Running out of gimmicks to goose 'earnings' growth
So, did the nauseating last few months of 2018 signal the end of the secular bull market?
Or is the rebound that kicked off 2019 a sign that the uptrend is still intact? Or it is just a dead-cat bounce?
Lance Roberts, chief investment strategist and chief editor of Real Investment Advice, returns to the podcast with fresh data that suggests the bear market that emerged late last year is still in play.
Of greater concern to him, though, is where things are headed from here:
When we get to the end of 2019 and we actually get estimates to where earnings should be by the end of 2019, the entire benefit of the tax cut will be erased because of the decline trend in earnings. So despite the fact that the tax cut in December of 2017 was touted as one of the greatest things for corporations ever -- it was supposed to result in a massive boost to earnings -- but ever since then, earnings have been on the decline. That's why the market didn't even respond last year to these tax cuts. Because, at the end of the day, we're not creating more revenue at the top line. Instead, we're eroding bottom line profitability.
And here's another bit of data for you. Corporate profits, as reported by NIPA, by the government agency that tracks corporate profits, profits before tax have not grown in eight years. They're at the same level currently (as of the end of last quarter) as they were eight years ago. Only corporate profits after tax have reached a new record. And that only occurred in the last quarter of last year.This tells a very important story: the revenue growth at the top line of corporations has only grown by about 45-50% since 2009 on a cumulative basis. That's not annual; that's the cumulative total. But yet, corporate profits at the bottom line (i.e. after tax), because of all the account gimmickry and jiggery that goes on, has exploded by over 350%.
So let's take a look at what happens at the top line. Profits before taxes has not grown in eight years. That's in line with what you would expect from revenue growth. Because of expenses, everything else in business is drawing basically at the rate of inflation, the rate of employment, et cetera, so we're getting some deterioration there in terms of that. But if we have very weak revenue growth, it's not surprising that bottom line corporate profitability hasn't grown before we strip out the tax manipulation.Which is why stocks are expensive across the board. Basically, on every measure that you look at, with the exception of free cash flow, they're expensive. They're running about two times price to sales, some of the highest levels in history for S&P stocks. And with price to earnings valuations, even given the recent end of 2018 correction, we're still trading on a ratio of 28x earnings. That's going to get more expensive as we move into this year, because earnings are going to deteriorate further.
When valuations truly contract, we're going to be looking at somewhere between 10 to 12x earnings on stocks in the S&P. That'll be your time to buy it. But that will require a 50-60% decline in the S&P from today's levels.
Click the play button below to listen to Chris' interview with Lance Roberts (53m:21s).
Chris Martenson: Welcome, everyone, to this Peak Prosperity featured voices podcast. I am your host, Chris Martenson. and it is January 16, 2019. Today, we're going to be talking with leading market analyst and commentator Lance Roberts. And when we last talked with him in August of 2018, Lance was telling us that the equity markets were waving a huge red fled. And boy, were they ever.
Well, now they recovered. Not just a little bit from their Christmas Eve lows, but have only seemed to go one direction - higher - ever since. CNBC and The Wall Street Journal and other market cheerleaders want you to believe the recent volatility was a glitch. The President wants you to think that as well.
But was it? So let's find out. Lance Roberts is today's guest, and he is one of my favorite analysts and commentators. He has a background of 25 years of private banking and investment management. He spends the majority of his time analyzing, researching, writing about investing. Investor psychology. He's got great macro views of the markets and economy. He says, "My thoughts are not generally mainstream, and are often contrarian in nature." Well, it guess it's a trait we all share for independent thinkers at all these days. So we'll get in to that in a minute.
Lance is also the chief strategist and economist for RIA Advisors, the editor of realinvestmentadvice.com, which I highly encourage you to visit. It's packed with really excellent articles and lots and lots of timely economic and financial data. You can also find him on KSEV in Houston at 700 AM, and he's the host of the talk show, of course, The Lance Roberts Show. Lance, welcome.
Lance Roberts: Glad to be here always, Chris. Good to talk to you again.
Chris Martenson: Lance, let's start here, the markets. The equity markets have bounced a lot since December 24th. They had that Christmas Eve wipeout. How are you viewing this bounce - as a dead cat, or the continuation of the longest bull market in history?
Lance Roberts: Well, first of all, let's just start by saying, just to make sure everybody's good, no animals were harmed during the conversation here. But this has all the earmarks as what the technicians term as the dead cat bounce. First of all, I think it's interesting - so, today that we're talking - it's January 16th, and the headline on CNBC right now is Dow nearly out of correction territory.
Now, think about this for a moment. Back in August, when you and I were talking, we were talking about the risk to the markets and what was going on. We had this big decline in November and December, and we've had a 10% rally since Christmas Eve, a little bit more actually, almost 11% now. And we're not even out of correction territory yet.
So think about the magnitude of the damage that was done technically to the markets and for a lot of individuals and professional traders as well. A lot of individuals got trapped into that decline. And again, at the end of last year, lots of articles being written about this is just a correction - we're going to get a bounce - it's going to come back.
There's a lot of individuals looking to basically get out of the market now because they realize - and we talked about this in the past, Chris - is that psychologically, when markets are just going straight up, we're forgiven for making a lot of investment mistakes, overpaying for companies, buying crap companies, et cetera. And what bear markets reveal is all those investing mistakes, people realizing how much risk they took on in their portfolio.
So look for this rally to begin to fail here, I would suspect here not much higher, probably within 2,650, maybe 2,700. We're testing the 50-day moving average now. The 200-day moving average is above that. Tremendous resistance from the October, November loads as well. All that's just ahead, and the markets have gone from extremely oversold, like we saw in December, back to extremely overbought already without making a tremendous amount of gains.
