Thursday, August 20, 2020

Stocks could fall 30 to 40 percent from its recent highs

There is no shortage of investors shrugging off the latest leg lower in U.S. Treasury bond yields, saying heavy central bank involvement in this part of the financial market make such moves less of a signal that the economy or that equities are headed for trouble. That interpretation would be a mistake.

Recall that yields on 30-year government bonds started to decline on Jan. 2, anticipating the fallout from the budding coronavirus crisis that had taken hold in China. Yields fell from 2.34% on that day to 0.94% on March 9, as the price of the benchmark 30-year bond leaped 29%. Only on Feb. 19—seven weeks later—did the S&P 500 Index begin its 35% slide. Fast forward and 30-year yields have fallen from 1.66% on June 8 to a recent 1.19% as their prices climbed 9%. The question is whether stocks will follow again, and with a similar lag of about seven weeks.

The fundamental economic scene favors a repeat. The situation is ghastly, with Covid-19 infections accelerating and plans for physical classes at many schools, colleges and universities this fall risking further contagion. Staying closed or holding virtual classes, however, promotes dropouts, pressure to cut tuition and fees and financial disaster for many schools. Then there are the problems of reopening businesses, re-establishing and reorienting supply chains and encouraging many to return to work who are now paid more by federal and state unemployment benefits than when they were employed.

The recent Treasury bond rally fits with our forecast that the recession has a second, more serious leg that will extend well into 2021, despite massive monetary and fiscal stimulus. Declining business activity saps private credit demand and makes Treasuries shine as havens. A deep recession also breeds deflation to the benefit of Treasuries. The government said Thursday that its core personal consumption expenditure index, which is what the Federal Reserve uses to track inflation, fell 1.1% in the second quarter.

Over the entire post-World War II era, the correlation between Treasury bond yields and inflation as measured by the Consumer Price Index is 60%. This is remarkably strong considering all the other possible influences on long-term interest rates such as federal budget deficits, wars, consumer sentiment and spending, and government actions. My forecast of Treasury bond yields starts and ends with my projection of inflation.

The spread between 10-year Treasury Inflation-Protected Security yields and conventional 10-year Treasury yields, which is what bond traders expect inflation to average over the life of the securities, recently dropped to a miniscule 0.50% from 2.5% in 2012.

Treasury bond investors concentrate on inflation, Fed policy and not much else. In contrast, equity mavens worry about a whole host of often conflicting issues such as corporate finances, profits, price-to-earnings ratios, to name just a few.

Sure, the Fed has been buying Treasuries and along with other fixed-income securities, so its assets have exploded to $7 trillion from around $4 trillion in February. Nevertheless, all this Fed-created liquidity hasn’t found its way into the real economy, as shown by the collapse in the velocity of money.

Then there is the argument that, except for a handful of technology shares such as Facebook Inc., Inc., Apple Inc., Microsoft Corp. and Google-parent company Alphabet Inc., the stock market continues to be weak. Goldman Sachs Group Inc. notes that these five have added more than a third to their market values this year, despite the sharpest recession since the Great Depression.

The S&P 500 is up 0.5% for the year thanks to the strength of those five companies, but the other 495 members are down about 5% on average on a market cap-weighted basis. Still, that 5% decline pales in comparison to the earlier 35% plunge in the S&P 500. Goldman Sachs calculates that if those five tech stocks were to fall 10%, the bottom 100 in the S&P 500 would need to jump 90% to offset the decline.

A Tale of Two Markets

Tech stocks have benefited from their relative independence from the nuts-and-bolts economy. Also, they’ve gotten a boost from homebound Americans who have replaced face-to-face contact with telecommunications. But they are very expensive and under fire from Washington and Europe for anti-competitive practices. And fads end. Recall the craze for Socks the Puppet and his dot-com buddies in the late 1990s. When that bubble broke, the Nasdaq Composite Index plunged 78%.

Also recall the so-called Nifty Fifty group of stocks in the early 1970s. When the only companies of interest to investors made gimmick cameras, ran amusement parks and built motor homes, it was clear the basic economy was in trouble. What followed was the severe 1973-1975 recession and deep bear market.

I believe the bond rally signals a renewed drop in stocks, with the S&P 500 down 30% to 40% from here as the great depth and length of the recession hits home.


Wednesday, May 6, 2020

Gary Shillings on big governments getting bigger

Gary Shillings talks about US Government policies and what can be done to improve the US economy and encourage people to work.

