Friday, July 27, 2018

Weekly Fundamental Stock Market Indicator Remains Bullish, So Far

So far, the escalating trade and currency wars aren’t weighing on the weekly stock market fundamentals that I track and discuss below. That’s because the US economy received a big boost from the Tax Cuts and Jobs Act (TCJA) at the end of last year. Federal tax receipts as a percentage of nominal GDP dropped from 18.2% during Q4-2017 to 17.5% during Q1-2018 (Fig. 1 and Fig. 2). That’s the lowest reading since Q4-2012. Normally, this ratio drops during recessions, not during expansions. So the TCJA is giving a big boost to an economy that is already at full employment. Let’s have a closer look:

(1) Individual tax receipts still growing after TCJA. The y/y growth rate of income taxes in personal income fell to 3.6% during May, down from a recent peak of 7.1% at the end of last year (Fig. 3). The ratio of personal income taxes to personal income has been in a flat trend around 12.5% since 2015. It edged down to the bottom of the range in May (Fig. 4). In other words, it’s hard to see the tax cut in these data because personal income has been growing, boosting individual income tax receipts even after TCJA-reduced tax rates. I suppose supply-siders can take credit (perhaps prematurely) for this development.

By the way, also contributing to the strength of consumer spending is the downtrend in the personal savings rate, which started in late 2015 (Fig. 5). Incredibly, the 12-month sum of personal saving has been nearly halved from a recent high of $829 billion during November 2015 to $458 billion during May (Fig. 6).

(2) Corporate profits jumped after TCJA. Corporate profits also received a big boost from the TCJA. In the GDP accounts, corporate profits taxes plunged from $446 billion (saar) during Q4-2017 to $332 billion during Q1 of this year (Fig. 7).

Industry analysts have raised their 2018 consensus estimate for S&P 500 earnings per share by $13.35 since late last year through the first week of July (Fig. 8). That’s a 9.0% increase that is mostly attributable to the slashing of the corporate tax rate. Soaring earnings is the bullish signal that is offsetting all the bearish noise coming out of Washington.

(3) Boom-Bust Barometer near recent record high. The recent weakness in some key commodity prices, such as the price of copper, hasn’t weighed heavily on the CRB raw industrials spot price index (Fig. 9). Meanwhile, initial unemployment claims remains at its lowest readings since early December 1969 (Fig. 10). As a result, my Boom-Bust Barometer (BBB), which is the ratio of the CRB index to jobless claims, remained in record-high territory during the 7/14 week (Fig. 11).

(4) Forward earnings soaring. The BBB is highly correlated with S&P 500 forward earnings, which soared to yet another record high of $170.21 per share during the July 19 week (Fig. 12). (As I explain in Chapter 13 of my book, Predicting the Markets, forward earnings is the time-weighted average of industry analysts’ consensus estimates for earnings during the current year and the coming year. It tends to accurately lead actual earnings during expansions. However, it consistently fails to anticipate recessions.)

(5) FSMI remains bullish. My Fundamental Stock Market Indicator (FSMI) is simply the average of the BBB and the weekly Consumer Comfort Index (Fig. 13). It remains at record highs, and has been highly correlated with the S&P 500 since 2000. The FSMI isn’t a leading indicator of the stock market, but it is useful for either confirming or raising some doubt about the direction of stock prices. In any event, it is still bullish, and helps to explain why stock prices have held up so well in the face of Trump’s escalating trade war with our major trading partners.

Monday, July 23, 2018

CFA Institute's Review of My Book, Predicting the Markets

Financial Analysts Journal
Book Reviews
2018, Volume 13 Issue 1

Predicting the Markets: A Professional Autobiography (a review)
Reviewed by Janet J. Mangano

Edward Yardeni’s (“Dr. Ed’s”) Predicting the Markets: A Professional Autobiography is a massive, entertaining, and enlightening work that captures the reader’s imagination and challenges established investment and analytical processes. The title only begins to suggest what is inside. Beyond “predicting the markets,” the book encompasses decades of intense, thoughtful research that shows there is no single simple—or even complex—way to predict the markets, the economy, or any sector within them. Solid research goes a long way, however, toward blazing a trail, creating new insights, and hypothesizing about the future.

To some extent, Predicting the Markets is more retrospective than predictive. Yardeni reviews past and present Federal Reserve Bank monetary policy and certain aspects of its implementation, such as setting interest rate and inflation targets and quantitative easing. He also addresses how valuation methods have changed from dividend-driven approaches to earnings-driven approaches and beyond.

The actual professional autobiography is charmingly presented in Chapter 1. It is so extensive that it could stand as a book on its own. In these pages, Yardeni recounts his four decades in the investment business, primarily as an economist but also in a breakthrough position he attained at C.J. Lawrence as chief economist/chief investment strategist. In 2007, he founded his own firm, Yardeni Research, where he continues to serve in the dual function of president and chief investment strategist.

Certain details of the book’s autobiographical component will probably strike current CFA candidates as quaint. Computers and databases were not easily available 40 years ago, but Yardeni and his contemporaries delved into time series and corporate filings while enjoying access to great thinkers and to corporate management in an era prior to Regulation Fair Disclosure. Yardeni grew professionally in a time when corporate buybacks were considered poor practice, if not borderline illegal.