Volume is declining. This rally has persisted on weakening daily volume. The advance decline line is still in a negative slope right now, which is a non-confirmation to the rally. So yes, to your question, this has all the earmarks of a dead cat bounce, not a return of the bull just yet.
Chris Martenson: Well, excellent summary, Lance. And you know, I was a little bit suspicious of the whole idea that Steve Mnuchin - I call him Munchkin - came out and publicly convened the PTT and answered a question nobody was asking or asked one, I guess, which was that bank liquidity was fine, nothing to worry about. That was all very odd to me.
But I'm also a little bit suspicious when we see these very markets as I grew up on them. And listen, I realize that they're not the same markets I grew up on, so maybe I'm just too old to really get this. But as a trader back in the late 90s to about 2007 when my system started to fall apart a little bit for me in terms of day trading, bottoms would form. You could watch the volume begin to settle. There was a feel to the markets about when they were about to turn.
Now, they turn like that. Just instant jams higher. And we were seeing as obscene as 20 S&P points in a two-minute candle just as recently as last month. What do you make of those sorts of wild gyrations? Just normal behavior in a computer dominated market? Or is it possible that some big player's coming in and putting a floor down then?
Lance Roberts: First of all, let's step back because when I was first coming up in the markets we were still using vacuum tubes to send trade. You had to send sheets of paper to buy stuff to the trading room. So yeah, I go back on all that. Only slightly before that was stone tablets to make trade.
So the speed at which data is transacting - just think about that for a moment. Back in the day I'd have to write a ticket out. I want to buy 500 shares of Exxon Mobil (XOM), put it into a vacuum tube, stick it into a vacuum. It would go over to the trading department, some guy would fish it out, he would look at the trading ticket, go through the process of entering the trade. Think about how much time that took versus the time that it takes to enter and execute trades today. And we're not talking about you and me sitting online on our computer and typing in buy shares Exxon Mobil, enter, it's done. We're talking about computers that can literally what we call sub-penny, which is almost a manipulation of price.
But we've got programs that can enter a million orders within one or two seconds and actually physically move the price of a stock in one direction or the other. So the speed at which things happen here are so incredibly fast. First of all, the average investor really has no ability to take advantage of that. For the average individual investor - and this is why a lot of my data focuses on weekly trends and monthly trends rather than daily because as average investors - and even as an advisor myself, I simply don't have the speed and technology available to me to trade at the same rate as algorithms run. And so what I've got to do is try to catch the trends of the data more correctly than trying to catch price swings.
But this is why, yeah, absolutely, to your point, after December the 24th, we saw big moves in the markets in just very short timeframes. Yes, that was big institutional players coming back into the markets. We talked about that was going to be an issue.
But the second thing is that these computer programs - we saw two things that we've been talking about recently. One is back in October, November, we said be careful when these algorithms switch from buying dips to selling rallies. That's what you saw in October, November. Every time the market rallied it was immediately with selling and algorithms were just selling off tremendous amounts of equity. It was one technical indicator was triggered after another.
The same thing is occurring now. As we continue to push up through levels of certain support or previous resistance, that triggers more buying. CTAs were extremely short in December. They're having to cover their short. So as the market rallies, shorts are being forced to cover. That's creating more temporary volume. But that, again, none of this is long term in nature. This is all very short-term technical impact. So that market that will fade probably starting next week.
Chris Martenson: So these CTAs are computer trading algorithms. It sounds like you're saying they're basically like they're playing ping pong on a table that's located on a ship. So that ship is headed somewhere…
Lance Roberts: But ships are pretty stable. I think it's more like a row boat in a storm.
Chris Martenson: But let's talk about where that boat is heading and let's start at the top of this. Of course, fundamentals always have to matter at some point. So corporate earnings - what are you seeing in corporate earnings?
Of course, we had Apple (AAPL) give that famous warning there which a little bit of a slowdown in their next quarterly earnings. Which surprisingly caused a couple of key currency pairs to actually yield crash, or the spread crash on them was - it was extraordinary to think that a corporation's earnings results would somehow blow up the Australian dollar, Japanese yen cross. It was weird. But we had it, right?
And Apple also - in the prior earnings release, just put some schadenfreude on that company and they said, you know what we're going to do here? If we turn out - we have volume issues, we're just going to hike the price and abuse our customers. It turned out that wasn't a great strategy. But that anecdote aside, corporations seem to be experiencing at least some headwinds now. What are you seeing there?
Lance Roberts: Well, I've been writing about this now for all of 2018. What I do is every month I download S&P earnings statements. And then I compare the estimates going forward over the next two years as to what was said in the previous month. So, for instance, if at the beginning of every year they say, well, at the end of this year and at the end of next year, earnings are going to be x. Well, every month I track that to see what the deviation is from their original statement.
So, as an example, from just August of 2018 earnings estimates for the end of 2019 declined by over $10 a share. They were down another $4 a share just in the month of December. So, in other words, and this is why I'm - if you use Ford's (F) operating estimates for buying stocks or making an argument, that is the biggest fraud on the planet. First of all, operating earnings are earnings that I wish I had if I didn't have anything else going on in the world - I didn't have to pay taxes and payrolls and all these other things and nothing bad happened. That's operating - it's my wish list of what earnings might be in the perfect world.
Reported earnings are what you actually end up with in your pocket after all the stuff that happens to a company. Those are the only things you should use as an investor, and you should use trailing reporting earnings on top of that because that's what's actually been counted. That's why you're actually buying in terms of future cash flow estimates, et cetera,
But when you take a look at Ford's reported earnings - and look I don't even look at the operating earnings - look at Ford's reported earnings estimates. Those have declined by almost 50% in just the course of the last year. And those are going to decline. They're still overly estimated. By the end of this year, those are going to decline by another $10.
