Quarterly Commentary 1st Quarter 2016

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The historic volatility evident since mid-2014 was even more extreme in this year’s first quarter. The dramatic market decline in last year’s third quarter was followed by an equally dramatic fourth quarter rally.  An almost identical decline and rally were compressed into the first three months of 2016.  Following the worst start to a year in U.S. stock market history, Fed Chair Janet Yellen gave stock prices at least a temporary boost when she surprised markets by not hiking interest rates at the Fed’s January meeting.  Her dovish tone gave investors hope that the Fed would still be supportive in the months ahead.  The brief late-January rally quickly faded, however, and prices retreated to a new low, breaking a potentially important support area on February 11.  Conspiracy theorists were given ammunition when rumors surfaced within ten minutes of the breakdown that the OPEC countries were preparing to meet to discuss cutting back oil production.  Oil prices immediately rallied, and stock prices followed.  Prices rallied into the end of the quarter, recovering all of the January – February decline, closing with a slight gain.

Late in the quarter, further dovish comments by Fed Chair Yellen as well as additional stimulative central bank actions in Europe and Asia were designed to boost economies and support stock and bond prices. They succeeded on the bond side, but stocks have shown far less enthusiasm in recent weeks in the US and throughout most of the world.  Despite extremely aggressive stimulus, Japan is a prime example of central bank ineffectiveness, with the Nikkei down about 11% year-to-date as this is written.  Despite an aggressive negative interest rate policy by the European Central Bank, European stock indexes declined an average7.7% in the first quarter.  Many opponents of central bankers’ experimental monetary policies are now arguing that such stimulative strategies have reached the limits of their effectiveness and may now, in fact, have become counterproductive.

Former Fed Chairman Alan Greenspan made a remarkable confession last week, saying: “Monetary policy is largely economic forecasting. And our ability to forecast is significantly limited.”  Bill King, who writes The King Report, had a classic response: “Nowwww he tells us that the Fed is Mr. Magoo when forecasting!”  I have written two articles in the past several weeks pointing out the absolute absurdity of granting the Fed, comprised entirely of academics and regulators, the power to effectively orchestrate the US economy.  (See http://www.missiontrust.com/blog/2016/03/reduce-the-feds-mandate/ and http://www.missiontrust.com/blog/2016/03/wheres-the-outrage/.) Also over the past several weeks the Organisation for Economic Co-operation and Development, the International Monetary Fund and the World Trade Organization all continued their now longstanding pattern of dropping earlier estimates of world GDP growth.  Their average estimate is now about 3% for 2016, essentially a recessionary level in much of the world.  In this country, the Atlanta Fed’s most recent estimate of first quarter US GDP growth is barely above zero, having been sharply reduced in recent weeks.  Reflecting slowing global growth, global corporate profits have been declining since 2011(according to Bloomberg) and are today well below their 2007 peak levels.  In the US, “as reported” profits for the S&P 500 are at 2012’s level, although stock prices have risen substantially over that same timespan, thanks to central bank support.

Wall Street remains silent about an imminent recession either domestically or globally. It is noteworthy, however, that over the past 45 years, Wall Street has forecast none of the past seven US recessions.  Wall Street isn’t likely to predict recessions, because it’s just not good for business.  One very telling statistic, however, that argues strongly for a global slowdown is the pronounced decline in global exports.  Exports are slowing because global demand has dried up.  Over the past quarter of a century, export growth has declined year-over-year only during recessions.

The unprecedented global central bank actions have so distorted normalcy that world interest rates in this cycle have descended to lows seen only once before, in the late-1500s. Short-term rates in Europe and Japan have been pushed into negative territory.  In this country, they are barely positive.  Thirteen European countries’ fixed income securities have negative yields to maturities out beyond a year, with Germany and the Netherlands negative out to eight years and Switzerland out to 15.  Owners of more than $7 trillion worth of securities have decided that paying those governments to hold their money is more attractive than all other alternatives– a remarkable distortion of everything we know about investments.  Some market commentators refer to today’s fixed income securities as “return-free risk.”  In the US, with the 10-Year Treasury Note at 1.8% as I write, it would take a very small increase in yield to produce a negative total return for a year or more.  While yields could always go lower, the risk/reward equation at these yields is extremely unattractive.

