Mish's Global Economic Trend Analysis |
- Mish Interview on Spanish Site "Libertad Digital" Regarding the Global Economy
- Fed Succeeds in Fostering Massive Speculation in Junk Bonds and Equities
- Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It's Far More Likely Than You Think
| Mish Interview on Spanish Site "Libertad Digital" Regarding the Global Economy Posted: 07 Feb 2011 08:38 PM PST In Mid-January I received a request from Angel Martín to do an interview for the Spanish newspaper "Libertad Digital". Dear Mish,Interview Questions and Answers I was happy to oblige "Libertad Digital". Here is the interview in Spanish: "No confíen en gobiernos o bancos centrales: son los culpables de la crisis" Here is the interview in English. Q: What is your general prediction for 2011? Will the crisis be over at the end of this year? A: I covered many specific topics for the US and global markets in my post Ten Economic and Investment Themes for 2011 My general long-term thesis is the US will go in and out of deflation for a number of years just as Japan has done. Stocks are richly price and historically are poised for no gains for another 10 years. That is not a prediction for 2011 as timing is very difficult. However that equity warning is similar to one I made in 2006-2007. Q: On Europe, what is your view of the European Bailout Funds? Should sovereign states go bankrupt? How could this be done? Will the European Monetary Union and the Euro survive? A: The Euro is likely to survive, but I can see things that could cause the member group to shrink. One thing I am certain of is there will be haircuts on sovereign bonds. What cannot be paid back won't. Eventually Ireland and Greece will default. However, it is important to step back and understand just who is being "bailed out" here. It is certainly not Ireland. It is bondholders of Irish debt that are being bailed out. Those bondholders are UK banks, German banks, French banks, and US banks in that order. The person footing the bill is the average Irish citizen. Those Irish citizens should not stand for it and they won't. I made my suggestions for the next Irish Parliament in my post Irish Government Collapses, Six Cabinet Members Resign, Election March 11; How To Negotiate Haircuts Prior to that, I talked about Ireland on numerous occasions. In general, this is how I see the IMF's "Trojan Horse Bailout of Ireland"  That comic is from To Ireland With Love In that post I noted how Iceland came out of its crisis by forcing haircuts on bondholders. Ireland should do the same. Q: In the United States, is the banking system healthy now, after the Paulson's Plan and the government interventions? Or do you expect more turbulence and troubles coming from the US banks? A: The entire global banking system is technically bankrupt. There is $40 trillion in US denominated debt that cannot possibly be paid back. European banks are in no better shape. That is what the sovereign debt crisis in Europe is all about. Look at Japan. It has a debt-to-GDP ratio of 200%. Yet, Japan's demographics could not be worse. The Japanese people were savers, but the government squandered it all and 100% more in foolish efforts to defeat deflation. The US is making the same mistake. Bernanke is crowing now, but US unemployment is still near 10% (if you believe the reported numbers). I don't. Unemployment in the US is higher. Q: What about China and the emerging economies (India and Latin America)? Will they be able to sustain such outstanding growth rates? China is overheating. It has the world's largest property bubble. I talked about that a number of times recently. Here are a few links. Shanghai Prepares for Property Tax to Curb 'Speculative' Buying; China Addresses Symptom NOT Problem "Consensus Nonsense"; Is the Yuan Undervalued? Who Wins a Currency War? China Secretly Buying US Treasuries Via UK Accounts? Trade Deficit Math; "Hot Money" Math Q: Many people, since 2008, have feared high inflation as a consequence of the expansionary monetary policy of the FED. However, this has not taken place yet. Why were they wrong? And also, will 2011 be a year of very high inflation as some predict? Fears of rampant inflation in the US are misguided. Yes, the Fed is "printing" but so is China, the ECB, the UK and for that matter everyone else. China is the real culprit regarding commodity prices and inflation. It's important to have an understanding of what inflation is. Here is my definition: "Inflation is a net expansion of money supply and credit, with credit marked-to-market". "Deflation is a net contraction of money supply and credit, with credit marked-to-market". That last phrase "marked-to-market" explains the US stock market rally nicely. Credit never expanded, but Bernanke reignited the junk bond market and bonds banks were holding went from "priced for bankruptcy" to "good as gold". This happened even though credit card debt, consumer loans, home