Here's the caveat to this, or here's' the tagline to this I should say. When we get to the end of 2019 and we actually get estimates to where they should be by the end of 2019, the entire benefit of the tax cut will be erased because of the decline in earnings. So despite the fact that the tax cut in December of 2017 was touted as one of the greatest things for corporations ever, it's going to be a massive boost to earnings. Ever since that, earnings have been on the decline and that's why the market didn't ever respond last year to these tax cuts because at the end of the day you're not creating more revenue at the top line, you're eroding bottom line profitability at the end of the day.
And here's the other - here's another bit of data for you. I've got an article coming out tomorrow talking about the economic is slowing down. Corporate profits, as reported by NIPA, by the government agency that tracks corporate profits, the NIPA profits, before tax, have not grown in eight years. They're at the same level currently, as of the end of last quarter, as they were eight years ago. Only corporate profits after tax have reached a new record, and that only occurred in the last quarter of last year.
Chris Martenson: Really? I'm really surprised by that data. Eight years?
Lance Roberts: Yeah, eight years. Well, what that tells you is, and this tells you a very important story about the economic, revenue at the top line - you and I have talked about this before - the revenue growth at the top line of corporations have only grown by about 45-50% since 2009 on a cumulative basis. That's not annual, that's a cumulative total. But yet, corporate profits at the bottom line, because of all the account gimmickry and jiggery that goes on has exploded by over 350%.
So you take a look at what happens at the top line. So before tax, my profits before I pay taxes has not grown in eight years. That is in line with what you would expect from revenue growth that has barely grown. Because my expenses, everything else in my business is drawing basically at the rate of inflation, the rate of employment, et cetera, so I'm getting some deterioration there in terms of that. But if I have very weak revenue growth, it is not surprising that bottom line corporate profitability hasn't grown before you strip out the tax manipulation.
Chris Martenson: Obviously these fundamentals have to happen at some point. And I love that distinction of looking at reported earnings and forward reported earnings rather than whatever that other gobbledygook non-GAAP stuff is - who knows what's in there.
So we look at these reported earnings - I was just listening to CNBC the other day. They said, hey, stocks are really a buy now. They're very cheap by a lot of measures. I don't see them as cheap on this basis that we're just discussing right now are stocks cheap, middling or expensive?
Lance Roberts: They're expensive across the board. Basically, on every measure that you look at, with the exception of free cash flow, they're expensive. Price to sells you are basically running about two times price to sell. Some of the highest levels in history for S&P stocks. Price to earnings valuations, even the fact that we've had this correction, we're still trading on a take ratio of 28-time earnings. That's going to get more expensive as we move into this year because earnings are going to deteriorate.
So if prices go up or even if prices remain the same, valuations on trading basis are to rise. All the arguments - this is my problem with these Ford's operating earnings - oh, buy the stock today because based on Ford's operating earnings stocks are trading at 15 times earnings, that's long-term average.
Two problems with that. One, that never occurs because operating earnings always come down sharply. They're always overestimated by as much as 33% at the beginning of a cycle. The second thing is that valuations have never in the history of the entire universe reverted only back to the long-term average and then started a new bull market from that point. You always revert beyond the mean because by the time you do what is called a fundamental reversion, or basically a fundamental contraction in valuations, you always go well beyond the mean.
When valuations truly contract and we get through a contraction process of valuations, we're going to be looking at somewhere between 10 and 12 times earnings on stocks in the S&P. That'll be your time to buy it, but that will equate to a 50-60% decline in the S%P when that happens.
Chris Martenson: And that really comports with something that I've been tracking for a while which is, you know, I don't analyze these in terms of business cycles anymore. You just mentioned at the beginning of a cycle. We had Greenspan. He came forward and hey, I think I can defeat that pesky business cycle. We're smarter than the average bear. We're 12 unelected people who are really smart. We've gone to the best schools.
So what we're going to do is we're going to have this things called the credit cycle, really amazing, and it gave us the 2000 bust. Bernanke came along, doubled down and said, hm, we just didn't do enough of that, so gave us the housing bubble. That burst. And here we are with an everything bubble across the world. It's a credit bubble or a credit cycle. And credit cycle do mean revert is a really ugly way and tend to overshoot for the prime reason that -
I think China's a great example here, and we can get into GDP around this part of the story. But, you know, China said, hey, we can't have any of this backward stuff. We need to always grow forward, we need a 7% GDP growth. What do we need to do? Doesn't matter. We'll throw all the liquidity, all the cash we can into our markets. And we're going to ignite not just a short of housing bubble but the biggest one I've seen in world history with media income to median price ratios of 20 times to 40 times, depending on which major metropolitan area we're talking about in China. Just off the charts. Just crazy.
And the only way they can keep that from blowing up is to throw more and more credit into the system. And eventually that becomes a problem. So when that finally corrects, my thesis is, it not just corrects but it has to undo a lot of, as John Stuart Mill said, that capital's already been betrayed into hopelessly unproductive works. Those ghost cities in China will never return money because they were built. They have not productive value.
So how do you analyze this in terms of looking at the fundamentals as you are but also understanding that we're in a massive credit cycle that's probably peaked out here?
Lance Roberts: There are a lot of people that will argue with you about that credit. Of course, one of my favorite arguments, by government that is, is it doesn't really matter. You don't have to pay it back anyway. It's complete lunacy. The reality is that debt matters. And debt ultimately matters a lot. The only question is is when does it matter? How long can you continue to go on? Take a look at Japan as an example. They're 235 times debt to GDP. The United States is running about 105%.