The credit quality of non-government loans is increasingly being called into question. According to The Wall Street Journal, energy company loans in danger of default are expected to top 50% this year at several major banks.  And J.D. Power estimates that the delinquency rate on subprime auto loans will hit 17.5% this year, approaching the 19.6% peak reached just before the financial crisis in 2007.  Bonds are hardly an attractive safe haven in the current environment.

Because of central bank actions, today’s debt excesses around the world are the most severe in history. In this country, equity valuations are at their historical highs 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 will be swimming against the historic tides in the years ahead.

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 virtually no investors 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 become more aggressive in equities in the quarters and years ahead at lower prices—possibly substantially lower.





Reduce the Fed’s Mandate

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Why do we refuse to call absurdity absurd? Meeting after meeting, news conference after news conference, it becomes increasingly apparent that we have conferred on the Fed Chair the role of economic and securities market orchestrator.  Markets typically tip-toe into Fed announcements only to explode into paroxysms of volume as algos move prices violently – often in alternating directions – in the initial moments following each announcement.  The ultimate market direction is dictated by the Fed’s dovish or hawkish tone relative to the market’s expectation leading into the meeting.  Imagine how much more orderly and intelligent it would be to have a rule-based decision-making formula that investors could monitor as new data unfold.

Because the Fed’s Congressionally-conferred mandate extends beyond currency stabilization to include maximizing employment, Fed members now scan the world for economic, monetary and securities market data, all of which now seem relevant in their decision-making process. In this week’s speech to the Economic Club of New York, Fed Chair Yellen relied heavily on global uncertainties as rationale for large doses of caution in considering future interest rate increases.

The Fed’s long history is replete with flawed judgments and policy moves. For years, forecasts of the current Fed have been far off the mark on economic growth and interest rates.  Off past performance, why would we expect this group of academics and regulators to have greater insight into domestic and world economic prospects than the broad universe of business people and investors?  It flies in the face of all logic to allow Chair Yellen and any small band of academics and regulators to wield the power that the Fed holds over domestic and world economies and markets.  Congress must take that giant club out of the Fed’s hands by reducing its mandate.

Since the general public and its representatives in Congress don’t understand this highly complex policy-making process, they vest power in a perceived wise person. They fail to recognize that any Fed Chair is less like Solomon and more like the wizard behind the curtain.

Either the Fed doesn’t appreciate the full effects of its decisions and actions, or it is simply satisfied with having rewarded Wall Street, though not Main Street. Whatever benefits accrued from history’s most generous monetary experiment have come at the expense of a generation of elderly retired who have had to choose between spending down life savings or risking those assets in historically overvalued securities.  The final chapter on how that unfortunate generation’s retirement will play out has almost certainly not been written.

Far greater pain likely lies ahead, perhaps to be borne primarily by generations which have had no role in approving the Fed’s decisions. Monumental debt loads, like today’s, have throughout history led to greatly inhibited economic growth for extended spans of years.  And many of history’s greatest securities market declines have accompanied such periods of economic lethargy.

Our unwillingness to confront the absurdity of allowing a few academics and regulators to orchestrate domestic and world economies is allowing the pain to continue for the elderly retired and to increase for future generations that will almost certainly inherit unprecedented debt burdens. We are allowing Janet Yellen to dig us deeper into a destructive dungeon of debt.  Congress and the general citizenry must make their voices heard in opposition.

Congress should immediately set about reducing the Fed’s current dual mandate to a single mandate of stabilizing the currency. Ideally, within that mandate, Fed decision-making would be formally rule-based rather than, as today, with each Fed voting member formulating his or her own non-binding and often fluctuating rules.

Let’s recognize the absurdity of the current arrangement in which any Fed Chair, essentially without veto, plays the largest single role in orchestrating the world economy.

Thomas J. Feeney is Managing Director and Chief Investment Officer of Mission Management & Trust Co., Tucson, Arizona.

For a related analysis of the inappropriate scope of Fed power, please see Tom’s immediately prior blog post “Where’s the Outrage?”.


Where’s The Outrage?

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In 1976’s Network, Howard Beale famously yelled: “I’m mad as hell, and I’m not going to take this anymore!”

The rise of Donald Trump and Bernie Sanders testifies powerfully to the anger felt by large segments of the American population. Tragically, that anger does not extend to the ascension of the Federal Reserve as orchestrator of the U.S. economy, despite no public approval of such a “third mandate.”