The corona-virus pandemic and its devastating effect on the U.S. economy has ensured that big government–the one that’s already spending some $4.7 trillion in the current fiscal year–is poised to get even larger. As in past crises that led to massive government interventions, new initiatives will largely stay in place once the business downturn ends to the long-term detriment of the economy, despite the “temporary” intentions of these programs.

Ronald Reagan once likened a government program to “the nearest thing to eternal life we’ll ever see on this earth.” A look at history suggests that once a new program or a new agency is established, with few exceptions, it stays established, regardless of whether it was intended to be temporary, whether it’s still needed and whether it actually solved the problem it was created to address.

Before the 1930s economic collapse, there was no federal safety net. State and local governments as well as charities generally looked after the less-fortunate, there were few pension systems in the U.S. and Washington’s role in providing assistance was minimal. The federal budget in 1929 amounted to about $3 billion, or 3% of total output, a fraction of today’s $4.7 trillion budget that accounts for some 21% of gross domestic product. That number will surely grow as federal spending surges, the  economy shrinks and tax collections fall.

The Great Depression marked the start of far-reaching and long-lasting federal government involvement in the economy as Washington strived to blunt the impact of the economic free-fall. The New Deal saw the establishment of numerous “alphabet agencies,” many of which still exist but only bigger and more costly.

The CCC (Civilian Conservation Corps), TVA (Tennessee Valley Authority), REA (Rural Electrification Administration), WPA (Works Progress Administration), FDIC (Federal Deposit Insurance Corp.) and the SEC (Securities and Exchange Commission) were among some of the first New Deal agencies. They were followed by the establishment in 1935 of Social Security, which has grown into a $1 trillion behemoth that is now at risk of running out of money.

The first food stamp program was established in 1939 and ran for four years, followed in 1964 by the establishment of the program that today is called the Supplemental Nutrition Assistance Program and costs close to $70 billion annually.

The 1960s Great Society efforts saw tremendous increases in federal involvement in many areas of American life, almost all of which have survived to this day, starting with the establishment of Medicare and Medicaid, whose costs continue to multiply. These programs eventually widened to include child nutrition, education, rural and urban development, affordable housing, air and water pollution levels, consumer protection and the availability of arts funding. Meanwhile, the Departments of Transportation and Housing & Urban Development were created during the Johnson administration along with the Environmental Protection Agency.

Disdain for government in general was a big factor in Reagan’s election, but despite his declaration that government was the problem and not the solution, the vast federal bureaucracy remained intact during his presidency and has only grown. The Departments of Energy, Education, Veteran’s Affair and Homeland Security are entrenched, and the Consumer Finance Protection Bureau survives despite being a top target of Congressional Republicans.

Meanwhile, Social Security and Medicare benefits have been greatly expanded, and many federal programs created over the past 90 years remain in existence, some with changed mandates and others with questionable results. The REA succeeded in supplying electric power to farms and rural areas, but vestiges of the agency remain in place today. 

I can find only a few agencies that have been eliminated outright, starting with the Civil Aeronautics Board, which was established in 1938 to oversee aviation services and dissolved when the airline industry was deregulated in 1978. The Synthetic Fuels Corp. was established in 1980 to spearhead production of alternative fuels, but it ended up funding just four synthetic fuels projects, none of which survive today, before being abolished in 1986. With the recovery of the financial system from the 2008 crisis, some provisions of Dodd-Frank have been scaled back but key measures, like large bank stress tests, remain.

All the trillions of dollars of federal corona-virus money to support income and jobs will require new bureaucracies to oversee disbursement of the funds. But once the money has been released and spent, what will happen to all those government agencies? If history is any guide, they and their constituents will come up with some rationale for the continued need for their functions.  

Furthermore, the power and reach of the federal government has been magnified greatly as the Federal Reserve, with its gigantic money-creating ability, has become, in effect, an arm of the Treasury Department. Its latest $2.3 trillion program lends directly to states, cities and mid-size businesses and even supports previously investment-grade corporate bonds that are now junk-rated. The central bank’s portfolio of assets, $4.2 trillion in February and now $6 trillion, may be headed for $10 trillion, or almost half of GDP. And the Treasury will cover $635 billion in bad Fed loans.

The labor participation rate for working-age American males has fallen steadily since World War II, in part because many find disability and other government payments more attractive than gainful employment. This has contributed to the slow growth in productivity and the economy, especially in the last decade. The likelihood that the corona-virus pandemic’s income supplements will persist beyond the recession implies that these trends will accelerate. The resulting slow growth in corporate profits will be a drag on post-recession stock prices.

via bloomberg opinion