The heart of the book is simultaneously professional and personal, as well as both retrospective and predictive. Yardeni addresses, in an economic setting, the critical issues driving the markets, considering current and hypothetical conditions. History always influences—and demographics invariably guide—his work. Readers will be rewarded for the effort required to understand the specific workings of the models and relationships that Yardeni explains not only through backtesting but also by observing how they are likely to perform in the future under different conditions.

Does anyone stress to the extent Yardeni does the need to study the Federal Reserve Bank’s “Financial Accounts of the United States” on a regular basis to gain a sense of where investors are investing? Economists will recognize the legacy he shares with Janet Yellen as a former student of James Tobin at Yale University. His neo-Keynesian focus is clearly on growth in real income and investment.

Among the chapters, “Predicting the Fed” is a standout. It is the lengthiest and the most comprehensive in revisiting the reasoning behind policies and the actions that result from them. Readers will perceive in a new light why certain monetary actions (such as deactivating the gold standard) were taken at specific points in time. Thanks to the questions Yardeni poses about quantitative easing, they will begin to comprehend why it has been as massive and has lasted as long as it has over the past decade. The discussions in this chapter make the reader feel like a member of the Federal Open Market Committee. Readers will also improve their understanding of inflection points in the economy, provided they are willing to put in the necessary time to perform the required analysis. This learning is also facilitated by reviewing the book’s excellent charts, along with timely updates that Yardeni makes available online.

The chapter titled “Predicting Valuation” is informative for individuals engaged in capital investments for businesses, corporate finance, and asset management. Its clarity rests in the applicability of particular valuation methods at different points in time and their lack of validity at others. Yardeni mentions CFA candidates in this chapter and the necessity that they understand the Fed’s Stock Valuation Model of 1997 and the 1999 Yardeni extension of it. Recall that Alan Greenspan was the first Fed chair to comment about the impact of monetary policy on the interaction between the inflation rate and the valuation of equities. (How could any of us then working as analysts and investors forget Chair Greenspan’s assertion that low price inflation was boosting valuation multiples to levels of “irrational exuberance”?) The importance of this exercise is to understand why such models were used, how the inflection points were measured, and how useful or useless they may be now and in the future. The tried and true dividend discount model cannot be applied in all situations, nor can earnings-centric models when real interest rates—or earnings—are at or below zero.

Predicting the Markets differs from the autobiographical works of other economists and investors (such as Henry Kaufman, Andrew Lanyi, and Michael Steinhardt) in its humor and occasional boasting. It is also grounded in disciplined study and analysis over decades, while providing clear, meaningful narrative and graphs. Yardeni demonstrates that his well-informed conclusions and insights are derived from hard data and facts and states that they remain subject to change as new conditions emerge. His mega-book will inspire both novice and seasoned economists and investors to use common sense, coupled with an intellectual edge.

Thursday, July 19, 2018

Donald Trump vs Blanche DuBois

Much like Blanche DuBois in Tennessee Williams’ play “A Street Car Named Desire,” the US has “always depended on the kindness of strangers,” or at least it has for a very long time. That’s because foreigners have been big buyers of bonds issued by Americans. They’ve helped to finance the US federal budget deficit. They’ve also bought lots of mortgage-backed and corporate bonds.

Trump’s escalation of the trade war between the US and all our major trading partners has raised concerns that foreigners will respond to Trump’s “America First” protectionism by cutting back on their purchases of US debt. Furthermore, Trump’s tariffs may boost inflation in the US by increasing the cost of imports. Both possibilities should be bearish for bonds. Yet bond yields remain eerily subdued. Let’s consider why, and also whether tariffs are necessarily inflationary:

(1) Bond yields and expected inflation. The 10-year US Treasury bond yield peaked this year at 3.11% on May 17, and has been trading below 3.00% most of the time since then (Fig. 1). The comparable 10-year TIPS yield has mirrored the nominal yield so far this year.

Expected inflation, as implied by the spread of the two yields, has been relatively stable around 2.00% after mostly rising during the second half of 2017 from a low of 1.66% on June 21, and jumping after passage of the Tax Cuts and Jobs Act (TCJA) on December 22 (Fig. 2).

The escalating trade war hasn’t boosted the expected inflation spread, so far, despite Trump’s threat to impose tariffs on lots of Chinese imports. So far, there is no sign that foreigners are bailing out of US debt securities. On the contrary, the outbreak of protectionist saber-rattling, and now jousting, has boosted the trade-weighted dollar (Fig. 3). This suggests that some global investors are taking sides in the trade war, betting that the US will win, if there is a winner, or at least will emerge the least bloodied.

Meanwhile, despite the potential of an escalating trade war to cause a global recession, the credit-quality yield spread between high-yield corporate bonds and the 10-year Treasury bond also remains eerily serene. It’s been in a tight range around 350bps since early 2017 (Fig. 4).

(2) Dr. Copper. The price of copper (a.k.a. “the metal with the PhD in economics”) has been falling since it peaked this year at 329.3 cents per pound on June 8 (Fig. 5). It continued to move lower last week, closing at 277.0 cents, down 15.9% from the recent peak. Since this says more about the economy of China than that of the US, it’s not surprising to see that Chinese stocks are getting hammered (Fig. 6).

