My Trip to the NYSE

http://www.cnbc.com/id/15840232/?video=1545073625&play=1  Above is my interview at the NYSE with Mark Haines and Simon Hobbs this AM. I'm not sure what war Mr. Hobbs is talking about but maybe you can tell me. I'm just trying to change the perilous direction the country is headed in. Seems to me that anyone saying that the U.S. can borrow to infinity with rates staying low is setting the table for disaster.

Congrats to the Fed

My compliments go out to the Fed. I'm not sure how they did it but they have managed to cause nearly everyone on Main and Wall Street to fret over deflation. But just because we have one or two months of sequential declines in CPI and PPI, doesn't mean that deflation has become a secular trend.

Are Stocks Really Cheap?

Perma-shills have been claiming of late that the stock market is now trading at an enticing valuation. Their main evidence for this, as they are fond to claim, is that the forward Price to earnings multiple is 12 times next year's earnings for the S&P 500. And, of course, a 12 PE multiple makes stocks cheap and the overall market a buy.

But for investors who want to accurately assess that number, there are two issues they should be aware of. First, the PE ratio isn't a good measure of the near term direction for the market. And second, nobody knows what the forward PE will actually be. Some pundits like to use that forward looking number because, when corporate earnings are projected to rise-as they almost always are-the PE ratio will look better.

So let's get into some real numbers that will help determine if the market is indeed cheap.

For Q1 2010, the PE ratio on the reported trailing twelve month earnings for the S&P 500 is 15.5. Historically speaking, the average PE ratio on the S&P is about 15 times earnings. So therefore, if one isn't promoting an ebullient guess as to what earnings will be in the future, the market is currently just fairly priced on a PE basis. Also, the PE ratio on an inflation adjusted average over the previous ten year period has ranged from 4.78 in December of 1920 to 44.2 in December of 1999. With such a wide range of valuations, it is difficult at best to make a case to buy or sell stocks solely on a PE basis. There are other factors like; the direction of inflation and interest rates that are necessary to consider when evaluating the PE ratio.

Some market cheerleaders also like to use the inverse of the PE ratio called the earnings yield when comparing stock prices to bonds. They say; with the current earnings yield being 6.4% and the Ten year note yielding around 3% that stocks are a great value. Again, there are problems here too. Firstly, investors don't earn the earnings yield as they do with dividends. And as mentioned, the earnings yield is merely the reciprocal of the PE ratio. The fact that the yields on government bonds are significantly below the earnings yield on stocks is merely an indication of the egregiously overvalued state of the U.S. debt market.

Rather than pick one or two statistics like the forward PE ratio or the earnings yield to convey an opinion on stocks, here are several important facts that will help you decide the future direction of the market.

A good metric to determine the valuation of stocks is the dividend yield. The current dividend yield on the S&P is a paltry 2.1%. The historical average dividend yield is a much greater 4.36%. The lowest dividend yield was 1.11%, which was reached in August of 2000. The highest dividend yield was 13. 84%, this was achieved in June 1932. Therefore, on a dividend yield basis, the market is currently significantly overpriced. To add salt in the wound of those low yielding stocks, tax rates on dividends are scheduled to increase significantly in 2011. Maybe that is the reason why all the cash sitting idle on corporate balance sheets isn't being sent back to investors in the form of dividends?

According to the Investment Company Institute, mutual fund cash levels are at a decade low. Cash levels as a percent of assets reached a cyclical high of 12% in 1991. Today, that ratio is less than 4%. With mutual funds already nearly fully invested where will the money come from to take stocks higher?

The Fed's balance sheet is at a record high $2.3 trillion. The unwinding of that balance sheet will send interest rates on their $1.1 trillion In Mortgage Backed Securities (MBS) soaring and will thus further damage the real estate market, stifle earnings growth and depress GDP growth. The Fed must also find buyers for all that MBS debt. This will crowd out investments that would have normally been made into stocks.

Household debt and the Gross National debt have never been at or above 90% of GDP at the same time. For the first time in U.S. history, that is the case today. Along with the massive deleveraging that still lies ahead for both the public and private sectors, the Treasury must auction off close to $9 trillion in debt each year to cover our ballooning deficits and to satisfy rollovers. This will further crowd out investments that could have been better placed into the stock market.

Once you view the real numbers on PE ratios and dividend yields it is hard to make an argument that stocks are cheap. And given the low levels of cash that exist at mutual funds and the crowding out of private investments that is taking place from the government, investors will find it difficult to assume the market can produce a sustainable rally of any real significance.

