Real Life Economic Research

I have written in the past that Federal Reserve Quantitative Easing and other Federal stimulus has grossly distorted the "traditional" economic principles in place since the 1930's. It has led to artifically restrained interest rates which in turn has changed asset values and reported inflation. Coupled with what I call the "Great Globalisation" of manufacturing and services as well as the rise of Hedge Funds, the field of economic forecasting for investments and investors has forever and dramactically changed.

Now, in 2020, we have the added situation of a Global Pandemic and additional government actions wihout any historical precedent.

Any forecaster that claims to "know" the future with any reasonable certainty is a fool or a charlatan.  We are now relegated to managing probabilities and risk acceptance. 

As always, a exhaustive and continuous search in the economic news media and academic literature is important. But today, I assert that it is also critical to physically observe economic activity, in person. 

Obviously, one cannot travel extensively globally or even nationally while maintaining "social distancing", but one can do so regionally. Traveling in one's personal vehicle on a regional basis, can provide valuable information from first hand, personal observations. Traffic levels, cars in parking lots, activity at recreational locations like parks and waterfronts. Interviews with places where people consider making large discretionary purchases--car dealers, marinas, yacht and aircraft brokers. 

During these uncertain times, it is important to assess some sort of probability distributions for asset price levels. I am engaged in that very activity and applying the knowledge gained toward intelligent investment advice and management of your portfolios.

Fortunately, Secretary Mnuchin has declared the Financial Service sector as "essential" so I am permitted to travel as long as social distancing guidelines are followed.

The recovery after the dramatic and global  "Great Shutdown" will certainly be uneven.

The greatest casualty is probably the sit down restaurant business.  Projections are that 75% of the businesses will be lost along with those employed.  Great uncertainty exists as to the hotel and other parts of the travel industry as "at home" work and "video" conferencing is likely to grow. Massive unemployment in these sectors is likely and the effect on the economy will be large.

People are likely to drive more in personal automobiles for "socially distanced" pleasure, but will be commuting to work less. Auto auctions are building used car inventory rapidly which will certainly lead to a glut in the used car market--falling prices will effect new car sales. There will likley be massive unemployment in the auto industry.

Despite a falling stock market, a large segment of the retired population hold significant wealth.  Socially distanced family entertainment may drive and increase in RV and Yacht sales.

Be skeptical of the present bump in stock prices. The market is dominated by institutional action reacting to Fed actions and massive stimulus. It has not yet factored in the almost certain unemployment drag on the economy.

Another underestimated issue is the probable cost cutting by state and local governments that cannot run deficits. They will have massive shortfalls and will cut employment as well as try to raise taxes--both will be a big drag on the economy,

On the other hand, be aware that central banks are printing money at a rate never before seen.  There is no way that it will not lead to inflation.  But, how that inflation shows up may be a surprise.

There is a significant probability that it will not appear in the price of necessities, but that it will appear in the price of assets. 

For sure--its complicated!

In a recent "field observation" I made for Baltimore, DC, Richmond, and Norfolk, I was shocked that road traffic was significantly higher than expected. Lunchtime lines are drive thru fast food restaurants were very long. Cars parked in strip center retail parking lots were much more numerous than expected.

Given, the continuing number of new Covid cases, even after 4 weeks of shutdown, it is apparent that more people are working than reported, and many more people are "out and about". I suspect some are simply ignoring the stay at home orders...and..I also suspect that we are beginning to see a growing "black market" cash only, under the table, economy that is growing. 

Interestingly though, there appears to be a wide variance in the level of "fear" as I noticed a large % of drivers, driving their cars with windows up and masks on....and many others walking about without a mask. 

The economic damage from the "stay at, shelter at home" orders has already plunged the country into a deep recession.  It will surely snow ball to affect many industries--including local and state government employees. The only remaining question is the recession's duration and speed for recovery. 

I think the effects on autos, banking and commercial real estate will be far greater than expected. 

Excess Capacity is the Cause of Economic Turmoil

It has been more than a year since my last post in 2018.   Then, I warned of an increasing probability of a nasty stock market correction.