But when you start talking about corporate debt, corporate leverage, this is a vastly different story. There is a very finite limit to the amount of leverage and debt that companies can take on, that they can handle, because, unlike the government who can actually print their own currency. Apple actually has to actually earn revenue to service the debt that they've got outstanding.
So, at some point, the cost of debt becomes a real issue. When does cost of debt become a real issue? It becomes an issue when interest rates rise. And this is where the big problem is. The Federal Reserve, Jerome Powell, who has done a nice - a very talented flipflop as of late in terms of his hawkish stance, so much more dovish stance about this. Still is concerned, he still makes statements that he's concerned about the level of corporate debt.
Here's an interesting statistic for you. In the 1950s and '60s when the economic in the U S was growing about roughly 8% on average, the level of debt required to generate a dollar's worth of economic growth was about $1.50. Today it's almost $4.50 in debt to create a dollars' worth of economic growth. Now, that's not just government debt, so don't go out and think government debt and say, well that's not true. It's corporate debt. It's municipal debt. It's personal debt. It's all this debt put together.
That because we use debt to go consume stuff. That's how we create economic growth. Economic growth is 70% consumption. So we go live on our credit cards so that we can buy stuff that we really can't afford today because we have a problem with having immediacy effect of everything we want. We can't wait. We can't save for it. We got to have today. That's why we have very low saving rates and very high debt balances. The average household has about a $4,000 annual deficit between what they earn and what they spend that all winds up in debt. Not surprising, we have record credit card debt.
Record corporate debt because corporations have been living on debt to fund the differences between what they're actually earning on revenue and what they want to do in terms of expansion. They've used debt very unproductively. And, directly to your point, talk about unproductive debt use, taking on massive amounts of debts to pay out dividends and do share buybacks which have a negative long-term effect to the valuation of the corporation in the long terms.
And then this just goes on for municipalities. $60 trillion in debt in and economy that's running roughly about $21 trillion in growth. So you can see the real problem here long term is that is interest rates ever do - if the bond bearers are ever right and interest rates ever do actually rise to 4.0 or 5.0%, the end of the universe will occur because that debt will come due immediately.
Chris Martenson: Well, we'll all be trading gold coins and baked beans at that point if - because we're talking about the destruction of the currency system involved which is really an Austrian view. Which is either you voluntarily abandon a credit cycle or you risk the currency system involved. Now, we see that happen to smaller countries. It's happening in Venezuela right now. It's happened in Zimbabwe. We're seeing those pressures arise.
The U.S. Federal Reserve had decided - they've been on a 30-year long rate reduction campaign. It clanged out at the zero mark. It's come up a little bit since then. But I'd be interested to talk about those interest rates a little bit further in just a second. But you mentioned something really important I want to get to first which is corporations - you mentioned before that they cash flow basis they look pretty good.
I was in a Twitter argument, which you should never do, with somebody who said, oh, corporations funded their buybacks from cash flows. And I said, well, isn't it odd though that they bought back about $5.5 trillion of stock and they took on about $5.5 trillion of new debt. Looks to me like they funded it through debt. Where do you stand on that idea?
Lance Roberts: You're absolutely right. Apple - you talked about Apple earlier - you know, apple was a fabulous company years ago. It still is. It's just a massive corporation, but they've quit innovating. After Steve Jobs passed away - and there's a point to why I'm telling you this so bear with me. After Steve Jobs passes away, Tim Cook took over. Really, the innovation has stopped to a great degree. Yeah, they're making some small changes here and there. Saw a commercial over the weekend for the new iPad Pro. They've come out with a new iPad and they're added a stylus to it. Terrific. Four years after the fact that Microsoft came out with the Surface, they've now invented the iPad Pro. And the lack of innovation is a problem.
So it's not surprising you're seeing two things happen with the company. One, you've got prices rising on product to a level that - they found the limit to what consumers can actually afford. When you got to $1,000 a phone consumers said, yeah, you know what, my other phone's still pretty good, I'll just hang on to it.
The second thing is you're not innovating to a degree that is enticing people to go ahead and cough up and take on additional debt to pick up that additional item. So their issue has become both an issue of burning cash flow but also looking how to manage that risk. And they have used debt to issue out dividends because they can borrow debt at a cheaper rate then what they were paying out in terms of a dividend. So it made a lot of sense for them.
The same thing goes for their share buybacks. They could use debt to buy back those shares. And so to protect cash flow, right, to protect their cash for future problems, acquisitions or whatever may come along, corporations are simply looking at this mathematically. Hey, I can burn a bunch of cash to buy back shares, or I can use debt, which is extremely - was extremely cheap - not anymore - was extremely cheap - I can use extremely cheap debt to buy back shares. Plus, there is a huge tax advantage for corporations to use debt to do share buybacks because there's actually an adjustment.
If the price of the bonds go down then they actually get a tax write off for that devaluation of the bonds that actually gives them a benefit on the bottom line of their balance sheet. So there's a lot of reasons that they use debt, but primarily they want to protect their cash. Their cash is invested in T bills and other investments that are actually making them money. It's not just sitting around in a lockbox full of cash. It's actually invested cash, it's just liquid. And so they're using that to create return.
Chris Martenson: As they create return with that though, where do you stand on the whole idea of them maybe dialing up more corporate buybacks of shares, things like that? I mean, that was a big, big story. 2018 was the record year for corporate buybacks. It was massive, and they went into debt to do that in many cases. Are we done with that, or do we have more of that coming up in 2019?