The Fed’s assumption of its expanded role displays a remarkable lack of humility given the long and checkered track record of that body’s errors of omission and commission. In recent months, regional Fed presidents Charles Evans and James Bullard have highlighted seriously flawed Fed forecasts.  In almost any other context, such frequent failings would lead affected constituencies to reduce a body’s decision-making authority.  Remarkably, just the opposite has occurred over the past several years with respect to the Fed and central bankers around the world.

To solve problems brought on by excessive debt, central bankers have conducted the greatest monetary experiment in history. They have attempted and continue to attempt to solve those problems with unprecedented amounts of new debt.  While it sounds simplistic, it is a very apt analogy to compare that solution to trying to cure a hangover with more “hair of the dog.”  It flies in the face of all logic.

Likely because monetary economics is a highly complex study, the general public and their representatives in Congress have little understanding even of its broad strokes, much less its intricacies. As a result, there has been only mild opposition by those most impacted today – a generation of retirees who have so far been able to earn no risk-free return for half an expected retirement span.  And, of course, there has been no objection from future generations who will inherit the monumental debt levels we have generated to paper over problems of our own creation.  If we actually understood the problem, who among us would deliberately improve our own wellbeing and demand that our children, grandchildren, even great grandchildren pay the bill?  So we silently allow central bankers to conduct what they themselves characterize as experimental monetary policies.  But this is not a small experiment.  Should the world’s monumental debt burdens unravel in an uncontrolled fashion, central bankers will be seen to have bet the world’s economy and the wellbeing of generations on little tested and certainly unproven policies.

Who are these people to whom we have defaulted such power? They are, virtually without exception, academics and regulators.  By all appearances, each is intelligent, well-intentioned and respected in his or her field.  But they are academics and regulators, unsullied by any practical experience in running even a single significant business, much less the world’s largest economy.  Regardless of their academic credentials, few, if any, would qualify for senior management roles in major domestic or international corporations.  Individual Fed members could certainly be blended with experienced business people to comprise capable boards.  Shareholders of any large corporation, however, would have every reason to be appalled by a board restricted solely to Federal Reserve Board members.  Where’s the real world experience, the appreciation of the profit and loss consequences of regular decision making?  Where’s the breadth of experience required to appreciate the effects of a company’s actions on both its customers and on the broader citizenry its actions affect?  Their academic and regulatory pursuits leave them remarkably sheltered from a real world appreciation of the breadth of the effects they create.  Yet we have allowed them to assume far more extensive power than exists in even the world’s most prestigious corporate or non-profit boards.  It can only be from ignorance or from a deplorable lack of concern that we as a citizenry have permitted central bankers to acquire such a powerful role in picking society’s winners and losers.  The mandate they have assumed is entirely too large.

In fact, the dual mandate given the Fed by Congress is responsible for the current overreach. Virtually anything unfolding in the domestic or international economies arguably affects domestic employment.  Consequently, the mandate to maximize employment effectively charges the Fed with monitoring and responding to massive numbers of potentially critical variables.  Recent quotes from several Fed members make it clear that monitoring and responding to the world’s financial markets falls well within the Fed’s perceived purview.

Wall Street is nothing if not ingenious and capable of creating its preferred market picture. In an era of rampant spoofing and bluffing, it’s hardly a stretch to expect self-interested, financial megacorps to paint the picture they want the Fed to perceive leading up to important central bank decisions.  When experienced investment pros misread market signals with some regularity, what are the odds that a group of academics and regulators are going to read them accurately?  At best, it’s an exercise fraught with hazard.  We’re asking Fed members to make decisions far beyond their areas of experience and competence.

Allowing the Fed to wield the power it now has is also creating massive stock market distortions. So much market reaction flows from Fed proclamations that analysts spend an inordinate amount of time attempting to interpret the slightest variations in language or attitude of Fed voting members.  For many strategists this has become even more important than the analysis of underlying fundamental conditions.  That dynamic becomes blatantly obvious whenever we see markets surge on an announcement of disappointing economic news, as the prospect for more stimulus increases–a clear distortion of traditional free markets.