In January of 2018, the Dow Jones Industrial Average was at 26149.  Today, it is essentially at, or slightly below that level.  During the 19 months since January 2018, the Dow has seen a low of 23327 in December 2018 and a high of 27359 in July 2019---a nearly 15% change.  And, the risk of a nasty stock market correction continues. (Even after the down turn in August, the Dow is still more than 10% above December 2018.)

The problem stems from a gross misunderstanding of basic economics and history.  Economists have known that increasing the money supply can stimulate economic demand.  The important distinction here is the word "can" versus "will".  Sometimes increasing the money supply (decreasing interest rates) does cause more borrowing and more consumption---assuming there is "pent up" demand that has been limited by higher interest rates AND limited by supply capacity. 

So, IF economic activity has been limited by high interest rates and a limited supply, THEN lowering interest rates will cause borrowing for the purpose of increasing capacity.

But, what happens if central banks lower interest rates when supply capacity is so excessive that nobody increases capacity?  The answer---people borrow money for purposes that do not increase economic activity---they borrow money to 1) speculate in financial assets; or 2) borrow money to simply rearrange the capital structure of their enterprise; or 3) borrow money for activities for which there is no demand. 

Without an increase in the money supply thru lower interest rates (or other ways of printing money) a situation with excess capacity results in deflation--falling prices. Central banks fear deflation more than inflation, so they tend to err on the side of too much stimulus vs too little.

That is exactly what has been happening for years--but has accelerated since 2013.  Speculation in financial assets has caused the Price/Earnings ratio of securities to increase. Corporations have borrowed money to buy back stock--reducing the number of shares outstanding resulting in higher Price/Earnings ratios of stocks. Governments have increased borrowing. Students have increased borrowing for education in areas where there is no demand. 

And, lower interest rates do have a cost. When central banks lower interest rates, they reduce the income from savings.  The loss of this income reduces economic activity dramatically.

Here is the text of my economic commentary mailed to clients this month:

Monetary Stimulus occurs when the money supply is increased by the central bank.  The central bank lowers interest rates and generally this provides an incentive for producers to borrow and invest, or for consumers to borrow and consume more. It is the borrowing that increases the money supply. In addition, the central bank can increase the money supply by literally depositing funds in banks thru a process called quantitative easing. It has always been assumed that this monetary stimulus is limited. Producers may not want to borrow and invest if there is already too much productive capacity. And consumers may not wish to increase their debt, or they are prevented from borrowing because they have reached their credit limit. These limitations are illustrated by the metaphor: “The Fed can’t push on a string”.  So, increasing the money supply may NOT actually stimulate the economy.

The other reason central banks increase the money supply is to fight against deflation.  Economists fear deflation for two reasons. Falling prices tend to cause consumers to postpone purchases in anticipation of getting a lower price later. This tends to cause an economic slowdown.  Secondly, falling prices make borrowing much less attractive as debt becomes relatively more expensive to repay—and debtors default.  Expanding the money supply can create inflation, even in a shrinking economy and central banks have dubiously decided inflation is better than deflation.

Whether it is a need to stimulate the economy or fight deflation---the underlying condition/s that create the need for stimulus is: excess capacity; fear and uncertainty about the future, or both.  In either case, monetary stimulus often does not expand the economy---producers do not invest in productive projects and consumers don’t consume much more. Consumers save instead of spend. What does happen is interest rates fall or stay low and the price of monetary assets increase to reflect the lower rate of return on money.  This is exactly what has been going on since 2013—all over the world. Corporations are borrowing more, but not to increase capacity—rather just to buy back stock.  The only consumer borrowing that has increased significantly is student loans—many of which will never be repaid in full.

Generally excess capacity is “cured” over a long period. Older and/or less efficient operations are closed and eliminated.  And, increasing population generally increases demand.  This can take a long time.  Most of the excess capacity was built outside of the US—that is why Europe and Japan are suffering the most.  China is likely to experience even more pain as they have increased capacity by historic proportions.   

When does this situation change?  One thing that can occur is that central banks reverse the stimulus for whatever reason---most often because they sense an expanding economy and fear inflation.  This in fact happened in 2018 causing a dramatic stock market correction in November-December.  Another is that the expanded money supply simply leads to rising prices. People, especially businesses and governments simply become willing to pay higher prices. Once prices begin to rise, interest rates tend to follow.

