The hyper stimulated "reopen" trade is feeding narratives that are simply wrong. Traders looking to find greater fools are spinning tales from soundbites, tweets and out of context data into today's echo chamber half truths.
Here is a truth to know and understand: there is no organic economic or stock market boom going on. What we are seeing is the impact of massive monetary and fiscal stimulus far in excess of what was financially lost from COVID-19.
We are in the midst of a multi-generational slowdown in long-term economic growth brought on primarily by aging demographics. In addition, massive amounts of debt are complicating the situation as counter parties likely can't be counted on when things get tough. Finally, technology has a disinflationary impact that is hard for governments to overcome as businesses become more efficient.
Eventually, the cost of the stimulus will exceed the benefits by so much that financial equations will need to be reset. This event or series of events will have a trigger, but it will not be due to some unforeseen black swan or swans.
Rather, what's coming is knowable and can be prepared for. What won't work though for most wannabe superstar trader chasers is a last minute escape from whatever elevator shaft they are playing in.
Make no mistake, I think the economic future can be bright. But it will take a lot to make it happen. And, to make the economy work, it just might be a drag on the stock and bond markets.
Demographics Is Destiny
We know that America and many other nations, including the next three biggest economies of the EU, China and Japan, are aging. Just these four large economies aggregate to a little more than half of the world's GDP:
Why is this important? During our lives there's a normal spending pattern. We spend the most during our household formation years when we're buying houses, cars and raising children. Our spending levels off in middle age as we save more for retirement. Finally, in retirement, our spending gradually falls until there's a spike in healthcare near the end of our lives.
We've almost all seen Harry Dent's charts on this. For those who haven't, here's his famous spending wave for the United States lagged for births and immigration.
The two charts above are a few years old, but demographics change slowly, so it doesn't matter, which is an important aspect to realize. Interestingly, immigration was greatly curtailed the past few years in America which likely skews the spending wave chart negatively a bit.
What we can see is that the Baby Boomers led the economy for decades. Both up and down. Nothing new for those following along at home.
In the years leading up to the financial crisis, Boomer spending peaked and began the turning over process. This coincided with a period of speculative frenzy in markets.
While correlation is never 100%, it's easy to consider that slowing spending running into a speculative mania with loose oversight and hot money contributed greatly to the Great Recession.
In the next three largest economies, and even some emerging economies, demographics are worse or getting worse fast. India appears to be a bright spot long-term despite their current tragedy.
What does this all mean? To put it simplistically, with global population aging, growth is slowing down. In fact, there's not enough demographically driven growth to support rising standards of living on a per capita basis across the entire planet and probably hasn't been in over a decade.
I first heard John Mauldin call what is going on the "muddle through economy" at an investment conference about a decade ago. As I mentioned, I've been calling it the "slow growth forever" economy since about the same time.
If we took the time to parse out the math here (there are better papers than what a few paragraphs from me would do justice), we would see that without government and central bank stimulus, the economy would likely have been stuck in a deflationary period since 2008.
Consider this chart I have put out recently. It shows that the cost of stimulus already is higher than the growth we're getting for it:
What this all adds up to is that we need growth from something other than population growth and people pulling out of poverty to lift global living standards higher.
What if we do not get that "something else?" Then I believe it means we see another "lackluster recovery" as some call the period after the Great Recession.
It also means, as I've argued before, that "helicopter money is inevitable." We will need it to rebuild the world creating growth until demographics and population smooth out in the second half of the century.
Enter A Black Swan Event: The COVID-19 Pandemic
The global coronavirus COVID-19 pandemic that started late in 2019 is probably the most significant economic event in modern history. I'm taking nothing away from the Great Depression, the World Wars or Great Recession.
We have never seen the economy literally stopped in its tracks before. The pandemic is the definition of a black swan event. It was unknowable until it happened.
Just before the pandemic, the United States already had been in stealth bailout mode to prevent the Repo market from collapsing. The Fed provided nearly a trillion dollars of stimulus from September 2019 to February 2020 to keep overnight financial lending from seizing up.
