DECEMBER 2012: GLOBAL MACRO TIPPING POINT - (Subscription Plan III)

FISCAL CLIFF: US Capitulates on "RISK FREE"

As the world's Reserve Currency the US has enjoyed what is referred to as "Exorbitant Privilege". The US has been able to 'print' money but not suffer the consequences of the associated inflation and currency debasement that comes with such irresponsibility. This is because the 'exorbitant privilege' effectively allows the US to export its inflation. This inflation returns initially as higher import costs, but eventually as hyperinflation, as the world slowly abandons the US dollar and its reserve currency status. This 'exorbitant privilege' continues to work until something which was well understood prior to the US going off the gold standard no longer works. That is a concept referred to as the "Triffin Paradox".

The US Council on Foreign Relations aptly describes why Triffin's dilemma becomes unsustainable: "To supply the world's risk-free asset, the center country must run a current account deficit and in doing so become ever more indebted to foreigners, until the risk-free asset that it issues ceases to be risk free. Precisely because the world is happy to have a dependable asset to hold as a store of value, it will buy so much of that asset that its issuer will become unsustainably burdened."

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NOVEMBER 2012: MONTHLY MARKET COMMENTARY (Subscription Plan II)

THE P/E COMPRESSION GAME: An Old Game with a Different Twist to Misprice Risk

We are manipulating markets metrics in such a fashion as to intentionally Misprice, Misrepresent & Hide RISK. Prior PE reference boundary conditions which reflected risk have decoupled. Never has the game of forward operating earnings (versus historically trailing earnings) been more inappropriate than presently. Forward PE's can only be of value in rapid revenue and profit growth eras. This is not what we have presently. It is the wrong tool for the wrong job! Unless you are a sell side analyst, then it is exactly the right too for the difficult selling job you have. We have an era of Peak earnings growth RATES, slowing profit growth RATES and Peak PEs which are reflective of rapidly contracting PE's. We have a secular bear market in REAL terms but PE's are not contracting at a sufficient enough rate to reflect this. Though PEs in nominal terms net out inflation, they don't reflect the underlying downward trend in real terms. MORE>>

MARKET ANALYTICS & TECHNO-FUNDAMENTAL ANALYSIS

NOVEMBER 2012: MARKET ANALYTICS & TECHNICAL ANALYSIS - (Subscription Plan IV)

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NOVEMBER 2012: TRIGGER$ (Subscription - Plan V)

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	PART I - Understanding FINANCIAL REPRESSION
	PART II - FINANCIAL REPRESSION in Europe
	PART III - FINANCIAL REPRESSION in the US & ASIA
	PART IV - Preparations for FINANCIAL REPRESSION

Password: macro

US FISCAL SITUATION - Insiders View

Mr. Cox, a former chairman of the House Republican Policy Committee and the Securities and Exchange Commission, is president of Bingham Consulting LLC. Mr. Archer, a former chairman of the House Ways & Means Committee, is a senior policy adviser at PricewaterhouseCoopers LLP.

Cox and Archer: Why $16 Trillion Only Hints at the True U.S. Debt 11-26-12 WSJ

Hiding the government's liabilities from the public makes it seem that we can tax our way out of mounting deficits. We can't. A decade and a half ago, both of us served on President Clinton's Bipartisan Commission on Entitlement and Tax Reform, the forerunner to President Obama's recent National Commission on Fiscal Responsibility and Reform. In 1994 we predicted that, unless something was done to control runaway entitlement spending, Medicare and Social Security would eventually go bankrupt or confront severe benefit cuts.

Eighteen years later, nothing has been done.

Why? The usual reason is that entitlement reform is the third rail of American politics. That explanation presupposes voter demand for entitlements at any cost, even if it means bankrupting the nation.

A better explanation is that the full extent of the problem has remained hidden from policy makers and the public because of less than transparent government financial statements. How else could responsible officials claim that Medicare and Social Security have the resources they need to fulfill their commitments for years to come?

As Washington wrestles with the roughly $600 billion "fiscal cliff" and the 2013 budget, the far greater fiscal challenge of the U.S. government's unfunded pension and health-care liabilities remains offstage. The truly important figures would appear on the federal balance sheet—if the government prepared an accurate one. But it hasn't. For years, the government has gotten by without having to produce the kind of financial statements that are required of most significant for-profit and nonprofit enterprises. The U.S. Treasury "balance sheet" does list liabilities such as Treasury debt issued to the public, federal employee pensions, and post-retirement health benefits. But it does not include the unfunded liabilities of Medicare, Social Security and other outsized and very real obligations.

As a result, fiscal policy discussions generally focus on current-year budget deficits, the accumulated national debt, and the relationships between these two items and gross domestic product. We most often hear about the alarming $15.96 trillion national debt (more than 100% of GDP), and the 2012 budget deficit of $1.1 trillion (6.97% of GDP). As dangerous as those numbers are, they do not begin to tell the story of the federal government's true liabilities.

The actual liabilities of the federal government—including Social Security, Medicare, and federal employees' future retirement benefits—already exceed $86.8 trillion, or 550% of GDP.

For the year ending Dec. 31, 2011, the annual accrued expense of Medicare and Social Security was $7 trillion.

Nothing like that figure is used in calculating the deficit. In reality, the reported budget deficit is less than one-fifth of the more accurate figure.

Why haven't Americans heard about the titanic $86.8 trillion liability from these programs? One reason: The actual figures do not appear in black and white on any balance sheet. But it is possible to discover them. Included in the annual Medicare Trustees' report are separate actuarial estimates of the unfunded liability for Medicare Part A (the hospital portion), Part B (medical insurance) and Part D (prescription drug coverage).