Of course, instead of inflation and interest rates rising, there could be a sharp economic slowdown—most likely from a pattern of debt defaults.  With the central banks having already used up their ability to stimulate---there is little that can be done to reverse the resulting economic decline.

Given that stock and bond prices are at historically high levels relative to their earnings---either case: Inflation or Recession will probably lead to a substantial decline in the price of many stocks and bonds.  Or, if not, there will be a very long period with historically low returns on investments--economic stagnation like never before seen.

If your investing horizon is less than 20 years, this high risk requires a careful assessment of your personal tolerance for risk. The very definition of risk is an uncertain outcome. The current situation has never existed before. Bad may never happen. But, bad may happen and you must evaluate whether you wish to reduce the negative consequences for your personal situation.

My personal advice for most clients: Do not over-react, but you should be more conservative in your investments with larger holdings of assets that do not fluctuate until this current uncertainty diminishes. And be prepared for this period of uncertainty to last longer than most people think. Be what is called a “Careful and Prudent Investor”. 

The future can never be predicted with absolute certainty.  I highly recommend that you read my January 2018 post.   I inferred that we are in a time like the 1920's. We are seeing all of the same kinds of "beggar thy neighbor" actions by governments around the world--increased tariffs and trade barriers, changes in currency valuations, arguments over trade and in China, the same kind of "totalitarian empire rising" issues that we saw in the late 1920's and throughout the 1930's with Japan and Germany.  A crash like 1929 may not be in the cards---central banks are very unlikely to allow deflation--and it is highly unlikely there will be the type of military conflict we saw in WWII--but it is highly likely that we will be seeing a very uncomfortable and long period of "transition" as demand and supply return to a more balanced condition and we see the outcome or a more clear picture of China's military and economic rising. 

And, since central banks tend to err on the side of inflation, it is very possible that central banks may allow inflation to rise more than expected.  In that case, they are likely to react swiftly by raising rates which will slow down demand and likely cause stock markets to fall for a time. 

(Keep in mind that when central banks stimulate by expanding the money supply--there is always inflation.  In the latest round of stimulus, since 2009, the inflation has been in the price of stocks and bonds. What many fail to realize is that low interest rates mean that bond prices are "inflated". The inflation we saw in earlier periods was in good and services--consumption and hard assets like commodities, oil, copper, gold, art, collectibles, silver and real estate. The inflation we have seen since 2015 has been pretty much limited to financial assets like stocks and bonds. At some point, it is possible and even likely that "excess" holdings of stocks and bonds will be moved toward consumption and hard assets---the "old fashioned" inflation. This will likely result in dramatic drops in the prices of both stocks and bonds, with bonds no longer being the "safe" investment they have been historically.)

So, whatever occurs, be prepared for above average fluctuation in investment market prices during this transition period. 

Bull Markets Come to an End--But WHEN??

Bull Markets Come to an End

When? 

Click on Chart to see it larger

The above chart illustrates some similarities between the 1920-1930 and 2008-2018 periods. Markets saw an approximate 40% correction in 1920-1921 (adjustments to aftermath of WW1) followed by an almost 8 year rise (driven by new technologies of electricity, radio, and autos) with a brief period of exuberance—then followed by a drop of more than 60%. Nobody is predicting anything close to the 1929 scenario, but the 300%+ 8 year rise from 2009-2017 (driven by new technologies in oil/gas, internet and medical) has some similarities to the 300%+ 8 year rise in 1921-1929. Often, such periods are followed by a period of euphoria with rising prices----and then a nasty correction.  The only conclusion to be drawn, is January 2018 appears to be a time with relative high prices and a great deal of investor euphoria---investor caution seems prudent and appropriate.  

At some point in time, even the market's greatest cheerleaders admit that sooner or later some sort of “correction” is coming. When and how big is completely unknown. Be prepared by managing risk—but not necessarily completely avoiding the risk. 