Why was that happening. Again, there's much more to say than a few paragraphs here will do justice, but it's tied to the questionable quality of counter parties in an age where organic growth is challenged at best.
At the same time, stocks were running up as excess liquidity entered the markets through the banking system. Here's a chart from my 2020 Outlook: From Euphoria To Despair.
You'll see that in January of 2020 the stock market already was historically overvalued. This despite, or because of, the Federal Reserve pumping money back into the financial system after a minor reduction of post financial crisis liquidity:
So, with the U.S. economy challenged by aging demographics, what we thought was overwhelming debt at the time, overvalued stocks, financial markets suspicious and the Fed already in bailout mode, the pandemic hit.
I would argue that the Coronavirus Crash of 2020 was triggered by the pandemic, but the conditions were already in place for something bad to happen.
GDP gave up three years of economic growth in one quarter.
Earnings fell over 14%, but did not plumb the depths of the Bernanke/Yellen QE years. But now, earnings have already fully recovered.
So, how is it that such a massive economic event, has largely been overcome, at least in aggregate in so short a time?
Firepower From Federal Reserve
I know there's a cult-like chant to bash Federal Reserve policies. And it's interesting to me that some corners of trader euphoria point to the Fed "pumping the market" while simultaneously going on and on about how we need cryptocurrency to displace the Fed. I wonder, what would they would say if the Fed, or dollar, were displaced and stocks crashed?
In 2015, just as markets were entering two choppy years that saw no gains in the stock market indexes. I wrote this on MarketWatch:
In response to the pandemic, after already reversing the normalization process due to a collapsing Repo market, the Fed did this: Operation "QE J-Pow."
I think that massive liquidity injections were necessary to pull the economy out of lurches with the least amount of short-term pain. Virtually all of the evidence supports that, feel free to look it up yourself to save me the regurgitation.
But I also believe that those injections in an environment of loosening regulation and tax cuts that go mostly to the investor class, i.e. about 10% of us, but mostly 1/2% of not us, quantitative easing has certainly exasperated wealth inequality and brought all the populist reaction with it we have seen recently.
Moving on, we can see GDP shrunk about $2 trillion in 2020. However, the Fed balance sheet grew by over $3 trillion in response. Does that seem as if the pandemic were the only problem?
The COVID-19 pandemic gave central banks an excuse to oversaturate the financial landscape with monetary fertilizer. Liquidity injected into the financial system by the Federal Reserve, and other central banks, is on a scale never before seen.
With numbers so big is it hard wrap our minds around how much is the Fed QEing? So, let's put it this way. QE has crossed the threshold to actually printing money.
You may ask, if there's debt attached, is it money printing? My answer is now "yes." Why? Because debt is only a debt if you intend to repay it someday. The Fed and other central banks have no such intention (more on that another time).
What the Fed is doing now is roughly equivalent to Modern Monetary Theory. Nobody will acknowledge it because of the theoretical implications and political ramifications, but I don't think we can see it any other way, unless we actually expect the money to be paid back (uh-huh).
I understand why crypto is taking off. I told my subscribers to buy Bitcoin (BTC-USD) last summer with part of their banks savings because of the frenzy that was starting and the chance that Bitcoin crosses from casino chip to commodity (likely) or currency (unlikely).
But I also know that the central banks and governments will not allow their currencies and financial controls to be displaced. And that's probably actually good, because without the inflationary policy, we would likely see a dystopian slide into deflation.
So, what's the bottom line? I think it's this.
Massive QE was necessary after the Great Recession and Coronavirus Crash because of the way the financial and economic systems have developed the past 50 years or so (think petrodollar) in conjunction with aging demographics which we have understood for about as long (hmmm).
The impact of all this monetary stimulus has been two fold.
We're seeing the first semblance of inflation in two generations. Let me repeat that, the Federal Reserve and other central banks are printing so much money now that they have finally overcome 40 years of deflationary pressure - for at least a hot minute.
We're also seeing the limits of monetary policy as wealth inequality is getting to the point of creating populist factions within western civilization that are becoming increasingly violent. And, for what it's worth, interest rates around zero and 1% are pretty low.
