning by the Bank for International Settlements (the central bank for the world’s central banks) that central banks are now virtually out of ammunition to deal with either a major market crash or a sudden world downturn.

We find the evidence compelling that a bear market has very likely begun. That does not rule out attempts by markets to rally back toward recent highs, such as today’s 390 Dow point rally, especially given the market’s short-term oversold condition, but it makes it unlikely that further gains will be sustained. The danger looms that a market, economic, political or military event could decimate investor confidence and lead to a persistent, destructive decline.

The primary hope for a more sanguine outcome lies with central bankers. History’s most massive stimulus efforts have supported stock and bond prices for 6 ½ years, with little tolerance for even minimal declines. The IMF is currently calling on the ECB to expand its quantitative easing program, and it recently indicated its belief that Japan may likewise have to expand its program. More than once, the IMF has urged the Fed not to begin interest rate normalization until 2016 at the earliest. This afternoon the Chief Economist at the World Bank warned that an imminent US rate hike could wreck “panic and turmoil” on emerging market countries. That these two world bodies continue to lobby for governmental support after 6½ years of unparalleled stimulus indicates their recognition of perilous underlying conditions throughout the world.

Many still believe that governments remain in control of markets. However, worldwide price declines over the past few months have to call that belief into question. And the two-month loss of more than one-third of the value of Chinese equities despite unprecedented government intervention should be exhibit A demonstrating that traditional investment factors will ultimately overcome even the most egregious governmental interference.

With so many caution flags waving, individual investors, even those with long time horizons, should evaluate carefully how much they want to leave exposed to equity risk. Institutional investors with permanent equity allocations should explore hedging alternatives. With many of the financial crisis’s problems merely papered over, not solved, a bear market in the years ahead could be deep and lengthy. And there might well be no rapid recovery with central bankers’ arrows already having been fired.


Volatility Continues

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Just a quick follow-up to yesterday’s analysis. Written on the weekend, we posted “Volatility Reigns” yesterday. The equity market volatility and indecisiveness profiled in that analysis was dramatically in evidence again yesterday and today.

Before the market opened yesterday, traders celebrated the news that Warren Buffett was making a major purchase of Precision Castparts. The economic news out of China was depressing with both July import and export figures down over 8%. In the perverse world of “bad news is good news,” that increased the likelihood that Chinese authorities would soon introduce even more stimulus. There were also reports that Greece and its creditors were close to agreement on another bailout for that beleaguered country. Oversold from more than a week of declines, stocks powered ahead, the Dow Industrials up by 254 points at the day’s high, closing up 241 points. Internals were likewise strong with advancing stocks outpacing declines by nearly three-to-one on the N.Y. Stock Exchange and by over two-to-one on NASDAQ. The only cautionary note was that volume was light and below the levels of recent weeks.

Overnight, China implicitly acknowledged its weakening economic performance by devaluing its currency by almost 2%. That precipitated selling of stocks throughout Asia and Europe despite rumors being confirmed that Greece and its creditors reached agreement on a massive bailout that may exceed 90 billion euros. Stocks reversed course in this country this morning with the Dow dropping 263 points to its low, then rising a bit to close down 212 points. Volume intensified on the decline.

Volatility continues, not just week-to-week but day-to-day. And governments and central bankers remain the major players.


Volatility Reigns

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Through more than 46 years in the investment business, I have never before seen such extraordinary price volatility as has characterized the U.S. stock markets over this past year. In that time, the Dow Jones Industrial Average has alternated directions 33 times by amounts ranging from 300 to 2000 points.

INDU 1 year with annotations

Twenty-nine of those moves have occurred in the most recent eight months, an average of an almost 600 point change of direction roughly every six market days. Last week, one of TV’s talking heads stated that we haven’t experienced such volatility since 1904. At the very least, this is far from a normal investment environment.

The Dow closed Friday almost 600 points below the beginning level of the eight months of wild vacillation, and about 1000 points below its May high. The indecisive fluctuations have brought prices back to the level of late-October 2014. Clearly, neither bulls nor bears have been able to gain control. Such indecision is similarly characteristic of stock markets around the world. About half of those markets are up for the year-to-date, half down. About half are trading above their 200-day moving averages, half below.