Keep in mind that most of the "experts" did not see the 1929 crash coming. In the first half of 1929, markets rose 25%+.

https://www.britannica.com/event/stock-market-crash-of-1929

Bond Dilemma

I am often questioned by clients about the makeup of the "fixed income" or "bond" portion of their portfolio.  Most clients understand risk associated with stocks--but the risks associated with interest bearing investments is less well understood.

Portfolio Allocation often is oversimplified as "60/40" or "70/30" referring to the mix of stocks and "bonds".  (i.e. 60% stocks and 40% interest bearing fixed income.)  In reality, Portfolio Allocation is much more comprehensive in that it relates to the form and benefits of "diversification".

The purpose of the "interest bearing fixed income" portion of the portfolio is generally two-fold. First to provide investments that are more stable and therefore less risky. Second, to provide investments that often are negatively correlated to stocks. (Negative correlation is when stocks "zig" then bonds can "zag.) So, essentially the purpose of the "interest bearing fixed income" portion of the portfolio is to reduce the volatility and risk of the portfolio.

What is often misunderstood, is that many fixed income investments carry SIGNIFICANT risk of loss.  When interest rates rise, the market value of the "bond" can fall significantly.  The longer the "term" or "maturity" of the bond, the more it will fall.  So, when interest rates are historically low, an important part of risk management is to hold more stable fixed income investments----meaning short term.

The definition of "short term" is important. To some, a one year maturity is "short". To another, "short" is more like 90 days.  The markets often tend to now use the term "ultra-short" or "cash" for investments that mature in 90 days or less.

The graph shows the "dilemma".  (Click on graph to see it bigger.) In the last six months, as interest rates increased only slightly: Ultra Short Term Fixed Income was essentially unchanged at 0.12%; 1-3 year US Treasuries fell by 0.72%; Short Term Corporate Debt fell by 1.39%; and 10 year US Treasuries fell by 6.23%.

Imagine having $400,000.00 or 40% of your "60/40" so called "conservative" portfolio invested in 10 year US Treasury Bonds (thru mutual funds or ETF's) and suffering a $25,000.00 loss in portfolio value!

So, since 2014, with the FED and other Central Banks engaging in unprecedented interest rate reduction strategies, the risk of rising interest rates has created this dilemma: Make low interest but take low risk, or try for higher interest and take the risk of suffering substantial loss. Such is the "dilemma" always faced when evaluating the best investments for a truly diversified portfolio that carries the level of "appropriate and acceptable" risk.

Post, Post Election (The Really Big Event happened in July)

Will the election of "dark horse" Donald Trump be the biggest event of 2016? Well, certainly it is a "big event" but many, including myself think that the end of falling interest rates (rising bond prices) will be the "biggest" event with the largest financial impact. 

Today, Myles Udland wrote an great article..

2016-marked-the-end-of-the-biggest-bull-market-of-our-lifetimes

"In 2016, the nearly 40-year bond bull market ended. Date of death: July 11.

And this was the biggest economic event of the year.

“The biggest of 2016, in a weird way, was not Trump, was not Brexit, was not the end of the OPEC war back in February, it was July 11,” Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, said at a panel on Wednesday.

“On July 11, 2016, a couple weeks after Brexit, the 30-year Treasury yield fell to 2.088%. On that day, the Swiss government could borrow money for 50 years — out to 2076, a year most of us won’t be around to see — at a negative interest rate.

“And that day was the day that the greatest bull market ever, in the bond market, ended. Since then, yields have been rising. And that without a doubt is the biggest event of 2016."

For many investment professionals, a secular decline in interest rates is the only reality they’ve ever known. Since the Paul Volcker-led Federal Reserve cranked interest rates up sharply in the early 1980s to end US inflation once and for all, bond yields have been on a steady decline. Bond prices rise when yields fall.

Through the decades, however, there have been episodes of yields rising. And this is not the first time strategists have called for the end of the bond bull market. But since the early 1980s — nearly 40 years ago — interest rates in the US, and most major developed markets, have been in decline.

A move towards interest rates rising, not falling, has implications not just for financial markets but the real economy, too. Rising interest rates will pressure mortgages. Rising interest rates also make it more expensive for governments, and businesses, to borrow money."

This sentiment is being heralded by many "gurus" such as Bond Czar, Bill Gross and his former Pimco associate, now Financial Pundit, Mohamed El-Erian.