equity loans, and consumer debt in general still continue to contract. This helps explain the recovery in financial assets but not the real economy or jobs. In contrast, prices are soaring in China along with unsustainable levels of credit expansion. Those who focus on prices as well as those who focus solely on money supply both miss the boat. Greenspan ignored rapidly expanding credit in the housing bubble years. China is doing the same now. In China, credit is expanding at 35% a year with GDP rising less than a third of that. That is a distinct sign of an overheating economy. India is in the same inflation boat with China. Australia is dependent on commodity demand from China. It should be easy to see what happens to Australia when China slows. Notice I said "slows". There is a good chance China crashes. Moreover, Australia faces a double whammy because its property bubble is starting to implode now. Those paragraphs should explain how interconnected and unbalanced the global economy is. Q: What is your view on the Spanish economic troubles? As an investor and analyst, would you trust the current Spanish Government? A: At first glance, Spain's woes appear similar to US and Ireland (housing bubble and property speculation) and dissimilar to Greece. However, all of the countries just mentioned are alike in regards to problems with public unions. In the case of Greece, public unions and unsustainable pension problems are the overriding concern. In other countries it is private sector debt. Thus, all of the countries have the same problems; it's just the order of importance of the problems that differs. I see no reason to trust any governments or central banks. The Fed took illegal actions and so did the ECB. Jean-Claude Trichet broke every major promise he ever made by cutting interest rates to nothing and by buying sovereign government bonds. Buying bonds was against the Maastricht Treaty. Germany has done things that are arguably against its constitution. There is even a power struggle at the ECB now as Trichet's term expires. Axel Weber is the leading candidate but he was against Trichet's bond purchases. I suspect they may declare an emergency and keep Trichet on beyond his term. Greece lied to the EU to gain admission. Japan's policies over the last two years have been a disaster. Are we supposed to believe Spain? Italy? Any central bank? Why? Q: Since the minimums of March 2009, the US and European stock markets have risen more than 60 %. What would you expect for the foreseeable future? A: I have a saying: "They don't know and neither do I". However, as I stated above, equities are hugely overpriced here. Expect Long-term gains to be minimum and most likely negative. Q: Finally, what are your recommendations for policy-makers to get out of the financial and debt crisis as soon and healthy as possible? And even more importantly, what must be done to avoid future crisis like this one? Everyone likes to blame lack of regulation. However, I like to point out that regulation created Fannie Mae, regulation empowered the big three rating agencies, regulation gave tax breaks to homebuilders, Greenspan openly endorsed derivatives, etc. I can go on for hours regarding the failure "of" regulation. In a free market, there would have been no Fannie or Freddie. Nor would there be 30 year mortgages. The first thing a decent regulator would do is shut Fannie and Freddie down. Instead we just guaranteed their debt. If you want to see just how screwed up the credit rating agencies in the US are, please read Time To Break Up The Credit Rating Cartel That is another clear case of government screwing up a perfectly workable system. I am not against all regulation, however. Regulation that protects property rights and prevents fraud is fine. Glass-Steagall should not have been revoked. It provides a wall to prevent some forms of fraud. However people use Glass-Steagall as a scapegoat. It would not have stopped this crisis at all. Finally, it is important to understand the root cause of this mess: Fractional reserve lending and the Fed (and central bankers in general). Note too, that it was regulation (legislation) that created the Fed. Together the Fed and fractional reserve lending are the driving forces that allow unmitigated creation of debt. They are all guilty. However, the Fed and the People's Bank of China are the worst. The result of central banker sponsorship of credit is bigger boom and bust cycles of increasing amplitude. Unfortunately, there will be another crash as the global imbalances and root causes of this mess have not been addressed. Mike "Mish" Shedlock http://globaleconomicanalysis.blogspot.com Click Here To Scroll Thru My Recent Post List Mike "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction. Visit http://www.sitkapacific.com/account_management.html to learn more about wealth management and capital preservation strategies of Sitka Pacific. 