While many markets are only a few percentage points below their all-time highs, there are clear signs of fatigue showing. The current U.S. stock market rally is already longer than most. With each new index high, fewer and fewer stocks are reaching individual highs. In fact, in recent weeks, more stocks are hitting new 52-week lows than highs. More than two-thirds of stocks in the broad Russell 3000 are trading 10% or more below their recent highs. A growing number are more than 20% below such highs.

While these market conditions typically precede important stock market declines, they are not precise timing tools. Major market indexes can continue to reach new highs even with fewer and fewer individual stocks participating.

The current market advance has seen greater government intervention worldwide than ever before. At virtually all the lows in the past year’s trading range, central bank or other government officials have stepped forward with actual monetary stimulus or at least promises of probable support. Such support has successfully prevented significant price declines even as major international forecasting organizations continue to reduce their estimates of U.S. and global economic growth. On the other hand, such intervention has been unable to stimulate prices to break above the top of the multi-month trading range.

We are increasingly learning that governmental intervention has taken the form of actual stock purchases. Most notable has been the commitment during the past month of nearly $500 billion by China’s government to prevent a potential stock market collapse. Japan continues to boost its market and others with massive stock purchases, both domestic and international. Switzerland, long considered a bastion of financial sobriety, recently reported that it purchased international stocks totaling 17% of its current Gross Domestic Product. The widely respected Zero Hedge website speculates that the U.S. has similarly stockpiled a huge portfolio in its effort to support stock prices. I have long believed that the Fed or Treasury has been strategically buying stocks, either directly or, more likely, through a surrogate. Such purchasing can continue to support markets indefinitely as long as governments believe they can print money or dedicate reserves to growing a national equity portfolio. Governments, however, have a less than positive track record with asset purchases over past decades. They have, for example, been widely ridiculed for stockpiling gold near all-time highs and selling gold reserves near major lows. There is little reason to expect their investment expertise to have improved.

According to Bloomberg, a few months ago, Matt King, global head of credit strategy at Citigroup, made the point that stock markets have become reliant on monetary support. He estimated that central banks need to pump about $200 billion into the global economy every quarter to keep stocks from falling. Without such stimulus, King estimated that stocks could drop by 10% quarterly, at least initially.

For several quarters, we have characterized the investor’s dilemma to be whether to bet on the continued success of central bankers supporting markets or to trust that deteriorating economic and stock market fundamentals will ultimately prevail. While history argues convincingly that fundamentals will dominate, governments remain on a multi-year winning streak. As prices and the soundness of fundamentals experience a growing divergence, however, the potential for a major market collapse increases. Such is the probable unintended consequence of years of unprecedented governmental interference with free markets.



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The second quarter saw a continuation of the frenetic volatility that has characterized the stock market environment since September of last year. The range in the second quarter was tighter, however, than in preceding months (back and forth from roughly 17,600 to 18,350 on the Dow) with essentially no net change over the three-month period. The S&P 500 returned a small fraction of 1% for the quarter, with most other equity indexes in the minus column. Stocks closed the quarter near the bottom of their recent range, bringing prices back to November levels.

With interest rates still not far above historic lows, most bonds lost money in the second quarter. Risk-free cash equivalents continued to provide virtually no return, thanks to central bank policy.

Vacillating headlines about the potential insolvency of Greece or of another bailout had a huge influence on markets, as stock, bond and currency levels moved in step with rumors and announcements. As I write, European countries are working to see whose money they will use to enable Greece once more to stave off a formal default. Realistically, there is no way Greece will ever repay all the money it owes; but the collective judgement of its creditors is that the consequences of a formal default would be worse than another episode of “extend and pretend.” The markets seem comfortable ignoring reality and settling for the pretense that Greece or somebody will someday make good on the growing pile of debt.