Ray Dalio is CEO of Hedge Fund, Bridgewater--largest in the world with $150 billion in invested assets. He is very smart and his commentary tells you a lot about how "big money" thinks about investing. He clearly indicates that "things are about to change".

Ray Dalio Commentary

"To clarify the distinction, one could have capable people driving conservative/right policies or one can have incapable people driving them, and the same is true for liberal/left policies. To understand where we are likely to be headed, we need to assess both. To be clear, we are more non-ideological and practical/mechanical because to us economies and markets work like machines and our job is simply to understand how the levers will be moved and what outcome the moving of them is likely to produce."

"Donald Trump is moving forcefully to policies that put the stimulation of traditional domestic manufacturing above all else, that are far more pro-business, that are much more protectionist, etc.  We won’t go down the litany of particulars about the directions, as they’re well known, discussed in my last Observations, and well conveyed in the recent big market moves. As a result, whereas the previous period was characterized by 1) increasing globalization, free trade, and global connectedness, 2) relatively innocuous fiscal policies, and 3) sluggish domestic growth, low inflation, and falling bond yields, the new period is more likely to be characterized by 1) decreasing globalization, free trade, and global connectedness, 2) aggressively stimulative fiscal policies, and 3) increased US growth, higher inflation, and rising bond yields. Of course, there will be other big shifts as well, such as pertaining to business profitability, environmental protection, foreign policies/alliances, etc. Once again, we won’t go into the whole litany of them, as they’re well known. However, the main point we’re trying to convey is that there is a good chance that we are at one of those major reversals that last a decade (like the 1970-71 shift from the 1960s period of non-inflationary growth to the 1970s decade of stagflation, or the 1980s shift to disinflationary strong growth)"

"As for the effects of this particular ideological/environmental shift, we think that there's a significant likelihood that we have made the 30-year top in bond prices. We probably have made both the secular low in inflation and the secular low in bond yields relative to inflation. When reversals of major moves (like a 30-year bull market) happen, there are many market participants who have skewed their positions (often not knowingly) to be stung and shaken out of them by the move, making the move self-reinforcing until they are shaken out."

Is this the time to buy???  Probably not. Opportunity is coming, but it will probably appear after we get the "big reset" in prices that will occur when the reality of increasing interest rates "sinks in" and becomes more certain.

Post Election

As I have often mentioned...the "stock market" is made up of "investors" and "speculating gamblers". Mr. Market fell into a severe depression as election returns came in, but somehow snapped out of it, emerging in a euphoric manic state as soon as he heard Trump's victory speech.

Before and after the election, the "speculating gamblers" were busy.  There were many smug commentators who predicted market directions who have turned out to be very wrong--as they usually are! At least in the first days, the market has gone almost exactly in the opposite direction they predicted.

There are lots of "bets" being made.  Just since Friday, 11/4:

CAT is up 15.9%. Crane maker MTW is up 44.5%.  Aerial platform and construction equipment maker OSK is up 15.4%.  

Vulcan Materials is up 18.3%. But the giant concrete supplier, CX is down 6.1%--probably because it is based in Mexico, even though it's operations in the USA are larger than in Mexico.

(Most of the rise in prices occurred before or at the open, the morning after the election!  A sure sign of computer algorithm driven gambling.)

XOM is up 5.2%. Coal miner, ARLP is up 8.8%. Coal hauling railroad, CSX is up 10.4%.

Healthcare bellweather JNJ is up 3.3%.

But, 20 year US Treasuries have fallen 5.4%. And utility ED is down 5.9%.

So the bets are all about a rise in construction, as well as a reduction in hate for fossil fuels, especially coal.  Any maybe drug companies will be able to keep raising prices.

These assumptions seem reasonable, but perhaps a bit overdone.

What I think is the most important "trend" is the expectation of higher interest rates and inflation that are underlying the fall in US Treasuries and Utility Stocks. The two most important determinants of stock prices are earnings and interest rates. And, interest rates are essentially driven by inflation expectations.