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| Fed Succeeds in Fostering Massive Speculation in Junk Bonds and Equities Posted: 07 Feb 2011 10:45 AM PST Another day, another market high. The longer this goes on, the bigger the next crash. In the meantime the Fed is openly bragging about its efforts even though Bernanke Warns of "Rapid and Painful Response to a Looming Fiscal Crisis". Bloomberg reports Fed Spends 40% on Benchmarks as Newest Prove Cheapest The Federal Reserve's Treasury purchases already have succeeded in driving investors to junk bonds and stocks. Now, policy makers are focusing on benchmark government securities, helping contain rising yields that set rates on everything from corporate debt to mortgages.It pains me to see such inaccurately worded statements. No one can be pushed into stocks, in aggregate. Except for new stock issuance, dept offerings, IPOs etc., for every buyer there is a seller, and at the end of the day sideline cash is the same. Moreover, this has been a futures-driven rally. Volume of actual shares trading hands has been low. However, the Fed has, for the time being, succeeded in reigniting a massive Greater Fool's Game in terms of what speculators at the margin are willing to pay for financial assets. Bloomberg Continues: More than 40 percent of the government bonds the Fed bought in January for its so-called quantitative easing were auctioned in the previous 90 days, up from 20 percent in December and 15 percent in November, according to Bank of America Merrill Lynch. The central bank is concentrating on newer securities as its $600 billion program depletes primary dealers' holdings of Treasuries to the lowest since November 2009.Bang for the Buck? In terms of treasury and mortgage yields, the Fed has not gotten any bank for the buck. Yields are way higher except at the very short end of the treasury curve. However, the Fed has succeeded in creating speculative demand for junk bonds. That in turn has helped lift the stock market. Quantitative easing has boosted demand for Treasuries as President Barack Obama's budget deficits exceed $1 trillion, adding to the nation's $8.96 trillion in marketable debt. Investors bid $3.04 for each dollar of bonds sold in the government's $178 billion of auctions last month, the most since September, according to data compiled by Bloomberg.Understanding Demand It is hard to say there is huge "demand" for treasuries when the Fed is buying them, others are unloading them, and yields are soaring on the high end. The next Bloomberg quote is correct. Since Nov. 3, when Fed Chairman Ben S. Bernanke announced the plan to buy government debt to keep the economy from falling into deflation, 10-year yields have increased about one percentage point as expectations for inflation rose. The purchases and signs that the economy is recovering have reduced demand for the safety of government debt in favor of riskier assets and the Standard & Poor's 500 Index has risen 9.4 percent.Fed's Willingness to Foster Speculation This is what the recovery has come to: the Fed's willingness to foster speculation in financial assets to the point of creating more financial bubbles. Once again, it will not be the banks that get hurt by the Fed's corrupt policies but those on fixed income and those chasing junk bonds and equities at bubble valuations. For details, please see
In response to my last post, someone commented "The biggest mistake one can make is to expect federal stimulus will end." Such thinking is common. It is also wrong. This is the correct way of looking at things: "The biggest mistake one can make is to think it will matter if federal stimulus doesn't end." Valuations eventually matter, and the market will at some point take matters into its own hands regardless of what the Fed does. Europe (especially Greece, Ireland, and Iceland) provides painful examples. Rapid and Painful Response to a Looming Fiscal Crisis Quoting the economist Herbert Stein, Bernanke said: "If something cannot go on forever, it will stop. The federal government must stabilize its budget. The question is whether these adjustments will take place through a process that weighs priorities and gives people adequate time to adjust, or whether there will be a rapid and painful response to a looming or actual fiscal crisis." The longer the Fed pursues these corrupt policies while egging on Congress to do the same, the bigger the financial bubbles, and the bigger the resultant crash. That is what happened in 2008 and it will happen again. Mike "Mish" Shedlock http://globaleconomicanalysis.blogspot.com Click Here To Scroll Thru My Recent Post List Mike "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction. Visit http://www.sitkapacific.com/account_management.html to learn more about wealth management and capital preservation strategies of Sitka Pacific. 
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| Posted: 07 Feb 2011 01:25 AM PST Market cheerleaders keep ratcheting up expected earnings, failing to note that much of the recent earnings growth is simply not sustainable. Reasons for Unsustainable Earnings Growth
Nonetheless, let's ignore the above factors and assume earnings will keep rising. Does that mean the stock market will go up, or is even likely to go up on a sustainable basis? Stock Market Cycles and PE Ratios Crestmont provides stock market returns and PE Ratios, for every year going forward, from every year since 1900.