Meanwhile, the S&P 500/400/600 are up 8.5%, 10.8%, and 17.1% since their lows on February 8. My switch back to a Stay Home from a Go Global investment strategy on June 4 was well timed, so far, as evidenced by the ratios of the US MSCI to the All Country World ex-US MSCI in both dollars and local currency terms. Both soared to record highs last week (Fig. 7).

(3) Flow of funds. As I discuss in my book, Predicting the Markets, I use the Fed’s quarterly report Financial Accounts of the United States to monitor the flow of funds in the capital markets. The data are currently available through Q1-2018. They show that the “rest of the world” acquired $674 billion in US fixed-income securities over the past four quarters (Fig. 8). That’s among the highest readings since the 2008 financial debacle. The figure includes $332 billion in US Treasuries and $267 billion in corporate bonds (Fig. 9 and Fig. 10).

The consensus view among economists is that Trump is wrong about trade wars. They aren’t “good, and easy to win,” as he tweeted on March 2. It is also widely believed that if he continues to escalate the trade war, everyone will lose because the result is most likely to be stagflation or worse. Weakening global trade will depress global growth, while higher tariffs will boost inflation. I am not dismissing this widely believed narrative. However, while Trump has opened up lots of fronts in his battle for fair trade with America’s major trading partners, the major fight is with China. Will China put up the white flag and make major concessions to get a cease fire out of Trump?

Currently, that seems to be an unlikely scenario. However, that’s exactly the story being told by the financial markets. As noted above, while Chinese stocks are falling, US stocks are rising. The weakness in the price of copper is a better economic indicator for the economy of China than for that of the US.

While the Fed continues to gradually normalize monetary policy, the People’s Bank of China cut reserve requirements sharply in recent weeks (Fig. 11). That undoubtedly contributed to the 6.2% plunge in the yuan from its mid-April peak (Fig. 12).

If Trump does raise the ante by slapping a 10% tariff on $200 billion of imports from China, a stronger dollar relative to the yuan might very well offset most of the inflationary consequences for the US. To add insult to injury, Trump could revive his attacks on China as a “currency manipulator.” However, in my opinion, it is US trade policies, not Chinese intervention, that is weakening the yuan.

Trump knows that a weak yuan could cause the Chinese some real pain, by increasing the yuan cost of buying dollar-priced commodities, especially oil. China’s PPI inflation rate, which was 4.7% on a y/y basis in June, could go higher and put upward pressure on the CPI inflation rate, which was 1.9% last month (Fig. 13).

Meanwhile, in the US, the year-to-date (through 7/13) performances of the S&P 500 sectors suggest that investors are more concerned about rising interest rates resulting from a strong economy than about a trade war depressing the economy (Fig. 14): Information Technology (15.3%), Consumer Discretionary (14.1), Health Care (5.8), Energy (5.7), S&P 500 Index (4.8), Real Estate (-0.1), Utilities (-0.3), Industrials (-2.8), Materials (-3.1), Financials (-3.5), Consumer Staples (-7.8), and Telecom Services (-10.3). Cyclical stocks are mostly outperforming interest-rate sensitive ones.

Sunday, July 15, 2018

Predicting the Markets

May I suggest you take my recently published book Predicting the Markets: A Professional Autobiography along to the beach this summer? If you like reading biographical histories that focus on financial markets and the economy, you should enjoy my book. If you prefer thrillers, then The President Is Missing by Bill Clinton and James Patterson might be a better choice.

I wrote my book to share what I have learned over the past 40 years as an economist and investment strategist on Wall Street. My hope is that investors in my age bracket find it to be an enjoyable and thought-provoking walk down Memory Lane and that younger folks find plenty of insights they can put to good use in their financial life. In writing the book, I’ve avoided jargon for a narrative that appeals mostly to one’s common sense.

My career has provided me with lots of opportunities for testing theories, and for learning from both successes and mistakes. I started my career on the Street at EF Hutton in 1978. The Dow Jones Industrials Average was around 1000 at the time. Now it is over 25000. I’ve been bullish most of that time. However, I also stumbled a few times along the way.

For example, I didn’t foresee the flash crash on Black Monday October 19, 1987. But I argued that it was a buying opportunity because the outlook for earnings remained solid. During 1999, I turned negative on tech stocks because they seemed significantly overvalued. I also warned that the Y2K problem might cause a recession. It did, but I was right for the wrong reason: Computer systems continued to work just fine after the stroke of midnight 2000; however, so much money had been spent on fixing the problem that sales of information technology hardware and software plummeted, depressing the economy.

From 2003 through 2007, I grew increasingly bullish owing to the positive implications I saw for commodity prices—and for the Materials, Energy, and Industrial sectors of the S&P 500—when China emerged as a major driver of the global economy. I turned bearish on the S&P 500 Financials sector on June 25, 2007, but I wasn’t bearish enough on the overall market because I never expected that the federal government would let Lehman fail, as it did on September 15, 2008. I did better at calling the major market bottoms in August 1982 and March 2009.