Contrary to fears of a market correction caused by uncertainty regarding Trump, the markets have priced in a "hope" of a rising economy that will result in higher corporate earnings, with added effects in part from expected cuts in corporate tax rates. This MAY be a reasonable assumption, BUT...

The "elephant in the room" is the fact that many stock prices are presently assuming a "lower for longer" scenario and the expectations about growth and tax cuts seem to indicate a high risk that this "lower for longer" scenario is wrong. IF markets abandon this "lower for longer" assumption regarding interest rates...then price to earnings ratios must decline...the market will need to be "repriced" lower even in the face of rising earnings.

The risk of the market being "repriced" continues to be high--not certain--but probable.  So, investors should be cautious, and "ready" to take advantage of lower prices later. 

Enjoy the euphoria of a market with upward momentum, but be skeptical.  The real future is still quite uncertain. 



This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

The Summer of 2016-Human Nature May be Wrong

In 2008, I wrote:

"Human nature is almost always wrong when it comes to investing. Many times, the most value a Financial Advisor can provide to a client is to help them GO AGAINST their human nature.

Our nature tells us to avoid injury by taking action in response to pain. In investing that means we want to sell that investment that has caused us pain and worry by going down in value. Investing is all about selling after prices go up and buying after prices go down."

Today, I would add, Investing is also sometimes about doing nothing. 

There are times to buy, times to sell and times to hold.

Lets take a look at two stock market indexes over just a little more than the last few months: The Dow Jones 30, a domestic only large cap index, and the DJ Global Ex US, an international only index.

In May, 2015, the DOW30 was at 18272.  Eight short months later, it had fallen 12.5% to 15973 in February, 2016. Six months later, now it is around 18470, up 15.6% since February but up only 1.2% since May, 2015. Like US bonds that are paying historically low interest rates, the domestic stock market over the last year has had a pretty anemic performance. 

In May, 2015, the DJ Global Ex US was at 246. It fell 25% by February, 2016. It has since risen 14.2% to about 211, but is lower by 14% from May, 2015. Like many international bonds with negative interest rates, the international stock market over the last year has had negative returns.

Despite, on average, poor corporate earnings growth, there is a "sentiment" by many that stocks are a "buy" because "there is no better alternative". Hence, the dramatic rise in both domestic and international stocks since February.

Stocks, by any measure, with the exception of the Energy Sector are historically overvalued. Some sectors, more than others.

On the other hand, there are many that see this recent rise and headlines of markets reaching "all time highs" as a sign to "sell" and take profits.

So, let me say again: "Human nature is almost always wrong when it comes to investing. Many times, the most value a Financial Advisor can provide to a client is to help them GO AGAINST their human nature."

The time to buy is when you have a reasonably strong and rational conviction that you are BOTH getting a good price and buying something with good prospects for growth. The time to sell is when you have a reasonably strong and rational conviction that you are getting a good price and selling something that has no good prospects for the future. (Getting a good price by the way has nothing to do with how much profit you have made--more on that later.)

The time to hold is when it not certain that you can buy or sell at a "good" price and you are not certain about the future prospects for growth. 

That "good price" for buying or selling has nothing to do with the past---it has only to do with the future.  A stock that has gone up in price in the past may or may not be an attractive stock to buy. What makes it attractive is whether it will produce dividend income and capital gains in the future. A stock to sell has nothing to do with it being a "dog" having declined in price in the past. And, a time to sell has little to do with a stock recently hitting a "all time high". What makes it a candidate for selling is that it's future prospects look bleak. 

I repeat: "Stocks, by any measure, with the exception of the Energy Sector are historically overvalued. Some sectors, more than others."  But, despite being historically overvalued, with a possibility of a price decline in the short run, I do not see a future bleak enough to justify any significant selling..nor with the exception of the Energy Sector, do I presently see any stocks that have BOTH a good price and good future prospects. 

Since we are in a period of high uncertainty, HOLD seems to be the wisest course of action, at least for now. Things change rapidly.  A significant pullback could create some interesting buying opportunities for long term investors. 

I never recommend significant adjustments to a sound long term investment strategy unless we see some indication that markets will fall far enough and stay low long enough to justify the risk of missing the gains when markets recover from excessive fear. At this time there does not appear to be any such indication.This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.