Lance Roberts: Well, look, share buybacks are by far and away not over, right. We're going to continue to see share buybacks. Why? It's an interesting conversation if you think about it. You were trading back in the '90s and I was too. And back then, it was every time a stock got to about $60, $70, $80 a share, Exxon Mobil - I'm in Houston - so every time Exxon Mobil got around $70, $80 a share, I'd get flooded with phone calls like, when's Exxon going to split their stock again? Because every time stocks got close to $100 or a little bit over $100, companies would split their shares to get their prices down to make it more attractive to the investing public because everybody was online trading stocks.
But when you split a stock you basically dilute shares, right? So you get more and more of these shares, and that begins to detract on earnings because you're taking a dollars' worth of earnings and instead of dividing a dollars' worth of earnings by ten shares you're not dividing a dollars' worth of earnings by a hundred shares, and that makes it much harder to grow your earnings per share. Well, this all worked fine and dandy as long as companies were vastly expanding during the dot com bubble, et cetera, and nobody was really paying much attention to earnings anyway.
And, of course, as Yogi Berra once said, can you please cut my pizza into four pieces because I can't eat eight. Share value. Splitting shares has no real value for shareholders as much as it does for stock delusion which allows more shares to be used for purchase, acquisitions, et cetera.
The problem came when revenue stopped growing. We talked about this earlier saying look, since 2009, revenue at the top line has stopped growing. If my top line isn't growing, in order for me to meet the constantly escalating promises or desires of Wall Street to continue to create higher and higher levels of profit growth, to continue to grow my earnings per share, I've got to resort of four primary methods.
I've got to reduce my labor cost. In other words, not hire as many people and suppress wages. I've got to work with my tax issues. I've got to do accounting gimmicks, postpone certain deductions, take certain deductions, do what I can to manipulate when and where I pay for issues. And then, of course, buy back shares to reduce the number of shares that I've got outstanding relative to the earnings that I'm making.
All of those gimmicks have been used to drive the price of the bottom-line earnings per share because the real profit - listen, the real profitability of companies is not there. You're overpaying. Valuations are substantially higher than what valuations look like because what's happening at the top line of the balance sheet is being grossly manipulated at the bottom line.
Chris Martenson: And so as we look forward in that, these companies, obviously, they're still going to be buying back shares because, as you mentioned, they don't have that many levers left. If fact, there's a little bit of wage pressure starting to show up in some of the data and things like that. They're having trouble growing the top line. But the corporation themselves, they exist within this larger subset of the economic. We'll call that the GDP for the moment.
GDP growth. We're seeing a lot of very worrying sort of smoke signals coming out of China. I know they have a lot of heavily, let's say, less than trustworthy data that comes out of there. But what is coming out doesn't look good.
Europe, Germany might as well be in recession at this point. Who knows what Brexit's going to do to the UK? But Europe looks pretty weak. The United States kind of mixed bag. But still, overall, I would have to say we're leaning towards weakening, not strengthening here with the exception of that lightening indicator, the 311,000 employment hires that we had in the last new cycle. What are you seeing here?
Lance Roberts: First of all, I just want everybody to relax a little bit here on earnings reports - sorry, on economic reports because we're not going to have any. As long as the government's shut down we really won't know anything. So the actual country has stopped growing momentarily. We're just waiting for the government to tell us what we're doing.
Chris Martenson: It's truly ______ [00:29:17] economic.
Lance Roberts: Exactly. Seriously. I actually am producing a report tomorrow - I'll mentioned this - talking about that the economic is slowing. I have an indicator that I built that I've tracked this for years now. You know, because we look at all these individual indicators, right. We look at ISM and surveys, and those surveys, those are emotional. Chris, how do you feel about your business? How do you feel about your order flow? How do you feel about these? And that's emotional. I feel great. Wonderful. Things are awesome right now. The National Federation of Independent Business - how do you feel about yourselves? What do you think you're going to do in the next quarter? Very sentiment, emotional based.
Then we have other indicators that are actually hard data. What was produced? How much was produced? Where was it produced? What was shipped? So the problem is comparing the soft data analysis, these surveys, to hard data. And, of course, we have all these despaired indicators and we tend to just pay attention to the ones that fit our personal parameter. So if we're very bullish we just pay attention to the ones that look good and we disregard all the rest.
Well, I created an indicator and tracked for years that combines the Chicago Fed National Activity Index, which is a very broad measure of 80 different economic indicators, hard data mostly. The ISM surveys, the PMIs, the leading economic indicators, the National Federation of Independent survey, all the Fed manufacturing complex surveys - the Philly Fed, the Empire Fed, the Dallas Fed, et cetera. I take all these, I combine them into one index because it's a massive overview of what's happening in the overall economy.
That's index peaked at about mid of last year when we saw consumer confidence record highs. We saw a lot of the economic confidence at highs. And that corresponded with all of the inflow, this influx of capital that was being spent on repairing from three major hurricanes. You know, here in Houston we were hit by Hurricane Harvey in late 2017, and then you had two more major hurricanes right after that that hit Florida and then the East Coast. And then you had the two major wildfires out in California that destroyed billions of dollars' worth of damage.
All that occurred roughly at the same time in 2017, required billions of dollars of government and state stimulus to rebuild that. And, of course, that demanded construction workers and manufacturers to go back to work to start producing stuff to fill this demand. Of course, commodities complex, and we saw everything go up. If you take a look at earnings reports for companies, they saw demand coming in. And, of course, we saw lots of excitement over this rebounding economic. We all said this was Trump's idea. This was all Trumponics at work. No, it wasn't. It was Mother Nature at work, and she created a very short-term boost to the economic.