PEs in the matrix tables are Case-Shiller normalized PEs. The matrix tables listed above are for taxable accounts. Crestmont also provides matrix tables for tax-exempt accounts. The concept may be hard to visualize until you see it, but as word of warning I have a 24 inch monitor and the matrix tables will not come close to fitting on my screen. To read the text and numbers in the PDFs, you will need to enlarge the size making it impossible to see the entire table at once. Nonetheless, please open up one of the above tables to get an idea of their size. The diagonal black line running through each table is a 20 year-line. Essential Ideas
It is invalid to exclude dividends, so I used the matrix (nominal returns + dividend) as the starting point for the following tables and analysis. The table below shows a sampling of years (some high valuation years and some low) along with annualized returns for two decades. Annualized Rates of Return for Select Years  Click on any table to see a sharper image Note how much the starting PE valuation matters. Someone who started investing in 1929 received an annualized rate-of-return of 0% for two full decades, even if they religiously reinvested dividends every year. However, someone investing in 1982 received an excellent annualized rate-of-return for two full decades (12% for the first decade and 9% annualized for 20 years). Note year 2000. Starting valuations were the highest in history. It should not have been a surprise to discover that 10 years later, the annualized rate-of-return was -2%. Bear in mind, the Case-Shiller normalized PE for the year ending 2010 is 23. Does that bode well for the next decade? Of course no one knows what this year or next year will bring. Take a look at 1996 in the above table. In spite of several years of huge stock market gains, the annualized rate-of-return to date sits at 3. Cycles of PE Compression and Expansion  Over long periods of time PE ratios tend to compress and expand. Unless "it's different this time", history says that we are in a secular downtrend in PEs. From 1983 until 2000, investors had the tailwinds PE expansion at their back. Since 2000, PEs fluctuated but the stock market never returned to valuations that typically mark a bear market bottom. Moreover, demographically speaking, the current decade not only starts with very rich valuations, but also comes at a time when peak earnings of boomers have passed. Those boomers are now heading into retirement and will need to draw down savings, not accumulate large houses and more toys. Of course, the market can of course do anything this year (or the next few years), but history strongly suggests that stock market returns for the next 10 years will be lean years, perhaps negative years. Annualized Rates-of-Return Starting PE Above 21 The following table shows annualized rates-of-return for the current year, the 10th year, and the 20th year for each year in which the PE started at 21 or higher.
Variance over Time
That median rate of return going forward will be influenced in an unknown but likely negative fashion from the current starting point and high PE valuations for the years that have yet to be determined. Annualized Rates-of-Return Starting PE Less Than 13 The following table shows annualized rates-of-return for the current year, the 10th year, and the 20th year for each year in which the PE started at 13 or lower.
Variance over Time
Valuations Matter in the Long Run Please consider the following snip is from the Sitka Pacific 2010 Annual Review. Depending on how closely you follow the financial markets, it may be surprising to learn that profits are at new highs even though stock prices, as measured by the S&P 500, are still 20% below their highs. In other words, new highs in profits haven't translated into new highs in stock prices. If we go back even further, after-tax corporate profits soared 175% from the first quarter of 2000 through the second quarter of 2010. However, during that same time, stock prices fell roughly 15%.Notes:
Swimming Upstream History shows that stock market valuations range from extremely cheap (10-year normalized PEs near 10 to extremely overvalued, 10-year normalized PEs of 44). Peak to trough changes in valuation occur over long periods as the market goes from one extreme to another. Here is another chart looks at things from the point of view of PE compression (stocks moving from extremely overvalued conditions to extremely undervalued conditions). Bear Market in PEs  Click on chart to see a sharper image The 10-Year PE declined from 44 in 2000 (the richest valuation ever), to a current valuation of 23. That is about a 47% decline in the PE ratio, yet as discussed above, a PE of 23 is a very rich valuation. When PE valuations are declining, and history suggests we are nowhere near the bottom of the PE compression cycle, generating positive returns in the stock market is much like trying to swim upstream. Even if earnings increase (a dubious point to start with as noted in the beginning of this article), prices will likely be dragged lower by the weight of declining valuations. Where to From Here? Hopefully you now realize that expectations of rising earnings being tremendous for the stock market is a fallacious construct. Such talk ignores high valuations, the long-term trend in valuations, and demographics. Moreover, it's debatable if earnings are likely to rise in the first place. With that in mind, people chasing this market as well as those fully invested do not realize how lucky they have been. Last week I received an email from someone who fears being out the market. I heard the same thing in 2007. I suggest people ought to fear being fully invested with no hedges. The same applies to pension funds. Note that most pension plan assumptions are on the order of 8% annualized rates-of return, and pension funds are typically 100% invested, 100% of the time. However, I do not know where the market is headed this year, nor does anyone else. 2011 may turn out like 1998 or it may turn out like 2008. Either way, history strongly suggests that 10-year and 20-year returns looking ahead are likely to be low, if not negative. Investing, like life, is a marathon not a sprint. Sometimes the prudent thing to do is sit on the sidelines waiting for better opportunities, even if it means enduring cat-calls and taunts from those who do not have any understanding of risk or history. Mike "Mish" Shedlock http://globaleconomicanalysis.blogspot.com Click Here To Scroll Thru My Recent Post List Mike "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction. Visit http://www.sitkapacific.com/account_management.html to learn more about wealth management and capital preservation strategies of Sitka Pacific. 
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