The only disclaimer here is if the Fed embarks on another doubling of its balance sheet in an attempt to crush whatever life is left in the value of the U.S. dollar. Then, in that case the market may rally in nominal terms. But you had better own precious metals and the companies that pull the stuff out of the ground if you want to earn a positive return after inflation.

Geithner: The Good and the Ugly

The Treasury Secretary conducted an interview with my friend Larry Kudlow this week. There was some good, and a whole lot bad with that interview. First the good. Treasury Sec. Geithner wants the capital gains and dividend tax to increase to only 20% instead of going to 39%. Here is Tim in his own words:

No Fuel for a Lasting Rally

Mutual fund cash levels are near an all time record low. So where will the fuel come from to engender a sustainable rally in stocks? Linked here is a chart of mutual fund cash levels. When cash levels get around 4% (as they are today) stocks usually sell off; not rally. And the inverse is also true. Cash levels must also increase significantly before the bear market ends.

The rally of yesterday is being heralded as the death of the double-dip recession theory and the beginning of a new bull market. But where is that money to send the market higher going to come from? Investors can't tap the equity in their real estate holdings and they aren't going to get it from wage increases either.

Be careful not to get sucked into believing all is well.

Double-Dips are Rare So...

Are your minds yet at ease? Have they not assured you all by saying that double-dip recessions are very rare indeed? In fact, their claim is they almost never occur.

While that is the truth, the important take away from that is; who cares? What exactly does that tell you other than this upcoming double-dip recession will be an aberration? In the roughly 130 years of stock market history, there is almost nothing we can say that happens so infrequently that the probabilities of reoccurring are infinitesimal.  There just hasn't been enough history to make that sort of judgment.

We have a synchronized global economic slowdown coupled with metastasizing sovereign debt crises, which was engendered by a massive amount of debt incurred on both the public and private sector levels. Those situations happen very rarely, but when they do, you get a depression.

GDP shrank by 3.6% during the Great Recession. During the Great Depression it shrank by 32%. Since we have yet to allow a depression to occur this time around; one must be still on the way.

Now I know what they say; the government has avoided another depression by spending and printing the economy into prosperity. So we don't have to pay for our transgressions because we can borrow money to pay off our debt as we inflate away the purchasing power of our currency.

Yeah sure, that will solve everything!

Non-Farm Payrollls: June Gloom

The June Non-farm payroll report gives more credence to the double-dip recession story. The BLS reported that a total of 125k people become unemployed last month. The only quasi-good news in the report was that 83k private sector jobs were created. Still far below the total needed to keep the unemployment rate from rising if job-seekers stay in the labor force. The bad news was that hours worked were down, earnings were down and the labor force shrank.

Average hourly earnings fell 2 cents to $22.53 in June, today's report showed. The average work week for all workers declined to 34.1 hours in June from 34.2 hours the prior month. And because people are becoming despondent in their search for employment, 652,000 people left the labor force last month.

The report from the BLS was not only disappointing on a headline basis, but digging into the report gives little support for better news in the coming months.

But all this makes perfect sense to me. Government spending and central bank money printing doesn't create jobs. Lower taxes, lower interest rates, increased savings, lowering inflation, reduced regulations, a stable currency and declining debt loads do. Those conditions are engendered when the government allows the free market to prosper. We are doing everything wrong.

Why The Greater Depression Still Lies Ahead

If one does not know the real cause of a problem, they should also be unable to provide a genuine solution.

Messrs Obama, Bernanke and Geithner do not understand the real cause of this debt crisis. They are politicians first and economists or students of the market second; if at all. Therefore, it is not wise to ask them if the great recession is indeed over, or for them to provide a plan to prevent another from occurring in the future.

The cause of the Great Depression in the 1930's and the Great Recession beginning in 2007 was an overleveraged economy. An overleveraged economy is the direct result of artificially-provided low interest rates from the central bank and superfluous lending on the part of commercial banks. That easy money provided by banks eventually brings debt levels in the economy to an unsustainable level. At that point, the only real and viable solution is for the public and private sector to undergo a protracted period of deleveraging. The ensuing depression is, in actuality, the healing process at work, which is marked by the selling of assets and the paying down of debt.

However, all efforts on the part of our politicians today are to fight the natural healing process and to promote the accumulation of more debt. During this latest economic contraction, the Fed took interest rates to near zero percent and the administration is leveraging up the public sector to record levels in order to re-leverage the private sector. The government's philosophy is tantamount to sticking a frost bitten man in the freezer so he won't have to suffer the pain associated with thawing off his extremities.