Now, that economic indicator, that very broad complex, that peaked in June, July of last year and has now rolled over rather sharply here in the last couple of months. And that corresponds with already what we're seeing happening in other areas of the economy right now. But it also corresponds with the fact, as you brought up, what's happening in Europe, South America, China, et cetera.
We are no longer an island in and of ourselves. We can to remain devoid of what's happening in the rest of the world. That global economic weakness is starting to come home to roost in our own economy, and not surprisingly.
Chris Martenson: That's certainly fascinating. And I noticed that our trade deficit with China is actually widened out a bit. And if you look at the underlying data, it's not because we're importing more from China, although there might have been a little inventory boost as people were trying to get around the tariffs that they thought might have been coming. It's because China stopped importing a lot of stuff from us. They're very nationalistic over there.
Remember when - I forget why - but Japan did something - I think it was a war memorial something. I think Xing Abe went to some war memorial. Anyway, in China they stopped buying Honda cars. They're like, that's it, we're done. So I'm not sure what's going on there, but certainly the idea that China's importing a lot less from us, that's got to have an impact at some point on our economy at some point. It's got to be a drag in there.
Lance Roberts: But real quick and to that point, also, too, if you take a look at third quarter GDP for this year - I'm sorry, last year - 2018 third quarter, third quarter GDP last year was at 3.5%. Well, the reason that was 3.5% is that 2.5% of that were businesses running out to stock up on inventory ahead of the tariff trade war between the Trump administration and China. Strip out the inventory build in third-quarter GDP last year; economic growth was only 1.0%.
So, again, a lot of that ramp-up that we saw had a lot to do with hurricanes, natural disasters and one-off events like trade wars that led to an early kind of economic prompt that's not sustainable long term. All it did was drag forward from future growth.
Chris Martenson: Let's talk about something else that is starting to impact growth at this point in time. You know what, Lance? Every time there's a government shutdown I don't even pay attention. I actually silently cheer a little bit because, you know, maybe people will figure out we don't need a Housing and Urban Development Department. I don't know.
But now it actually feels like it's starting to get to the point where it actually will bite. What are your thoughts?
Lance Roberts: I agree. First of all, I've joked about this before with government shutdowns. We're always talking about trying to save money in government, and we lay off these 800-900 thousand nonessential government workers. I don't know about you Chris, but in my business, if somebody's classified as nonessential they're not employed. I don't sit around and pay people who are nonessential.
So I think there is something to that. If you're classified as nonessential, maybe we need to rethink your job title and what you're doing.
Look, very importantly is that you just laid off 900 thousand people. It is going to show up in the employment reports when we get them because, again, we're not going to get employment reports until the government's not shut down anymore. But that is going to show up. That's going to reduce consumption to some degree. It's not going to be a huge hit to the economy.
What's going to be a bigger issue, and I think you're already seeing that, is what's happening to rates. Rates have come up - now rates have come down a little bit here lately, but rates are higher than they were last year. And we're already starting to see curtailment in people's activities in terms of housing and autos and other things. That is, I think, when you want to take a look at where the economy is headed, pay attention to what's really happening in auto sales, home sales, et cetera, because those are the things that actually move the economy long term.
Chris Martenson: Well, let's talk about interest rates real quick. You know, we had that flattening of the yield curve. It was all over the financial news last month, then it widened again a bit. I think the best description of this was from Wolf Richter in a recent piece. He called it yield curve spaghetti. Let me see what I can do here to explain to people what we're seeing on the yield curve.
So we're looking at the one-month yield, the three month, the six month, the one year, two year, three, five, seven, ten, twenty year. As we go out that curve, one month yield as of yesterday was 2.41% and out at three months it goes 2.43. So it's still positively sloped. We go all the way out to one year, we hit 2.57, and then at two years backs up at 2.53, three year 2.51, back out to five year 2.53. So very flat.
The point here is that when we go out to seven years from just six months, we only have 10 basis points of difference. That's a really flat curve. Is this meaningful to us anymore or has price discovery been destroyed by the Central Banks so much we don't know what to make of this?
Lance Roberts: There's a possibility of that. I certainly don't discount that. You know, I do pay attention to the yield curve. The problem with the yield curve is, and of course, there's been just a plethora of articles written about this. It doesn't matter anymore, it does matter, it doesn't matter. Look, here's the bottom line, and you're seeing this in bank earnings right now, by the way. Banks, they borrow short and they lend long. So if the yield curve flattens, profitability for banks becomes much more challenging. And you're seeing that in earnings now. And you're also seeing in the fact of mortgage originations, mortgage revenue as well, not surprising. Interest rates went up; people said I can't afford the house so I won't buy it. And that slowed that mortgage revenue down to a great degree.
So banks are very vulnerable to what happens with yield curves. Corporations also make decisions upon profitability. The issue becomes - used to, at the end of the day corporations borrowed money to go do stuff with, build a plant, employ more workers. They used that to do that. And as long as the project or the capital expenditure exceeded what the cost of the debt was then we do it.
So theoretically, if the cost of the debt exceeds what the return on the invested project is then they're not going to borrow money and, of course, that creates slower economic growth because they're not doing these things. But even in the same stance of doing stock buybacks and doing dividend payments, et cetera, for the first time that we've seen in the last decade, the yield on two-year treasuries is actually above the dividend yield of stocks. All the sudden there is an alternative to stocks in terms of yield. And so this is starting to attract money in other areas. So that's pulling away from productive investment as well.
So, again, yield curves matter longer term in the economic. .And here's one of the mistakes I think people make when they talk about this. They go, well, historically speaking, last time the yield curve inverted it was 19 months or 24 months or whatever the number of months was between that point of yield curve inversion and when the economic went into a recession.