Greece, however, is far from the only debt pretender. A recently published report from the highly respected McKinsey Global Institute highlighted the bloated, unsustainable levels of debt that have been amassed globally, and the huge risks they present when interest rates eventually begin to rise. The report made the point that rather than deleveraging since the 2007-08 financial crisis, the world has added about 40% to the debt levels that precipitated that crisis. The current amount is a staggering $200 trillion, a level that, according to McKinsey, “poses new risks to financial stability and may undermine global economic growth.” The report contends that “government debt is unsustainably high in some countries.” Pointing to China specifically, McKinsey voices concern that “half of all loans are linked, directly or indirectly, to China’s overheated real-estate market; unregulated shadow banking accounts for nearly half of new lending; and the debt of many local governments is probably unsustainable.”

While all U.S. Government promises will certainly never be fulfilled in dollars at today’s value, most of those commitments lie well into the future, and the federal government has the privilege of printing more of its own currency. Minus those two advantages, Puerto Rico has recently had to admit that it is close to default on some of its $72 billion of debt. “The debt is not payable,” according to Puerto Rico’s governor. Many U.S. investors hold Puerto Rico bonds–directly or indirectly–because of the island’s special tax exemption. According to Morningstar, 80% of Puerto Rican debt is in muni-bond funds, despite five years of recession and the island’s low junk bond ratings. This is yet another example of the danger of ignoring risk and reaching for yield. We’ll soon see who gets paid and how much.

Similarly, holders of Illinois and New Jersey debt may have reason to fear being less than fully repaid. Will the U.S. Government cover unpaid liabilities of its states, as Europe has been doing for Greece? Probably, but it’s a gamble risk-averse investors should be unwilling to take.

With debt levels growing around the world and governments almost universally responding by expanding the money supply, we continue to build a small gold hedge. While deflation appears to be a more immediate concern in most countries than inflation, the dramatic increase in money supply lays the foundation for a potential inflationary spiral. So long as major central bankers continue to “print money”, we will gradually expand that hedge if we can do it at progressively lower gold prices.

Abandoning all caution has been the path to maximum investment success for more than the past six years. By driving interest rates to the zero bound, the Federal Reserve and other major central banks have done their utmost to eliminate risk-free return and to push investors to take risk. Until recently, accepting such risk has been amply rewarded. Stocks and bonds have risen, and various currency plays have worked as central banks have anticipated.

Suddenly, earlier this year, the Swiss National Bank reneged on its stated policy, in place for 3 ½ years, to hold a 1.2 peg between the franc and the euro. Market pressures overcame the central bank’s policy pledge. The value of the currencies diverged by 38% in just a few minutes. There was no opportunity to escape. Because of heavy leverage, some investors and a few firms were wiped out. Now comes China.

Over the past year, the Chinese equity market has been the quintessential example of a government-influenced market. To offset the negative psychological effect of an economy growing at its slowest annual rate in a quarter of a century, the government did its best to stimulate the equity market. It cut interest rates several times, injected funds into the banking system and cheered investors. The process worked as market prices soared. Even after prices had almost doubled in less than a year, the People’s Daily, the Communist Party’s mouthpiece, declared that “4,000 (points on the Shanghai Composite index) was just the beginning.” As the belief grew that the government had investors’ backs (shades of the Greenspan, Bernanke and Yellen put?), new investors flocked to open brokerage accounts. Over 40 million new accounts were opened in the year ending in May. At the peak, accounts were being added at a rate of over 3 million per week. Deutsche Bank marveled at the stunning lack of sophistication of these new investors. Two-thirds had left school before they turned 15, with a third leaving at age 12 or younger, and 6% illiterate. Because the market looked to be a guaranteed moneymaker, the idea of borrowing to make even larger investments seemed to be a no-brainer. And borrow they did, committing about one-third of a trillion dollars to the major equity markets. Such margin lending rose to as high as 20% of the total market capitalization. By comparison, it is about 2 ½% in the U.S. That lack of sophistication didn’t prevent Chinese speculators from making money, however. Prices ultimately rose about 150% to the June peak, at which point the average price/earnings ratio was about 57. Everybody was making money until it suddenly stopped.

