Wednesday, July 24, 2019

Inflection Point

We have reached the crucial phase in the stimulus cycle. This is something that I realized from the history of the stock market in relationship to our economy. The boom-bust business cycle is the work of Keynesian economics. Don't get me work. We have had boom-bust periods prior to his theory, but they fall under the old problems of over-capacity, tariff, trade and currency. Keynesian Theory says government should provide stimulus to cover downturns in the economy. My problem with him is there is no mention of re-paying government for the debt incurred by providing stimulus. This debt burden causes conflict in the bond market as government edges out private concerns for access to money. This is how inflation rises. Demand raises price. With interest rates rising, the price for money goes up. This is inflationary.

Enter the Fed

Modern central banks use monetary policy to stop this type of inflation. By controlling interest rates, central banks can engineer money. Lower interest rates and keep the price of money from rising. This is all well and good on paper except man is greedy. He will work the system. Of course, you can replace the word man for nations. Nations use many other types of manipulation to gain an edge. They use currency manipulation like Japan, China and EU. Nations can use tariffs like every nation in the world and the latest technique. They use regulations, however those concerns are not what is worrying the market today.

Market Today

The market is rising on the wall of worry. The market realizes that this stimulus, bull cycle is the longest on record. The evaluations are rising. Stocks are no longer cheap. The Fed entered the equation by changing policy. They began to raise rates, This caused a knee jerk response by the market. To counter this action, the new president put pressure on the Fed to lower rates, again. Then, we had conflict in the other areas of the economy, mainly tariffs and trade. On the surface all those influences added a gloomy projection to the market and to the economy. However, there was an inner feeling that a trade deal would happen and the Fed will do what the market wants, be accommodative. This battle between the bulls and bears became more evident as we enter the earnings season.

Earnings, Cap Ratio and GDP

As I say in my unpublished book, all things are connected. Earnings have been rising in relationship to the GDP since the 1990s. Historically, there is a cap ratio between earnings and GDP. The average is 80 and the highest level was 148 back in 2000. Then, we had the bust. Today, the level is 146. This is your wealth gap. The market cap is 80% higher than the norm. This is trouble in a big way. With that info, there are other, more deeply concerns behind the scenes. The banks reported solid earnings, but the transports hit bear territory in June. They could not rise to their old high while the rest of the market was hitting new highs. This discrepancy showed when CSX, a very large railroad reported a terrible quarter. They used excuses like the weather, but core business was weak. The other two main railroads reported earnings that met expectations. So, what does this mean? We have to look at the market leaders to see more evidence or we can listen to the views of two CEOs.

Morgan Stanley vs. Blackrock

The CEO of Morgan sees trouble ahead. Take your money out and wait to a better reentry point. Blackrock says, "Stay the course!" Sebastian offers this view...
*FB =                                      is in a sideways action.
*NFLX =                                is down 70 points from high.
*AMZN =                               is trading sideways.
*GOOG =                               is down 150 points from high
*MSFT =                                is up at record levels.
Result =                                  in conclusive.

Other Important Indicators

The semiconductor industry has pre-warned the market. They claim not to meet expectations. We have seen this movie before. CEOs sandbag and then, report better earnings. We will see shortly.
However, we do have solid evidence with a manufacturer in Fastenal. This giant firm is worth $17 billion. They had a bad quarter with an even worse outlook. Peter Boockvar at Bleakley Advisory says, "Global manufacturing is in retraction." The Shanghai Exchange plummeted last week. Next, we have the airlines. According to Boeing, the fix on the 737 Max would be done by now. The reality is maybe by January 2020? In addition, the company will take a $5 billion charge and they also said costs are rising. Not good. They are not alone, Textron, an aerospace giant, also reported a weak quarter and weaker outlook. Then, the most important commodity, oil. There is a glut and the outlook says oil firms will enter a bear market. Finally, the auto industry. Sales are steady even with prices rising. On the flip-side auto loan delinquency is rising. This is bad for bond loans and the economy in general. Many of the above issues has seen the transports fall steeply from its high. This poses a conflict in Dow Theory which requires both indexes to rise concurrently. Adding the pluses and minuses leads to the next point which has Sebastian siding with Morgan Stanley.

Bank of International Settlements(BIS)

They reported that corporations in the US have added $9 trillion in debt. They estimate that one in six companies are walking dead or zombies. A zombie corporation is one that does not meet expenses with its budget. They borrow cheap money and banks lend in this low interest environment. This is how they stay in business. It is blood for Dracula CEOs. If one derivative or missed payment happens, this horror film will burst on the scene. By the way, China is an empire of zombie firms. Anyway, banks realize that these firms could be toxic. They bundle these loans into collateralized obligations(CLOs). They are presented as high-yield investments. Pension funds, hedge funds and mutual buy them.
Covenant lite
For bond holders it means no protection. After bankruptcy, you get next to nothing. Case in point: Last Friday, 4L Technologies dived. Moody's says it will default. This is what the BIS study refers too. This is spreading the disease. This is repeating the sins of 2008. Now, those high-yield
junk bonds are showing up in the yield curve in the most dreaded fashion: the inverted yield. If banks get nervous like with the Fed tightening, they will stop lending. This will kill the zombie firms. Banks are first in line for assets, but bond holders get screwed. This destroys lending and bonds which causes layoffs and then, a recession. Maybe this is the real reason why the Fed is indicating another change in monetary policy. Back to rate cuts. Back to cheap money. Eventually, this leads to inflation. Bottom line: If you want to be able to afford to go to the movies to see this horror film, get some gold.