Well, the big difference is where is the economy at the start of that cycle? At every other point in history, you were running at rates of 4.0 or 5.0% of economic growth. So to go from 4.0 or 4.5 to zero, actually negative to get to a recession, it takes a much longer time to get there. So yeah, sure, 18-24 months to get to a recession.
You're running at basically 2.5%. You're one half of the rate of economic growth that we've seen in the past. So therefore, just logic tells you that a yield curve conversion is going to get you to recession twice as fast because you have half the distance to fall.
So while I don't pay a tremendous amount of attention to the yield curve, I'm looking more at the other economic data. The yield curve is a good leading indicator ultimately of what happens in economic activity. I don't think it's much more than that. I wouldn't use it for a market timing indicator or anything else. But I think it's a good telltale sign that there is trouble in wonderland, so to speak.
Chris Martenson: I mean, somebody's looking at this and saying, you know, I'd rather pay more for five-year paper than one-year paper because the yield is lower out a five than at one. So somebody's looking at that and doing that. And I look at this whole yield curve spaghetti; I can't make a lot of sense of it particularly because - and it's kind of related to the government shutdown - but I look at the deficit numbers that are coming up.
Now, what's interesting to me, Lance, is that I think ten years ago the deficit that we currently see right now would have been all over the news. You practically can't read anything about it. People seem to just be shrugging. It's not part of the investment narrative right now. Nobody really cares.
Lance Roberts: Wait, wait, wait. Did you say ten years ago it would have mattered?
Chris Martenson: It would have mattered, yeah.
Lance Roberts: See, I disagree with you there because remember, all through the Obama administration and look, let me just rewrite a _____ [00:41:07] - I'm a fiscal conservative. I believe that we should operate our government fiscally responsibility. So I am anti-deficit. I am anti-debt. I am believing that if you want to create a strong economic growth environment, create capital prosperity for every American, your debt is a problem.
So what I cannot stand in terms of politics is somebody being hypocritical. And for eight years under the previous administration Republicans were ranting and raving about the debt and deficit and the fact that Obama administration doubled the national debt. This is horrible. Barrack Obama himself, in 2007, when he was campaigning to be President, said that it was treasonous that the Bush administration had doubled the national debt.
Only since this current administration taken office has the debt and the deficit no longer mattered. In fact, at the beginning of 2018 we passed a budget deficit bill that basically removed all limits from government spending, which was one of the big reasons we got bumped economic growth because we had a massive dump of capital being spent by the government into the economy in literally about four months that topped some of the economic growth numbers short term.
But since Trump was elected into office, the entire conservative complex has gone dead silent of the issues of debt of deficit after railing for eight years about the importance of debt and deficits.
Chris Martenson: I totally agree. Listen, politicians, they'll flipflop about anything. We got Nancy Pelosi saying we have to ban all these different types of guns, but I'm sure that her personal security detail will have access on her ban list. I guaranty it, right.
Lance Roberts: I don't want to get into a political discussion.
Chris Martenson: Me neither. [Cross talking] Ten years ago remember we had the Peterson Institute and you had David Walker out there and there was movies like I.O.U.S.A. coming out. It was a conversation piece that I don't see any more in the media and I'm confused by that. The media's looking for every possible reason to vilify Trump. They're just giving a complete pass on the deficit. It's not a headline. They're just little articles like, oh, this is odd, we're going to be a trillion-dollar deficit going forward.
I think these are going to bite at some point in time. I think this is an investment narrative that will came back to the fore. Currently, it seems almost dead from the financial places I frequent.
Lance Roberts: You're correct. And here's the one take. So forget everything else for just a moment. Here's the one thing that you need to understand about deficits. John Maynard Keynes, in his whole premise about economic environments, is that during an expansion governments should run a surplus so that when you have a recession governments can engage in deficit spending to help offset the drag from consumers, lesson the recession, and then, when you come out of the recession, you move the government back into a surplus to prepare for the next eventual downturn.
Well, beginning in the '80s, Ronald Regan - we had two back to back recessions. We had spiking interest rates. Reagan and Volcker did the right thing. They engaged in lowering interest rates, engaged in deficit spending to try to get the economy turned around. They were successful, and then every administration since then said, well, look a little deficit spending is good; a lot should be a whole lot better. And we continually engaged in increasing levels of deficit spending.
But here is the takeaway from this that you need to understand. In the middle of a financial crisis, whether it's the dot com crash or the finance crisis of '07, that's when you want the government in there doing deficit spending to help reduce the drawdown of an economic downturn, supporting areas of the economy that need to be supported. If you're going to run a $500 or $600 hundred billion during a recession that's fine. When you come out of it, you reverse that back to a surplus.
We are currently, at this moment, running a trillion-dollar deficit in a supposedly economically strong environment. What are you going to do when you actually have a recession? That's what everybody should be asking.
Chris Martenson: Well, I think the lesson of the '80s is spend more.
Lance Roberts: Well, you know, we can hit a $3.0 trillion deficit pretty quick, I guess.
Chris Martenson: This has all been excellent. Final question, I'm just wondering what your thoughts were on the Powell flipflop. For a while there I thought he was going to be cut from a different cloth than Bernanke and Yellen. And I guess shame on me, fool me three times. He looks the same to me.
Lance Roberts: You obviously talked to my dear friend Danielle DiMartino Booth at some point because she was a big - and look, I love her to death. I think she's brilliant. But she was very much adamant at the beginning of Jerome Powell's tenure that he was, to your point, a man cut from a different cloth. He was going to surprise everyone as to how hawkish that he was going to be. And he was initially.