In about three and a half weeks, one-third of the value of Chinese stocks disappeared, as prices plummeted day after day. Margin calls led to more selling. Many investors were in disbelief. Where was government support?

Destroying any pretense of a reformed Chinese free market, the government stepped in with both feet. Once again, authorities have cut interest rates and reserve requirements. They suspended initial public offerings, which could divert potential investments. Directors, senior management or any owner of more than 5% of a company’s stock are not allowed to sell for the next six months. Institutional holders are to refrain from selling until the Shanghai Composite rises above 4500. Companies have been ordered to submit plans to stabilize their stock prices with such measures as share repurchases or employee shareholder plans. Authorities are planning to take action against “hostile short-sellers.” Chinese police and stock regulators are also announcing crackdowns on illegal stock and futures trading, spreading rumors, insider trading and stock manipulation. In case those measures should prove insufficient, over $200 billion is being made available to state-owned brokerages to buy shares directly. Bloomberg just reported that China Securities Finance has an additional $483 billion available to support the stock market. Sounds like a free market to me. Imagine how eager investors will be to put new money into a market in which they might be forbidden to sell. Wow!

This direct monetary intervention is reminiscent of U.S. bankers banding together to buy stocks to stem the 1929 market crash. In our county that worked briefly, but market forces ultimately overwhelmed artificial intervention, and prices continued their decline in the biggest stock market collapse in U.S. history. In the current environment of immense government central control–even in ostensibly free markets–it will be fascinating to see how long such intervention will outweigh fundamental market forces.

Despite seven years of historic government stimulus, fundamental conditions continue to deteriorate around most of the world. The International Monetary Fund has recently lowered its global growth estimate for 2015 to the weakest rate since the financial crisis. The White House budget office dropped its U.S. outlook to 2% from 3%. And the Fed’s Federal Open Market Committee began dropping its 2015 GDP projection in early-2013 to 3.3%. In subsequent meetings, it progressively dropped its estimate to 3.2%, 3.1%, 2.8%, 2.5% and a month ago to 1.9%. Along with declining GDP projections, earnings growth estimates continue to slow, yet equity prices and price/earnings ratios have expanded, fueled by newly printed money. Expectations of improving economic conditions have been wrong for the past several years, yet faith in ongoing central bank support has held stock prices near all-time highs.

Warnings have begun to surface from respected sources. The Bank for International Settlements, the central bank for the world’s central banks, expressed concern that “an unprecedented period of ultra-low interest rates masks deep weaknesses in the global economy.” Former Fed governor Larry Lindsey warned that U.S. debt and capital market distortions keep building. “Eventually, the Fed will find itself way behind the curve. And that is going to be a very disturbing event for the markets and the economy.”

Government support has so far overcome deteriorating fundamentals, and a great many investors have come to view those issuing warnings as “the boy who cried wolf.” No matter how long prices defy weaker fundamentals, however, history argues convincingly that fundamentals will ultimately prevail. One of the unfortunate lessons of history is that the longer distortions last, the greater the number of investors who come to believe this time is different and who lose patience with time-tested valuation principles. Having had a largely negative view of debt and valuation levels since the end of the 1990s, we have great sympathy for those who have been unwilling to ignore the risks present throughout the first decade and a half of this century. Notwithstanding the past six years having marked the longest period of dissonance between price and fundamentals, we have been greatly rewarded throughout our history for remaining patient and correctly anticipating a reversion to long-term means. Our client portfolios came through the most recent two bear markets with flying colors. In the 2000 to 2002 50% stock market decline, our clients saw their portfolios grow. During the horrendous 37% S&P 500 decline in 2008, we couldn’t quite put up positive numbers, but our average portfolio declined a mere fraction of one percent.