Along the way, I learned lots of lessons that I hope will be helpful to investors, many of whom don’t pay enough attention to the big picture. Without further ado, here are some of the major lessons I’ve learned and why they are relevant to investors today:

(1) Getting inflation right is imperative. In my book, I observe: “Accurately predicting price inflation is one of the most important prerequisites for predicting the outlook for the stock and bond markets. A bad inflation forecast almost certainly will result in bad investment choices in all the major financial markets.”

During my career so far, inflation has trended downward. Fortunately, I was an early proponent of “disinflation.” I never bought the idea promoted by Milton Friedman that inflation is solely a monetary phenomenon that can be controlled by the Fed or any other central bank. Instead, my view has been that price inflation is also determined by more microeconomic factors, particularly the competitiveness of markets. Globalization, deregulation, and the advance of information technologies have been major forces heightening competition, in the US and abroad, over the past few decades.

Following the Great Recession of 2008, the major central banks sought to avoid deflation and adopted 2.0% inflation targets. They lowered their official interest rates close to zero and pumped liquidity into their economies with quantitative easing programs, i.e., by purchasing bonds in the capital markets. Yet inflation remains remarkably subdued, with relatively lackluster economic growth among the major industrial economies. Much of the liquidity seems to have gone into the financial markets, driving bond yields lower and stock prices higher. Real estate also has benefited from the ultra-easy policies of the central bankers.

(2) The Phillips curve isn’t working. In the US, Fed officials have been expecting that their policies would lower the unemployment rate and boost wage inflation, which would be marked up into price inflation. They based that on the Phillips Curve Model, which posits an inverse correlation between the inflation rate and unemployment rate. The jobless rate dropped below 4.0% recently, the lowest in decades. Yet wage inflation remains subdued. Globalization and technological innovation may account for much of the “flattening” of the Phillips curve. Globalization is currently being challenged by President Donald Trump’s protectionist saber-rattling, while technological innovation seems to be happening at a faster and faster pace. The jury is out, but I expect that the net effect will be that inflation remains subdued.

(3) No boom, no bust. Inflation is a key driver of the business cycle. In the past, recessions were followed by recoveries, with GDP regaining what was lost during the downturn. During the subsequent expansion phase, GDP rose to record highs. Along the way, excesses developed as businesses scrambled to add capacity and to hire more workers at higher wages. The good times encouraged more borrowing to finance the expansion. Debt-to-income ratios rose rapidly. The Fed was clearly behind the curve, and raced to get ahead of rising inflationary pressures. Rapidly rising short-term rates triggered a financial crisis as some borrowers failed to service their debts when their sales disappointed. That triggered a widespread credit crunch as even good borrowers were denied refinancing by their lenders, who were plagued by mounting bad loans. The yield curve inverted as investors in Treasury bonds started to anticipate that the boom soon would be followed by a bust, which invariably happened.

This time may or may not be different. But for now, business managers are remaining relatively cautious. Many of them faced a near-death experience during the Trauma of 2008. Ever since, they seem to have been focusing on increasing their profit margins, which rose to a record high for the S&P 500 during the fourth quarter of 2017, before Trump’s tax cut, and even higher during the first quarter of this year, after the tax cut.

Also different this time, so far, is that the flattening yield curve may reflect investors’ perceptions that the Fed is ahead of the inflation curve, which explains why Treasury bond yields aren’t rising as rapidly as the federal funds rate. Furthermore, the US bond market has been globalized in recent years, with record-low yields in the Eurozone and Japan keeping US yields lower than otherwise.

(4) Profits drive the economy. Economists and investors tend to focus on the business cycle, which I believe is driven by the profits cycle. While politicians pat themselves on the back for creating jobs, it is businesses that actually do the hiring, especially small ones that aspire to grow into bigger ones. Profitable companies expand their capacity and increase their payroll head count. Unprofitable companies retrench across the board. Record-high profit margins show no signs of fulfilling bearish market prognosticators’ warnings throughout the bull market that they are bound to revert to their means.

(5) Forward earnings drive the stock market. Forecasting the stock market should be easy since it involves forecasting just two variables—namely, earnings (E) and the valuation multiple (P/E). Getting them right is the hard part. In my book, I explain why I favor tracking the industry analysts’ consensus expectations for the operating earnings of the S&P 500 on a weekly basis. In my opinion, the market discounts forward earnings, which is a time-weighted average of the consensus forecasts for the current year and the coming year. S&P 500 forward earnings rose to a record high at the end of last year, before Trump’s tax cuts took effect. They shot up in January when the tax cuts became effective.

Yet stock prices have been zigzagging since late January on fears that the Fed’s interest-rate hikes and balance-sheet tapering might cause a financial crisis, as happened during previous tightening rounds. There’s mounting evidence that the normalization of monetary policy in the US may be stirring up an emerging markets crisis. Trump’s protectionist saber-rattling is another source of concern, though most cyclical sectors of the S&P 500 have been outperforming the overall index so far this year, while the “safe” interest-rate-sensitive sectors have been hard hit by the rising bond yield.

With forward earnings continuing to rise into record territory, the zigzagging stock market has been driven by the zigs and zags in the forward P/E. Valuation multiples that were awfully high in January are closer to their long-run fair values based on forward P/Es. I devote a chapter of my book to all the widely followed valuation metrics. P/Es based on forward earnings tend to be too optimistic, especially just before recessions; that’s because industry analysts collectively don’t see recessions coming and must slash their forecasts as recessions unfold. On the other hand, P/Es based on trailing earnings (like Shiller’s CAPE, which is based on 10-years-trailing earnings) tend to be overly and prematurely bearish during bull markets.