In recent years, Fed Chairs Bernanke and Yellen have gone to great lengths to promote the idea of Fed transparency. At the same time, we are subjected to Fed members repeatedly performing like traditional two-handed economists with the apparent intent of keeping upcoming decisions unclear.  A rule-based system to determine monetary policy would certainly be preferable to the frequently flawed Chair-led decisions heavily influenced by personal perceptions and biases.  The arguments against relying on a rule-based system typically involve pointing out how such a system would have led to an arguably unacceptable monetary position in one or more instances– as if the existing system itself has not placed the country in an extremely dangerous position.  If a rule-based system appears imperfect, improve the rules.  Clearly, each voting member of the Fed relies on his or her own set of rules in making monetary decisions.  They are not, however, publicly known, so we are left to speculate on how voters, especially the Chair, will make their decisions.  The securities markets would be far better served if analysts knew the rules on which monetary decisions would be based.  Strategists could abandon the psychological analysis of voting members and their probable decision-making patterns and return to an analysis of how the data align.

If we are not to turn to a formularized rule-based monetary system, we need to expand the influence of the many constituencies affected by monetary decisions. Obviously, any decision-maker would need a strong background in monetary economics.   Additionally, it’s only fair that they represent the many segments of society that will be impacted by those decisions: large and small businesses, employees, elderly retired, investors, non-profits.  The current Fed has much too broad a mandate and is woefully unqualified to pursue the many objectives on its plate.

Notwithstanding the best of intentions, the Fed in recent years has bet America’s future on a flawed (now failed) experimental monetary policy. Until we speak up loudly, we remain at risk of their experiments further decimating the future economic prospects of our nation and coming generations.

Difficult and confusing as this subject is, Congress needs to step up now and rein in Fed power. It’s important for all of us to recognize that this king wears no clothes.


Markets At A Crossroad

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In a September 8, 2015 blog, I indicated my strong belief that a major worldwide bear market had begun.  At the recent February 11 lows, the S&P 500 was about 15% below its May and July 2015 highs.  Most foreign markets had suffered more significant declines.  The dangerous conditions outlined in that earlier blog remain major intermediate and long-term concerns.

One of the weakest beginnings to a new year ever turned short-term investor sentiment very negative.  At extremes, sentiment measures can be excellent contrary indicators.  In a bear market, sentiment can remain pessimistic far longer than during bull market corrections, but significant pessimism often marks at least a short-term market bottom.  Notwithstanding numerous ongoing negative conditions, we must now remain alert to see whether stock prices need to rise appreciably to relieve excess negative sentiment.  A telling point is likely to be whether stock prices can remain above their February 11 lows (about 1810 on the S&P 500 and 15,500 on the Dow Jones Industrials).  Remaining above those levels could rekindle more bullish feelings for a while, even leading to a test of former highs.  On the other hand, a break below the February 11 lows could unleash torrents of selling as investors come to believe that central bank rescue efforts have become ineffective.  Either way, the year ahead is likely to be extremely volatile with the potential for a market, economic, political or military event decimating longer-term investor confidence and leading to a persistent, destructive market decline.


Quarterly Commentary 4th Quarter 2015

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2015 disappointed almost all investors. At the start of the year, there was unanimity among strategists from all major investment firms that the Fed-supported stock market rally would continue. It did not, as the average U.S. stock declined and at year-end was 24% below its 52-week high. The strength in a small number of institutional favorites kept the major equity indexes from similar declines. In fact, while the total return on the Dow Jones Industrials was negative, a 2% dividend return on the S&P 500 lifted that index out of the negative column to a total return just above 1%. Risk-free cash equivalents continued to provide no return, and bonds were mixed with the broadly followed Barclays Aggregate Bond Index registering a total return of 0.55%. At the lower end of the quality spectrum, high yield bonds lost 4% for the year.

Such nondescript returns masked an unprecedented level of volatility. Throughout the year, there were repeated violent market swings with no lasting trends developing. Hedge funds had a particularly difficult time – with some of the most successful over the past few years dropping by 20% or more. Warren Buffett’s normally profitable Berkshire Hathaway Corporation declined by 12%.

As we begin 2016, investment strategists and economists are once again convinced that stocks and the economy are primed for a positive year. We disagree. About four months ago, I wrote a blog explaining why Mission believed that a major bear market had begun. Subsequent events have done nothing to dampen that conviction. Let me update the major factors that led to that belief.