Many years earlier, we had serious concerns about the Japanese stock market that had been screaming upward for years, far outdistancing any relationship with underlying fundamentals. While we professed no significant expertise regarding the Japanese market, a profound appreciation for the dangers of severe overvaluation led us in 1987 to caution investors to avoid exposure to Japanese stocks. Stock prices continued to rise. We repeated our caution at our 1988 client conference with the market continuing its persistent ascent. In 1989 we urged readers and listeners to trust history, rather than embrace “It’s different this time” thinking. While prices continued up through the remainder of the year, the bubble burst on New Year’s Eve. The market closed 1989 at roughly 39,000. From there prices plummeted, hitting 14,000 in 1992 and ultimately bottoming at about 7,000 in 2009, taking prices back to the levels of the early 1980s. There’s an old saying, “You can’t fool Mother Nature.” Similarly, you can’t indefinitely defy fundamental norms that have prevailed for a century or longer, no matter how long excesses prevail.

Today’s debt excesses around the world are the most severe in history. In this country, valuations exceed those throughout history but for the dot.com bubble at the turn of the century, from which point stock prices were more than 50% lower nine years later. Over the decades, there has been a very clear negative relationship between valuations at the time stocks are purchased and subsequent returns. With valuations currently stretched near all-time highs, stocks are swimming against the historic tides in the years ahead. And the experiences this year with the Swiss National Bank and the Chinese stock market demonstrate how quickly such losses can unfold.

Aldous Huxley famously observed: “Facts do not cease to exist because they are ignored.” The facts are that debt and equity valuations remain at dangerous extremes, having been ignored for years. Instead, trust has been placed in government’s willingness and ability to keep stock prices elevated. So far over this market cycle, that trust has been well placed. Investors are still faced, however, with the dilemma of whether to bet on a continuing divergence between equity prices and underlying fundamentals or to expect market prices to revert toward historic fundamental norms. For all but relatively short-term traders, we strongly suggest the latter alternative. It is important to recognize that, for virtually all investors, they don’t get to keep what they have at market highs but rather what still remains at market lows. And given how overextended this market is after seven years of powerful government support, we fully expect there will be opportunities to get more aggressive in equities in the quarters and years ahead at lower prices–possibly substantially lower.


Fear At The Fed

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I strongly suspect that Janet Yellen is afraid to pull the trigger on the first rate hike.  Having passed on earlier opportunities to dismantle her debtor-friendly Zero Interest Rate Policy (ZIRP), she has painted herself deeper and deeper into a corner.  Raising short rates will likely lead to rate rises all along the yield curve, adding increasingly to debt service burdens for government, business and households.  And declining bond prices may do serious damage to the Fed’s bloated balance sheet.

IMF Managing Director Christine Lagarde upped the ante recently when she counseled the Fed to defer a first rate increase until at least 2016.  Yellen and her cohorts on the Fed have already demonstrated serious timidity in the face of any negative stock market reactions. Should stock prices fall precipitously after a Fed tightening action, Yellen would rightly be blamed for having facilitated the trauma with a multi-year destructive monetary experiment.  Additionally, her professional credentials would be seriously stained because the IMF would likely be perceived as more foresighted than the Fed.

The Fed’s ZIRP has been misguided from the beginning, bailing out seriously overextended debtors on the backs of savers and taxpayers in general.  Moral hazard runs rampant, and lightweight reforms leave few barriers to a repetition of the past decade’s debt-fueled problems.

It would be no surprise if the Fed were planning to implement a stock market support plan in conjunction with an initial rate rise, whenever that might occur, to erase evidence of a cause and effect relationship.  In fact, I believe the Fed has been actively supporting stock prices at strategic times over the past several years, either directly or–more likely–through surrogates, in pursuit of its goal of increasing the wealth effect.

When the history is ultimately written about the Fed’s misguided effort at economic central planning, there will be plenty of blame to go around.  One unfortunate consequence will be the distortion for years–even decades–of the performance of formerly free stock and bond markets.  I doubt that Janet Yellen fully appreciates the magnitude of the consequences of her past and pending actions; but I believe she hesitates to take the next necessary step because she fears the potentially significant unknown.  Unfortunately, the longer she waits, the more dangerous the ultimate consequences become.


Is “Extend and Pretend” the Only Answer?