(6) The end is far. Lots can go wrong in the foreseeable future. Trump’s protectionist saber-rattling could trigger a global trade war. The Fed could trigger another financial crisis, especially among emerging market economies. In the intermediate term, say the next 12 months, inflation could make a surprising comeback (at least surprising to me), forcing the Fed to tighten more aggressively. In the long term, say the next one to three years, swelling federal government budget deficits combined with the Fed’s balance-sheet tapering could push up bond yields to levels that cause trouble.

I might be overstaying my welcome in the bullish camp, but I believe that strong earnings will remain the signal that the market heeds. I’ve noted since the start of the bull market that it was prone to panic attacks on fears of another trauma like the 2008 calamity. I’ve consistently argued that they would pass, followed by relief rallies. One day, there will be a recession and a bear market. But as long as inflation remains subdued, the Fed is unlikely to raise interest rates to levels that precipitate these events. I expect that the current economic expansion will continue through at least July 2019, when it will become the longest one since the end of World War II.

(7) Technology is often a pleasant surprise. By now, you may have concluded that I am an optimist. Guilty as charged. I’m looking forward to writing a book about the next 40 years of my career, and I’m counting on biotech innovations to keep me going that long. Technological innovations are mostly ignored by economists, particularly of the pessimistic variety. They often fail to foresee, let alone to see, that the inexorable advance of technology is a major source of productivity, which keeps a lid on inflation and boosts both profits and standards of living.

(8) Economics is the study of abundance, not scarcity. In the book, I write: “The latest (19th) edition of Economics (2010) by Paul Samuelson and William Nordhaus teaches students that economics ‘is the study of how societies use scarce resources to produce valuable goods and services and distribute them among different individuals.’ This definition hasn’t changed since the first edition of this classic textbook was published in 1948. I’ve learned that economics isn’t a zero-sum game, as implied by the definition. Economics is about using technology to increase everyone’s standard of living. Technological innovations are driven by the profits that can be earned by solving the problems posed by scarce resources. Free markets provide the profit incentives to motivate innovators to solve this problem. As they do so, consumer prices tend to fall, driven by their innovations. The market distributes the resulting benefits to all consumers. From my perspective, economics is about creating and spreading abundance, not about distributing scarcity.”

(There are more than 700 charts referenced in the book. All are automatically updated and posted on the book’s website, If you teach economics or finance courses, please inquire about my partnership program to motivate students to major in these subjects. Send me a message at

Tuesday, July 10, 2018

Is the Yield Curve Bearish for Stocks?

The yield curve is commonly measured as the spread between the 10-year US Treasury bond yield and the federal funds rate (Fig. 1). This spread has narrowed significantly since the start of this year, raising fears of an imminent recession and bear market in stocks (Fig. 2). That’s because in the past, the yield curve spread has flattened (i.e., narrowed) and then inverted (i.e., the bond yield was below the federal funds rate) immediately preceding the past seven recessions.

Recessions cause bear markets in stocks, which is why the yield curve has received lots of buzz in recent weeks (Fig. 3). Do a Google Trends search on “yield curve” for the past five years, and you’ll see a trendless series through the end of last year, followed by an upward-trending series so far this year with a spike in June.

The Federal Open Market Committee (FOMC), the entity that sets the Federal Reserve’s monetary policy, raised the federal funds rate by 25 basis points (bps) on June 13 to a range of 1.75%-2.00%, following a similarly sized hike on March 21 (Fig. 4). Yet the 10-year US Treasury bond yield peaked so far this year at 3.11% on May 17 and fell to 2.82% in early July. The spread, which had been just over 150 bps earlier this year, has narrowed to just below 100 bps now. The yield curve spread between the 10-year and 2-year Treasuries has triggered even wider concern, as it has narrowed from over 75 bps earlier this year to almost 25 bps recently, i.e., closer to zero (Fig. 5).

A higher short end of the yield curve than long end suggests that investors expect interest rates to decline, which usually happens just before recessions. Is the yield curve about to invert? If it does, will that mark the eighth time in a row that this indicator accurately predicted a recession and a bear market in stocks?

It’s hard to argue with success. It’s always unsettling when arguments are made for why “this time is different.” Nevertheless, let’s go there. Consider the following:

(1) One of 10. In my new book Predicting the Markets, I observe that the yield curve spread is actually one of the 10 components of the Index of Leading Economic Indicators (LEI), which is deemed to provide a recession warning roughly three months before one starts. A list of the 10 can be found on The Conference Board’s website. Among the 10 are the S&P 500, initial unemployment claims, and measures of consumer and business confidence. Collectively, they’ve pushed the LEI up by 6.1% over the past 12 months to yet another new record high during May (Fig. 6). So the LEI certainly isn’t sounding a recession alarm.

(2) Credit crunches. In the past, the Fed would raise the federal funds rate during economic booms to stop an acceleration of inflation. Fed officials did so aggressively, perhaps in no small measure to shore up their credibility as inflation fighters. Tightening credit market conditions often triggered a credit crunch—particularly during the 1960s and 1970s, when interest-rate ceilings on bank deposits were set by Regulation Q—as even the credit-worthiest of borrowers found that bankers were less willing and able to lend them money (Fig. 7).