During the Great Depression, real GDP plummeted 32%. According to the National Bureau of Economic Research, this Great Recession--which we are still struggling through--began in December of 2007. In contrast to the 1930's, during this recession GDP shrank only 3.6% from Q4 2007 to its low point, which was reached in Q2 of 2009. And from Q4 2007 to the latest reading on output in Q1 2010, GDP contracted a total of just 1.1%. 

But the contraction in GDP which occurred during the Great Depression was the direct result of consumers paying down debt and selling off assets. Household debt as a percentage of GDP reached nearly 100% in 1929. The only other year it approached that level was in Q1 of 2009. To put that number into perspective, after the depression ended Household debt did not go back above 50% of GDP until the third quarter of 1985.

From the start of the depression to the end of WW11, Household debt fell from 100% to just above 20% of GDP. Although it was a painful process, it was the only real solution to an economy soaked in debt. But today, thanks to government efforts to carry on our debt-fueled consumption binge, this current Great Recession has witnessed Household debt barely contract at all; it fell to 92.53% of GDP in Q1 2010.

To make matters even worse, during this current crisis our government's response to the economic contraction has been to dramatically increase their borrowing. At the start of the great depression, gross Federal debt was just 16% of GDP. It peaked at just fewer than 44% by the time the depression ended. So while the National debt did increase significantly during that period, it still was relatively benign when viewed from a historical perspective. At the start of this Great Recession, the gross National Debt was 65% of GDP. Today it has exploded to 90% of GDP! Therefore, if you compare the relatively innocuous level of debt in the 1930's with that of today, it clearly illustrates the perilous state of the economy.

While it is true that the National Debt did rise dramatically during WW11 (120% in 1946), consumer debt plunged concurrently. So while the nation was adding on debt during the process of fighting and winning the Second World War, households were taking the necessary steps to ensure their balance sheets were well prepared for the aftermath of the battle.

Today, for the first time in our history both the gross national debt and household debt are at or above 90% of GDP.

Many are contending-unfortunately most of those in power at this time--that the government must spend more while the consumer contracts. Their hopes are based in the belief that once the economy gets going they can unwind that debt. There are two problems with this Keynesian theory. One is that government spending doesn't increase GDP; it only serves to choke off private sector growth. And the other is that the government never believes it's ever a good time to pay off the debt incurred. Therefore, the country is left with a private sector that is contracting and with a massive overhang of debt. That contraction in growth exacerbates debt to GDP levels even further.

Since we have yet to address the real cause of this recession, we are moving inexorably closer to causing The Greater Depression. And a long period of debt reconciliation still lies ahead.

If one does not understand that the progenitor of a depression is debt, they will also be unable to provide the genuine solution, which is the process of deleveraging.

 

 

 

Just Get In

Investors need to get back into the market to save for retirement. Or so says Robert Reynolds of Putnam Investments. But the past 12 years have been devastating to those who embraced the buy and hold market strategy.

In the 80's; tax rates were coming down, regulations were being cut, inflation was coming down from 15% to 2% and interest rates were plummeting from 20% to 6%.

Today we see the exact opposite occurring. But Mr. Reynolds says there is cash on the sidelines (which is bull crap) and that earnings will have a better year in 2011 than in 2010. He also says that "the market climbs a wall of worry" and that investors should "dollar cost average" and that he is "very, very bullish." No real facts to give you. Just the idea that he likes the market. Oh, he also thinks the market looks attractive from a value standpoint.

What keen insight! With such trite sayings coming from the CEO of Putnam Investments, it's no wonder the average investor has given up on Wall Street.

Saving Money is Good

Some good news for a change. Personal Income increased more than expenditures. Therefore, savings increased for the month. Consumer purchases rose 0.2 percent, Commerce Department figures showed today. Incomes climbed 0.4 percent, and the savings rate increased to the highest level in eight months.

Now, I don't fret over savings like most economists do. Without savings there can be no investment. Investments are needed to grow the economy. There is no such thing as the paradox of thrift, where consumers can save themselves into oblivion. If those savings are turned into loans for the creation of capital goods then everybody wins. As savings increase interest rates fall. If they fall far enough, people will stop saving and start consuming. That's how it's supposed to work in a free market economy. I wish we still had one.

I like good news, I'm just not convinced it will last.