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“China orders banks to keep lending to insolvent provincial projects.” That front page headline in the May 16-17 weekend edition of The Financial Times shines a spotlight on one of history’s most perilous financial conditions. Since the end of the 1990’s, we have been warning of the extreme danger posed by excessive debt. In this century’s first decade, the world suffered two painful recessions, and domestic stock markets twice declined by 50% or more.

According to former Fed Chairman Ben Bernanke and former Treasury Secretary Hank Paulson, the United States was headed into a depression following the Lehman Brothers bankruptcy, necessitating what has become the most massive financial rescue in history. In this country alone, the Federal Reserve has created about $3.5 trillion since 2008, in the absurd, but ironic, attempt to solve a problem precipitated by excessive debt by creating even more egregious levels of new debt. That effort has succeeded in levitating stock, bond and home prices, although the broader economy has made only meager progress. With no dire consequences so far attending the “money for nothing” approach, the central banks of Japan, Europe and China have decided to follow the U.S.’s lead in supplying unprecedented levels of monetary stimulus.

One need only reread the headline at the top of the page to view the logical extension of this misguided policy. The U.S. banking system has become expert at the “extend and pretend” approach to excessively indebted borrowers. The European Central Bank continues its ongoing charade with Greece over debts that will never ultimately be repaid. Now China has reached the point at which numerous local government projects can’t meet principal or interest deadlines. Again, the solution around the world is not to stop borrowing but rather to borrow more, ultimately creating a bigger problem but deferring the day of reckoning.

In February, the McKinsey Global Institute highlighted the dangers of the expanding world debt burden. Their report warns that the $200 trillion global debt, much of it recently accumulated, “poses new risks to financial stability and may undermine global economic growth.” Former Fed governor and close personal friend Martha Seger stopped by our offices recently, where she was once Mission’s first Vice Chairman. Martha confessed her concern that someday she’ll awake in the middle of the night, turn on financial TV and learn that the over-indebted world financial system has unraveled.

None of that seems to bother equity investors, who have bid prices in most of the world close to all-time highs. There is a remarkable complacency that central bankers have the situation under control. History disagrees. As Carmen Reinhart and Kenneth Rogoff point out in copious detail in This Time Is Different, debt levels even less onerous than today’s have been severely punished with regularity over many centuries. With central bankers building the debt edifice ever taller, investors are betting either that they’ll be able to time a prudent exit or that this time is truly different.


Do Regulators Even Care About Honest Markets?

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Since July of last year, the Dow Jones Industrial Average has experienced 16 price moves ranging from 600 to 2000 points, eight up and eight down. Twelve of those moves have taken place in the last five months, each lasting an average of just two weeks. This is highly abnormal market action, clearly demonstrating a lack of investor conviction. In fact, volatility has become even more intense since mid-April. The Dow has experienced six moves ranging from 350 to 450 points in just 17 market days, each move completed on average in less than three market days. Some rallies and declines have lasted as little as a day or two.

In recent months, volatile market moves have typically come in response to domestic or international news, especially related to our Federal Reserve or other central banks. Now, apparently, markets have decided to move many hundreds of Dow points in a day or two without the stimulus of news stories. This, too, shall pass, but not without leaving a trail of serious investors longing for regulators to crack down on high frequency traders and others gaming the system for ill-gotten short-term trading profits. Reform on Wall Street is desperately needed.



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March marked the sixth anniversary of the Fed–sponsored stock market rally that, along with the housing recovery, has resuscitated the balance sheets of the wealthiest segment of the American population. Having benefited from mountains of essentially free money and generous accounting forbearance, the nation’s major banks were rescued from insolvency. The Fed’s intended “wealth effect” has served the wealthy well. Unfortunately, it has done relatively little for the vast majority of Americans, who continue to struggle in the slowest economic recovery in three-quarters of a century. As the latest iteration of money printing winds down, the dominant question is whether or not stock and bond markets can continue to progress without the benefit of unprecedented Fed stimulus.