Sensing this mounting stress in the credit markets and expecting the credit crunch to cause a recession and a bear market in stocks, investors would pile into Treasury bonds (Fig. 8). The yield curve inverted, accurately anticipating the increasingly obvious chain of events that ensued—i.e., rising interest rates triggered a credit crisis, which led to a widespread credit crunch and a recession, causing the Fed to lower short-term interest rates.

(3) No boom, no bust. So how can we explain the flattening of the yield curve during the current business cycle? Inflation remains relatively subdued, having risen to the Fed’s 2.0% target (measured by the personal consumption expenditures deflator excluding food and energy on a year-over-year basis) during May—for the first time since the target was explicitly established by the Fed on January 25, 2012 (Fig. 9)!

The Fed has gradually been raising the federal funds rate since late 2015, yet few critics charge that the Fed is behind the curve on inflation and needs to raise interest rates more aggressively. The economy is performing well, but there are few signs of an inflationary boom or major speculative excesses that require a more forceful normalization of monetary policy.

(4) Globalized bond market. In my opinion, the flattening of the US yield curve is mostly attributable to the negative interest policies of the European Central Bank (ECB) and the Bank of Japan (BOJ) (Fig. 10). The ECB first lowered its official deposit rate to below zero on June 5, 2014. The BOJ lowered its official rate to below zero on January 29, 2016. Those rates, which remain slightly below zero, have reduced 10-year government bond yields to close to zero in both Germany and Japan since 2015 (Fig. 11).

Such yields certainty make comparable US Treasury bonds very attractive to investors—especially when the dollar is strengthening, as has been the case this year (Fig. 12). When investors turn defensive and want to park their money in a safe asset, the US Treasury bond clearly offers a more attractive return than bunds and JGBs.

(5) Bond Vigilantes. In other words, the US bond market has become more globalized, and is no longer driven exclusively by the US business cycle and Fed policies. In my book, I discuss the close correlation between the 10-year Treasury bond yield and the growth rate of nominal GDP, on a year-over-year basis (Fig. 13 and Fig. 14). The former has always traded in the same neighborhood as the latter. I call this relationship the “Bond Vigilantes Model.” The challenge is to explain why the two variables aren’t identical at any point in time or for a period of time. Nominal GDP rose 4.7% during the first quarter of 2018 and is likely to be around 5.0% during the second quarter, on a year-over-year basis. Yet the US bond yield is below 3.00%.

During the 1960s and 1970s, bond investors weren’t very vigilant about inflation and consistently purchased bonds at yields below the nominal GDP growth rate. They suffered significant losses. During the 1980s and 1990s, they turned into inflation-fighting Bond Vigilantes, keeping bond yields above nominal GDP growth. Since the Great Recession of 2008, the Wild Bunch has been held in check by the major central banks, which have had near-zero interest-rate policies and massive quantitative easing programs that have swelled their balance sheets with bonds. Meanwhile, powerful structural forces have kept a lid on inflation—all the more reason for the Bond Vigilantes to have relaxed their guard.

As noted above, a global perspective certainly helps to explain why the US bond yield is well below nominal GDP growth. So this time may be different than in the past for the bond market, which has become more globalized and influenced by the monetary policies not only of the Fed but also of the other major central banks.

(6) Another Fed Model. The latest minutes of the June 12-13 FOMC meeting offers another reason not to worry about the flattening yield curve. During the meeting, Fed staff presented an alternative “indicator of the likelihood of recession” based on research explained in a 6/28 FEDS Notes titled “(Don't Fear) The Yield Curve” by two Fed economists. In brief, they question why a “long-term spread” between the 10-year and 2-year Treasury notes should have much power to predict imminent recessions. As an alternative, they’ve devised a 0- to 6-quarter “near-term forward spread” based on the spread between the current level of the federal funds rate and the expected federal funds rate several quarters ahead, derived from futures market prices (Fig. 15).

The note’s authors stress that the long-term spread reflects the near-term spread, which they argue makes more sense as an indicator of a recession that is expected to occur within the next few quarters. They also observe that an inversion of either yield spread does not mean that the spread causes recessions.

Their current assessment is that “the market is putting fairly low odds on a rate cut over the next four quarters,” i.e., 14.1% (Fig. 16). “Unlike far-term yield spreads, the near-term forward spread has not been trending down in recent years, and survey-based measures of longer-term expectations for short term interest rates show no sign of an expected inversion.”

What a relief! So now, all we have to worry about is a recession caused by a trade war!

Thursday, July 5, 2018

Mother of All Credit Bubbles?

A 6/8 article in The Washington Post was ominously titled “Beware the ‘mother of all credit bubbles.’” Author Steven Pearlstein is a Post business and economics writer and the Robinson Professor of Public Affairs at George Mason University. The article has been “trending,” with 555 comments since it was posted on the Post’s website. I received several emails from accounts asking me to comment on it. So here goes:

(1) The end is coming. Pearlstein concluded his article as follows: “It’s hard to say what will cause this giant credit bubble to finally pop. A Turkish lira crisis. Oil prices topping $100 a barrel. A default on a large BBB bond. A rush to the exits by panicked ETF investors. Trying to figure out which is a fool’s errand. Pretending it won’t happen is folly.”