I think two things happened to Jerome Powell that are not really surprising. I don't think they should be surprising to anyone - is that one, there is a tremendous amount of political pressure in Washington. You can go in, I think, with the best of intentions about being different, but at the end of the day, there's a tremendous amount of pressure from the political side of the ledger.
There is a bigger pressure from the financial side of the ledger. Remember that the Federal Reserve is owned by its' member banks which are your big, major Wall Street banks: Goldman Sachs, Bank of American, JP Morgan, and so forth and so on. Those are the member banks of the Federal Reserve.
And you cannot tell me for a moment that in the midst of this decline that we saw in October and November, that phone calls were not being made to Jerome Powell to basically shut the hell up. Because his context - hey, it's a strong economic, we're going to continue to cut our balance sheet, we're going to continue to hike rates, was the wakeup call for the markets in October. And that really was the moment, shortly after that, we got into November and then early December, we saw immediately that flipflop as the market continued to deteriorate as it weighed on the economic.
And, of course, you have Donald Trump, who had pegged his entire presidency on the movements of the stock market, which, by the way, I said was going to be a really bad idea when he got elected. But we saw that immediate flipflop. So yes, I think that Jerome Powell is a very intelligent man. He is a different animal in terms of previous Federal Reserve members. But I think what you saw was the pressure of Wall Street and the political process change his attitude.
Chris Martenson: I would agree with all that. And so we found out what the pain point of the Federal Reserve is. It's about a 10% drawdown. And what's unfortunate about that is that I think one of the things that Bernanke said was, in that famous op-ed in The Wall Street Journal is, listen, we have to get house prices back up, there's this thing called a wealth effect. We want financial assets to go higher.
And they have what I think is an unfortunate reference price sort of analysis. Like, oh, houses were at 2007 prices, we need to get them back there. No, those were too high. That was a bubble. There's no reason that you have to get back to your old bubble heights. So I think they have this thing like well, the stock market hit x - 26 thousand and change for the Dow, that's its correct price. And it's not, of course. So attempting to maintain that reference price takes more and more and more effort.
My catch phrase for this year is until and unless. Until and unless the Central Banks actually start to do more QE, not even just pausing QT but I mean more QE, I think we see more of this volatile and the rest is just, again, ping pong being played on a ship that's headed in a direction on some very stormy seas.
Lance Roberts: I think you're absolutely right. And the big thing that people need to remember about QE is don't forget that when we started QE in 2009, the Fed balance sheet was about $500 billion. So you went from $500 billion - it was five, eight hundred billion, and you go to $4.5 trillion on the balance sheet over the last decade.
So, in theory, if you want to try to create another 100% rate of return or 200% rate of return on the stock market, you're talking about increasing their balance sheet to $20 trillion to get the same net effect on the overall market itself and the economy.
And the question is that they actually have to buy bonds. There is only a limited supply of bonds within the market. And they can only buy, by the way, without a change by Congress in their charter, they can only but government guaranteed instruments. There are only so many treasuries and government national mortgage association bonds available for them to buy before they lock up the entire treasure market.
So there's a real risk here that lowering interest rates from 2.25% back to zero and doing QE may not even be enough of an effect to offset the risk of a corporate debt bubble type implosion, you next credit related event, as you spoke of earlier.
Chris Martenson: Exactly. Well, I would also support a full audit at transaction level detail of the Fed just to make sure there are no conflicts of interest or any illegalities happening. And to make sure that they are strictly - you know, they have their other category on their balance sheet. It's a very, very big number.
And don't forget, after super storm Sandy, the United States Federal Reserve at New York said hey, we didn't like all that water that came in. We're going to move our trading desk. We're going to move it to, oh, Aurora, Illinois, right next to the CME servers. Interesting move there.
So I'd be very interested to see because there's nothing on the CME that they will admit to buying. But the CME has announced that they have a Central Bank preferred buyer program because they're such great customers. We don't know which one's it could be - the Central Bank of Zimbabwe. But would love to know.
Lance Roberts: Well, they are next door, right.
Chris Martenson: They are next door, of course. But, you know, on the CME that's just futures and options. There's nothing on there that legally any Central Bank - I've scoured Central Bank balance sheets. Not one of them admits others owning a put, an option or a future on anything. But they're the best buyers on the CME, so take that for what it's worth. Just something that's sort of fun to wonder about.
So with that, Lance, we're out of time. Thank you so much for your time today. Please, tell people how they can follow you, your excellent work, all the people who write for realinvestmentadvice.com and anything else you want to tell people about.
Lance Roberts: Basically you just summed it up. Our website is realinvestmentadvice.com. We publish every single day, myself, Mike Lebowitz, CFA. Of course, we've got CFPs that publish work as well. Like you, we just try others publish work that is about what's about occurring. It's always considered to be contrarian or bearish or whatever it is. But we're simply pointing out the risk.
And what our philosophy is simply that we're invested in the markets. We're not sitting around in cash and sitting in a bunker with beanie-weenies and shotguns. We're invested in the markets. So we want the markets to go higher. We are investors. We do manage money for clients, and so we need the markets to go up to make our clients money.
So telling you why the markets are going to go up doesn't really help you be a better investor. What we need to focus on is the risk that's going to take our capital away. So that's what we really focus on. We talk about the economic data, the fundamental data, the technical data to help you make better investment decisions both there as well our as professional site, raipro.net.
Chris Martenson: Fantastic. And I follow you as well on Twitter @lanceroberts. So that works out great. Thank you so much for all the work you're doing and for you time today.
Lance Roberts: Sure. Absolutely, Chris. Let's do it again soon.
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