Even after the worst first week of a new year in U.S. stock market history, valuations remain higher than ever before but for the months surrounding 2000’s dot.com peak. Data stretching back more than a century make the point that returns for the years following periods of significant overvaluation tend to be much weaker than average. It has been in such time spans that the market’s most destructive declines have unfolded.

The vast majority of U.S. stocks are trading below their 50- and 200-day moving averages, showing that they are trending down. Of the 46 world markets that we monitor, only five are trading above their 200-day moving averages and only three above their 50-day.

Even on most rally days, more stocks are reaching 52-week lows than 52-week highs. The market’s internal deterioration can be seen clearly in statistics compiled by Lowry Research Corporation, an institution with an 88-year history of highly respected research. In twelve months through December 30, the percentage of stocks within 2% of their 52-week highs declined significantly: Large caps from 27.1% to 17.45%; Mid caps from 23.24% to 15.53%; and Small caps from 14.38% to 3.33%. Over the same time period, the percentage of stocks down from their 52-week highs by 20% or more increased dramatically: Large caps from 8.87% to 19.81%; Mid caps from 18.06% to 34.36%; and Small caps from 39.05% to 61.71%. These statistics are not consistent with a healthy market.

This internal deterioration took place while our Federal Reserve and other major central banks were flooding their respective economies and markets with historic amounts of monetary stimulus. The European Central Bank and the Bank of Japan have pledged to continue that torrent of new money, but the Fed has begun a belated process of “normalization”. Interest rates have been nudged above the zero bound for the first time in years, and the essentially free new money from quantitative easing will be missing in 2016. We can only speculate how the economy and markets will behave without that familiar stimulus.

In a process that began over two years ago, volume going into rising stocks has deteriorated steadily relative to volume going into declining stocks. In the second half of 2015, the cumulative volume total going into declining stocks 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.

For most of the past two years, the yield on lower quality debt has been rising notably– both absolutely and relative to U.S. Treasuries. That trend has preceded some of history’s most severe stock market declines.

Those who interpret Dow Theory announced a bearish signal in August when both the Dow Industrials and Transports descended below their October 2014 lows. The precipitous market decline in 2016’s first week has brought the Transports to a new low not yet confirmed by the Industrials.

Weakness in technical conditions is not alone in sounding an alarm. Fundamental conditions, as well, continue to deteriorate. Notwithstanding consistently optimistic forecasts from investment bankers and brokerage firms, worldwide growth remains weak. The International Monetary Fund (IMF), the Organization for Economic Cooperation and Development (OECD) and, most recently, the World Bank have all once again dropped their estimates for both U.S. and world growth. IMF head Christine Lagarde last week forecast 2016 global growth to be “disappointing and uneven.”

China’s growth continues to slow, and smaller emerging economies are increasingly distressed by the strengthening U.S. dollar. After China’s surprise devaluation of the yuan, an increasing number of countries are likely to be motivated to weaken their currencies to maintain or improve their export potential. Aggressive currency wars are possible as countries fight to avoid recession. When last common, such currency wars contributed greatly to the length and depth of the 1930s’ worldwide depression.

In the U.S., corporate earnings declined in 2015 and are at approximately the same level as at the end of 2013. With no net earnings growth for two years and the most optimistic forecasts projecting uncertain growth in 2016, valuations not far below all-time highs make no sense.

Weak technicals and fundamentals by themselves pose significant dangers. Mix them into an environment marked by the highest debt levels in history throughout most of the world, and the risk of severe and rapid market price declines is high.

Standing guard against such an outcome are Janet Yellin, Mario Draghi and central bankers worldwide. For several years, they have stepped into the breach whenever significant price declines have threatened.

History argues strongly, however, that central bankers can prevail over weak fundamental conditions only so long. Markets eventually adjust to fundamental levels, and the adjustment can be abrupt if, as now, prices have diverged dramatically from underlying fundamentals.

We continue to caution investors against being lulled into a state of complacency by apparent central bank control over market prices. In past communications, we have highlighted two striking 2015 examples of the power of markets ripping control from the best efforts of governments. The highly respected Swiss National Bank (SNB) saw the euro diverge from the franc by 38% in minutes when the SNB dropped its long-held peg between the currencies. Far less respected Chinese monetary authorities were shocked when stock prices plummeted by 45% in weeks despite significant governmental support for markets. More surprises are likely in 2016.



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.