I agree that there will be another credit crisis—eventually. In my book Predicting the Markets, I show that most of the post-war recessions were triggered by rising interest rates. Here’s how that typically happened: Rising interest rates triggered a financial crisis when some borrowers couldn’t service their debts at the higher rates. The jump in bad loans forced lenders to cut lending across the board, even to borrowers with good credit scores. A widespread credit crunch resulted, taking on crisis proportions. The crisis grew into a contagion, and recession ensued (Fig. 1). The stock market naturally fell into a bear market (Fig. 2). It bottomed once the Fed started easing credit conditions to end the crisis.

(2) Corporations will lead the next meltdown. Pearlstein correctly observed that the previous credit bubble was inflated by “households using cheap debt to take cash out of their overvalued homes.” This time, in his opinion, the epicenter of the coming debacle is “giant corporations using cheap debt—and a one-time tax windfall—to take cash from their balance sheets and send it to shareholders in the form of increased dividends and, in particular, stock buybacks.” This is where we part ways.

Pearlstein calls it the “Buyback Economy,” where future growth is sacrificed for current consumption. The article quickly turns into a liberal progressive rant claiming that corporations are “diverting capital from productive long-term investment.” Instead of investing for the long term, they are engaging in “financial engineering” by converting equity into record debt. And needless to say, this is all making the rich richer. And who are the rich? Round up the usual suspects: They are corporate executives, wealthy investors, and Wall Street financiers.

It’s true that nonfinancial corporations’ (NFCs) debt—both debt securities and loans—is at a record high, having risen from $6.0 trillion at the end of 2010 to $9.1 trillion during Q1-2018 (Fig. 3). But NFCs’ liquid assets ($2.7 trillion during Q1-2018) and cash flow ($1.8 trillion over the past four quarters) continue to set new highs. The ratio of NFC debt to liquid assets is matching its lowest readings since the mid-1960s (Fig. 4).

The ratio of NFC short-term debt to total debt has been falling since the 1980s (Fig. 5). It is down from 40%-45% during the 1980s and 1990s to roughly 28% during the current economic expansion. This confirms that NFCs have been extending the maturity of their debt to lock in lower interest rates.

(3) Corporate bond debt at record high. It is also true that NFCs’ corporate bonds outstanding was at a record high of $5.4 trillion during Q1-2018, having doubled since the mid-2000s (Fig. 6). But again, this may partly reflect opportunistic lengthening of NFC debt maturities. The spread between gross and net NFC bond issuance rose to a record high slightly exceeding $600 billion last year (Fig. 7 and Fig. 8).

(4) Buybacks are troubling. Pearlstein claimed that buybacks amount to “corporate malpractice,” observing that companies have been spending more than 100% of their net profits on dividends and share repurchases. That’s true. Historically, however, corporations collectively have paid out roughly 50% of their profits in dividends rather than investing for the long term; that use of profits has never been viewed as malpractice (Fig. 9).

The sum of buybacks plus dividends has been running around 100% of S&P 500 after-tax earnings (Fig. 10). That means that buybacks have been 100% funded by retained earnings (i.e., after-tax profits less dividends). Even so, Pearlstein claimed without supporting evidence: “The most significant and troubling aspect of this buyback boom, however, is that despite record corporate profits and cash flow, at least a third of the shares are being repurchased with borrowed money, bringing the corporate debt to an all-time high, not only in an absolute sense but also in relation to profits, assets and the overall size of the economy.”

Not so fast: Retained earnings are just one portion of NFCs’ cash flow, which is also determined by the capital consumption allowance (CCA), i.e., depreciation reported to the IRS (Fig. 11). I like to think of the CCA as a huge tax shelter for corporate earnings.

(5) Corporations have been eating their seed corn. Progressives like Pearlstein are most incensed about how corporations aren’t investing in the future. Instead of buying back their shares with 100% of retained earnings and even borrowing to do so, the thinking goes, they should be spending more on plant and equipment. They should be paying their workers more and providing them with the skills they need to make their companies more productive, so that real incomes can grow.

What are the facts? The data show that NFCs’ gross capital expenditures are at a record high (Fig. 12). These outlays continue to be funded predominantly by cash flow in general and the CCA in particular (Fig. 13). Net fixed investment broadly has matched the spending pattern of the past two expansions (Fig. 14).

The data also show that net bond issuance has been relatively small compared to cash flow (Fig. 15). Cash flow has been ample, financing lots of capital spending and share buybacks. So buybacks haven’t come at the expense of capital spending. Furthermore, as noted above, corporations have refinanced and extended the maturities of lots of their debt at lower and lower interest rates (Fig. 16).

(6) Corporate borrowing is increasingly risky. Pearlstein claimed: “In recent years, at least half of those new bonds have been either ‘junk’ bonds, the riskiest, or BBB, the lowest rating for ‘investment-grade’ bonds. And investor demand for riskier bonds has largely been driven by the growth of bond ETFs—or exchange traded funds—securities that trade like stocks but are really just pools of different corporate bonds.”