Both domestically and internationally, central bank largesse has overcome a litany of geopolitical and economic concerns including: Greek solvency and Eurozone membership, Russia/Ukraine and sanctions, Israel/Gaza, ISIL, Ebola, the end of Quantitative Easing and the prospect of rising rates, IMF warnings of another Eurozone recession, Japan slowing, dramatically slowing growth in China, growing evidence of global deflation and the emergence of currency wars. Clearly, the world’s investors retain confidence that central bankers remain willing and able to keep stock and bond prices elevated despite this lengthy list of concerns.

Failure to accept major risks has seriously reduced portfolio performance for the past six years. On the other hand, properly identifying major risks preserved portfolio values over the nine immediately prior years. Over that nine-year period following the dot.com peak in 2000, Mission’s risk-adverse approach produced a 5% per year return for clients with the S&P 500 declining by 6% per year. That 11% average annual advantage saved clients from one of the most dangerous periods in U.S. market history. Evidence strongly indicates that at least one more major stock decline is probable before the long cycle that began in 2000 ends. We expect that Mission’s appreciation of today’s unique risks will serve clients well as this decade further unfolds.

Central bank policies have driven risk-free rates to zero, which has eliminated return for those unable or unwilling to accept investment risk. The Fed has held short rates at the zero bound for more than six years, penalizing savers to rescue overextended debtors.

Those willing to invest in the normally low-risk Treasury bond market may, in fact, be assuming far more risk than they perceive. Longer fixed income yields in the U.S. and around the world are at or near historic lows. At current yield levels, an increase in rates of less than one-half of one percent would turn the total return on a 10-year U.S. Treasury negative for a year. A significant jump in rates would decimate a fixed income portfolio. At these yield levels, the penalty for being wrong in fixed income securities is far greater than the reward for being right.

Fearful of danger to the world’s financial system, investors have committed $4.2 trillion to securities providing no yield or a negative yield. In a quest for safety, many are paying for the privilege of loaning money to several seemingly safe countries for periods even up to ten years. This is the quintessential example of investors concentrating on the return of their money rather than the return on their money. There is no comparable example in world history, and it highlights how far from normal are today’s financial conditions.

To implement their stimulus programs, our Federal Reserve and other major central banks have effectively “printed money.” So far, those programs have successfully supported both stock and bond markets, but at the expense of creating historic, formerly inconceivable debt burdens. By horrific example, in its first 95 years the Fed built a balance sheet of just over $800 billion. In just over six years since, it has multiplied that balance sheet by more than 400% to about $4.5 trillion. Over centuries, countries that have created debt burdens even less onerous than today’s relative to the size of their economies have suffered economically and in their securities markets for a decade or more.

Compounding the problem, stocks today are more overvalued than at any point in U.S. history but for the dot.com mania at the turn of the century, from which point stock portfolios were more than 50% lower nine years later.

For the third time in the last 20 years, stocks have risen steadily to levels of overvaluation unprecedented before this period. In all three instances, investors willing to ignore fundamental risks, ride the momentum train and believe in central bank guidance substantially outperformed investors who relied on fundamentals and historical precedent. After each of the first two instances, however, despite aggressive Fed support, stock prices plummeted by more than 50%. In fact, the stock market decline from 2007 to 2009 took prices back their 1996 levels, eliminating 13 years of price progress. In the current instance, the Fed has played an even more aggressive role, and the price advance could continue if investors retain their faith in central bank support and control. Confidence in central bankers may waver, however, as investors reflect further on central bank activities in the early months of 2015.

In January, the highly regarded Swiss National Bank, with no warning, abandoned its peg between the franc and the euro, which it had held for 3 ½ years. This so shocked the foreign exchange market that the relative value of the two currencies diverged by 38% in minutes, a move that would normally take years. Soon after, the Austrian central bank indicated that it would not make good on the debts of the “bad bank” set up to house the weak loans of a leading Austrian bank rescued in the financial crisis. And most recently, the Brazilian central bank abandoned its expressed intent to support the Brazilian real. Within three months, three central banks were forced by overwhelming market action to abandon clear commitments, with disastrous consequences to investors who counted on those central bank promises. If investors begin to doubt more broadly the ability of central bankers to support markets, there may prove to be an air pocket beneath prices. As seen in the case of the Swiss National Bank, such consequences can unfold with lightning speed.