Investors also should keep in mind that Chairman Powell is not likely to get another term as he has supported loosening of financial regulation. Even if a new Fed Chairperson is not notably tighter on monetary policy, that person will likely be tougher on regulation.
Santa Biden Is Here With Fiscal Treats
Build Back Better is a crummy slogan, but there's a huge element of truth to it. I have told subscribers for years that to finally put to rest deflationary pressure, we need to "rebuild the world." If you watch my webinars you've heard me say it over and over.
Why is rebuilding the world so important? Because what else is there? Without useful infrastructure and creative destruction, the economy does not grow absent of demographically driven demand growth.
So, President Biden is suggesting a massive infrastructure bill (much like President Trump) and other fiscal spending to drive demand growth from the middle out and bottom up. The devil of course, is in the details and most of us don't have time or tolerance for details.
If we presume that the combined fiscal packages are around $4 trillion and the tax increases on the investor class aren't as high as suggested (thank you Joe Manchin), then again, I'd ask, how big is the growth deficit? Remember, a $2T reduction of GDP in 2020, but we're heading for a combined monetary and fiscal stimulus since last March about to go over $10 trillion.
Here's what I think investors need to watch. As fiscal stimulus comes into the economy, if it drives jobs growth, which it likely will, then inflation could become more disruptive. Janet Yellen just told us that there are plenty of monetary tools to control inflation.
While I don't think it would take much in monetary tightening to quell inflation in the face of generational deflationary pressures, with the shift to fiscal policy clearly on, it begs the question, just how big of a taper tantrum do we get the next time the word "normal" is used in a sentence having to do with monetary policy.
Overvaluation Matters Eventually
Back to the how the markets will and should react to all of this. First off, valuations always matter eventually. Always. I have said this in a dozen articles the past five quarters.
In an article this week titled "Take A Bow, Jay Pow" Jesse Felder points out many of the same things I have.
The Buffett Indicator...
S&P 500 valuation...
... and more.
There's so much more to say about valuations, but I'll pick this one metric to make my point. According to Stock Rover there are only 47 S&P 500 (SPY) (VOO) stocks trading with EV/EBIT of 10 or lower, i.e. the area where private equity firms feel there is some value.
That means that 90% of the S&P 500 is likely overvalued by some amount compared to historic norms according to a preeminent group of value vultures.
I do not know if there will be a massive correction. I do think as monetary policy gives the lead to fiscal policy though, and liquidity shifts away from financial markets, that there will be some form of correction or corrections.
Markets of course can remain irrational a long time. I'm not shorting anything because of the power of the trading herd so long as they can get margin and have the firepower to bid up calls.
I am on record as suggesting that the rest of 2021 can look a lot like 2015-16. Choppy and with indexes not any higher by year-end.
What Investors Should Always Do
I'm not going to try to tell swing traders what to do because I know that none of them would ever get caught in an elevator drop correction.
Position traders, i.e. longer-term investors generally holding investments for years, I would point out this metric:
It's important to monitor your asset allocation and to truly know what you have at risk. Look at the EV/EBITDA ratios (for most industries). For REITs break down what the AFFO truly is likely to be if rents do not fully rebound in a particular segment.
A simple rotation away from sectors and industries with secular or government headwinds or that rely on exceptionally easy money is a good first step. I wouldn't own a big bank if my life depended on it as they are completely tied to the economy and offer no real upside vs. the indexes now that they have to dance to the song of the Fed's monetization of U.S. debt.
Overall, rotate to quality and higher growth. This should go without saying, but too many investors hold onto mediocre investments that have full market risk without any additional upside.
Focus on sectors and industries with a secular tailwind and government support. These are the first two steps of our four-step process which includes:
- Analyzing secular trends
- Assessing government and central bank policy
- Diving into industry and company fundamentals
- Applying technical analysis
Ultimately, only include investments in companies that you think can beat the market by a lot and that don't have much downside. Easier said than done, I know. But that focus will raise the bar for your overall portfolio and create a bigger margin of safety for you. I will talk more about how I pick out stocks in upcoming articles where I reveal 10 companies we are invested in now.