Furthermore, Pearlstein said he is troubled that “a greater part of corporate borrowing has come in the form of bank loans that are quickly packaged into securities known as CLOs, or collateralized loan obligations, which are sliced and diced and sold off to sophisticated investors just as home loans were during the mortgage bubble.”

This may be Pearlstein’s most credible concern. Lots of junk has been piling up in the corporate credit markets, just as it did in housing’s subprime credit calamity during the 2000s. However, there was a significant stress test from the second half of 2014 through the end of 2015 in the high-yield market. The collapse of the price of oil caused credit quality spreads to blow out, especially for the junk bonds issued by oil companies. With the benefit of hindsight, that was an amazing opportunity to buy junk bonds.

My working hypothesis is that future credit crunches may be mitigated by all the distressed asset and debt funds that are around these days, with billions of dollars just waiting to scoop up distressed assets and debt at depressed prices. They may be the credit market’s new shock absorber. I believe that’s why the recent calamity in the oil patch was patched up so quickly without turning into a contagion and a crunch.

(7) Dangerous excesses abound. At the tail end of his article, Pearlstein covered all the bases with the usual litany of other credit market excesses. Rising interest rates and defaults could send ETF prices into a “tailspin.” The “global economy is now awash in debt.” The US budget deficits will exceed $1.0 trillion per year on average over the next 10 years. Household balance sheets are in worse shape than widely recognized. Margin debt is at a record high. He did concede that “[While] banks are in better shape than in 2008 to withstand the increase in default rates and the decline in the market price of their financial assets, they are hardly immune.”

Pearlstein deserves credit for having cogently presented the dangers lurking in the credit markets, which have almost always been the epicenter of potential trouble for the economy and the stock market. However, writing as an alarmist, he ignored lots of evidence that doesn’t support his alarming points. I don’t disagree that there may be another crisis—eventually. As I observed in my book, “I’ll go out on a limb and predict that there will be another financial crisis in our lifetimes. However, like previous ones, it probably will offer a great opportunity for buying stocks.”

(8) Accentuating the negatives. Pearlstein is an experienced financial journalist writing for a reputable publication, so I am not disputing all his assertions. My beef is that he accentuates the negatives and ignores the positives for NFC debt discussed in the reports he cited from the US Treasury, International Monetary Fund (IMF), and Moody’s. Trouble may be brewing for NFC debt, but there really aren’t any indications of stress yet.

Pearlstein notes: “‘Flashing red’ is how this buildup of corporate debt was characterized by the U.S. Treasury’s Office of Financial Research [OFR] in its latest annual report on the stability of the financial system.” I agree that it is hard to ignore the red boxes in Figure 20 in the OFR’s report. The red represents high “potential vulnerability” for US NFC credit risk based on corporate leverage ratios, which compare debt to assets and earnings. On the other hand, the same figure in the OFR report also shows green boxes, which represent low potential vulnerability—i.e., ample ability for US NFCs to cover their interest obligations, based on the ratio of earnings to interest.

The OFR reported: “On the positive side, many companies have rolled over existing debt at lower interest rates, while also lengthening maturities of their debt. These steps make servicing the outstanding debt less costly and boost these companies’ creditworthiness. In 2017, almost 60 percent of high-yield bond deals, by count, included repayment of debt as a use of proceeds. This is the highest level since at least 1995.” The OFR added: “Excluding commodities-related companies, the default rate for non-investment-grade, nonfinancial corporations has held steady at about 2 percent in recent years.”

“The International Monetary Fund recently issued a similar warning” about the level of NFC debt, noted Pearlstein. But notwithstanding the high level of NFC debt, one of the IMF’s key findings was that the allocation of corporate credit isn’t nearly as risky as it was before the 2008 financial crisis. In the IMF’s April Global Financial Stability Report, Chapter 2 focused on the IMF’s new global measure of the riskiness of credit allocation as an indicator of financial vulnerability. The IMF found that “a period of high credit growth is more likely to be followed by a severe downturn or financial sector stress over the medium term if it is accompanied by an increase in the riskiness of credit allocation.”

The riskiness of credit allocation at the global level has rebounded since its post-global-financial-crisis trough back to its historical average at the end of 2016, observed the IMF. Yet it is not nearly as high as it was when it peaked at the onset of the global financial crisis (see Figure 2.4.1. on page 63 in Chapter 2 of the IMF’s report). “The relatively mild credit expansion in recent years, combined with postcrisis regulatory tightening, contributed to a softer rebound in the riskiness of credit allocation than might be expected given the very loose financial conditions,” explained the IMF.

“Mariarosa Verde, senior credit officer at Moody’s, the rating agency, warned in May that ‘the record number of highly-leveraged companies has set the stage for a particularly large wave of defaults when the next period of broad economic stress eventually arrives,’” observed Pearlstein. Indeed, Moody’s May report contended that “the non-financial corporate debt burden today is higher than its peak before the 2008-09 financial crisis.” However, Moody’s also found that “the near-term credit outlook is benign and the speculative-grade default rate remains low.”

(9) Hedge clause. Needless to say, I've accentuated the positives to counter Pearlstein's comprehensive litany of negatives. The most obvious risk for stocks these days is trade protectionism rather than the bursting of a credit bubble. That's a subject for another day.