As we head into the year’s second quarter, investors are faced with the dilemma of whether to align assets with historic probabilities or to cast their lot with central bankers. Central bankers have been winning for the past six years, but with experimental policies that have been penalized throughout history. As has been the case twice so far in the 21st century, capital preservation may soon again prove critical in the period ahead. Mission’s great success through the last two major market declines was the reward for our accurate anticipation of the pending problems.

The final page of this analysis summarizes our concerns about threats to the world economy and markets. The cartoon originally appeared in The Financial Times and we have provided annotation and statistics.



Free Markets: May They Rest In Peace

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For more than two centuries, Americans have pointed with great pride to this country as a bastion of democratic free markets. Many have looked with antipathy at European economies tinged with socialism and with disdain at the centrally planned economies of communist countries. Whether out of convenience or desperation, we have recently come to welcome central planning.

In pursuit of its dual mandate of a stable currency and maximum employment, the Fed has apparently decided that it simply cannot allow even a garden-variety recession–possibly ever. With the Fed balance sheet and total domestic debt at levels inconceivable just a few years ago, it is hard to imagine a scenario in which a recession would not lead to dangerous debt defaults.

This week’s Federal Open Market Committee meeting produced a statement designed to be all things to all people. Language from earlier statements was eliminated, and Fed Chair Janet Yellen stressed that future action on interest rates would be “data dependent.” Those words, however, have now become meaningless, because prior data hurdles that were to be triggers for interest rate rises have all been abandoned when reached. This Fed has clearly painted itself into a corner. They hate to leave interest rates at the zero bound, because they have no ammunition left to counter future problems. At the same time, they are deathly afraid to raise rates because the economy remains in its weakest recovery since World War II. Celebrating the continuing medicine of easy money rather than fearing the underlying disease necessitating it, Wall Street partied on, the Dow Jones Industrial Average rising 400 points intraday from just before the FOMC announcement to just after.

Because the Fed continues to accede to Wall Street’s wishes, there are few complaints from the financial community about the erosion of free market principles and the progressive evolution toward central planning. Should the Fed’s experimental monetary policies fail to keep stock prices buoyant, however, stones will inevitably be cast. There will logically be questions asked about how the country could have allowed its economy to be controlled by a group of academics and regulators, virtually unsullied by any real world business experience.

This week’s violent anti-European Central Bank protests in Frankfurt, Germany bring to mind other potential problems. Our central bank has been an integral force in creating an environment in which the economically privileged have prospered mightily from Fed-sponsored stock and bond market progress, while little benefit has filtered down to the broader economy. Should that disparity continue or worsen, it’s not unrealistic to imagine large protests born out of economic frustration in this country as well.

I have long opposed the Fed’s zero interest rate policy and the massive expansion of its balance sheet. With an admitted objective of pushing stock prices higher for a positive wealth effect, the Fed, I suspect, has also succumbed to the temptation to support stock prices with strategic buying, almost certainly through surrogates. Since the market bottom in 2009, buying has mysteriously appeared at points from which price breakdowns would normally have proceeded in decades past. Should the Fed eventually be found to have surreptitiously supported stocks as part of their central planning and control, I hope they will be properly punished. And if Main Street protestors become sufficiently incensed, they may seek to identify those who unjustly rewarded Wall Street insiders.

As one firmly committed to non-violence, I regret seeing public protest turn violent. However, I would welcome comprehensive investigations and appropriate prosecutions of anyone who distorted free and honest securities markets–up to and including Fed officials. If individuals can be prosecuted for distorting market prices, so should those wielding far greater power. And if regulators really wanted to reestablish free markets, they could and should go after large trading desks that paint the tape in one direction to create an environment in which they can establish their intended larger position for a move in the opposite direction. Distorted markets will continue until the clamor is loud enough to make them free and honest. A welcome first step would be for the Fed to abandon its direct interference and to back away from its artificial experimental monetary policy.