As of the most recent Trustees' report in April, the net present value of the

1. Unfunded liability of Medicare was $42.8 trillion.
2. The comparable balance sheet liability for Social Security is $20.5 trillion.

Were American policy makers to have the benefit of transparent financial statements prepared the way public companies must report their pension liabilities, they would see clearly the magnitude of the future borrowing that these liabilities imply. Borrowing on this scale could eclipse the capacity of global capital markets—and bankrupt not only the programs themselves but the entire federal government.

These real-world impacts will be felt when currently unfunded liabilities need to be paid. In theory, the Medicare and Social Security trust funds have at least some money to pay a portion of the bills that are coming due. In actuality, the cupboard is bare: 100% of the payroll taxes for these programs were spent in the same year they were collected.

In exchange for the payroll taxes that aren't paid out in benefits to current retirees in any given year, the trust funds got nonmarketable Treasury debt. Now, as the baby boomers' promised benefits swamp the payroll-tax collections from today's workers, the government has to swap the trust funds' nonmarketable securities for marketable Treasury debt. The Treasury will then have to sell not only this debt, but far more, in order to pay the benefits as they come due.

When combined with funding the general cash deficits, these multitrillion-dollar Treasury operations will dominate the capital markets in the years ahead, particularly given China's de-emphasis of new investment in U.S. Treasurys in favor of increasing foreign direct investment, and Japan's and Europe's own sovereign-debt challenges.

TAXING CAN'T 'MATHEMATICALLY' WORK

When the accrued expenses of the government's entitlement programs are counted, it becomes clear that to collect enough tax revenue just to avoid going deeper into debt would require over $8 trillion in tax collections annually. That is the total of the average annual accrued liabilities of just the two largest entitlement programs, plus the annual cash deficit.

Nothing like that $8 trillion amount is available for the IRS to target. According to the most recent tax data, all individuals filing tax returns in America and earning more than $66,193 per year have a total adjusted gross income of $5.1 trillion. In 2006, when corporate taxable income peaked before the recession, all corporations in the U.S. had total income for tax purposes of $1.6 trillion. That comes to $6.7 trillion available to tax from these individuals and corporations under existing tax laws.

In short, if the government confiscated the entire adjusted gross income of these American taxpayers, plus all of the corporate taxable income in the year before the recession, it wouldn't be nearly enough to fund the over $8 trillion per year in the growth of U.S. liabilities. Some public officials and pundits claim we can dig our way out through tax increases on upper-income earners, or even all taxpayers. In reality, that would amount to bailing out the Pacific Ocean with a teaspoon. Only by addressing these unsustainable spending commitments can the nation's debt and deficit problems be solved.

Neither the public nor policy makers will be able to fully understand and deal with these issues unless the government publishes financial statements that present the government's largest financial liabilities in accordance with well-established norms in the private sector. When the new Congress convenes in January, making the numbers clear—and establishing policies that finally address them before it is too late—should be a top order of business.

FISCAL CLIFF - Status of First Salvos

BUILDING IN "LACK OF ACCOUNTABILITY"

Tim Geithner's Solution To The Debt Ceiling Is So Reasonable, Nobody Could Possibly Object 11-29-12 BI

A Plausible Endgame To The Fiscal Cliff That Would Actually Be Fantastic For The Economy... 11-29-12 BI

We finally got details of The White House's "opening offer" in the debate. The big surprise is that there's actually a lot of stimulus:

1. Mortgage relief,
2. Extension of the Payroll Tax holiday,
3. Extension of emergency unemployment benefits, and
4. Some infrastructure spending.

WAGE-PROFIT DISPARITY - Peak Profits, Trough Wages

Corporate Profits Vs. Total Wages 11-29-12 BI

PATTERNS - Bear Market Short Squeeze

Is November's Epic Short Squeeze Roundtrip Over? 11-29-12 Bloomberg via ZH

The broadest US equity indices began to fall following the 2nd Presidential Debate in mid-October, and stabilized after the 3rd Debate. Weakness was well balanced with the 'most-shorted' names staying in sync with the indices (in a more systemic risk-off manner). Hurricane Sandy appears to the beginning of traders pressing the most-shorted names (we would suspect this was beta chasing on expectations of weakness) and then once the election results were known the most-shorted names really outperformed (i.e. fell considerably more than the index). As the chart below shows, just as the Washington 'cone of silence' began, the Russell 3000 had fallen 6% in November (and 8% from the 2nd debate), while the Russell 3000's Most-Shorted Index had dropped almost 10% for the month (and 12% from the debate) for a massive 400bps outperformance. The following two weeks led to today where the most-shorted index has been squeezed 9.25% higher to catch up to the broad Russell 300's performance for the month. As the month closes, the index and its most-shorted names are perfectly in sync and unchanged with one another - thus reducing dramatically the fast-money ammunition for further squeeze potential.

The Russell 3000 and its most-shorted names have recoupled after dramatic short-chasing post-election.

Chart: Bloomberg

LGIVs - Local Government Investment Vehicles

Will LGIVs Be The 'Straw' To Break China's Credit-Fueled Growth 'Back'? 11-23-12 Barclays Research via ZH

We presented a detailed look into China's credit bubble earlier this week and why serial-extrapolators may well have to adjust their strategy calls sooner rather than later; but the more we look around in the detritus of China's non-centrally-issued datasets, the more concerned we become. To wit, the major issuance of local government investment vehicles (LGIVs) in the last few months to stabilize growth amid falling fiscal revenue growth.

The unintended consequence of PBoC-sponsored debt restructurings (as Barclays notes, rolling over debt via the issuance of new products or buyouts by asset management companies) is creating a false sense of security for these instruments, reinforcing the belief of an 'implicit government guarantee'. We tend to agree with Barclays when they conclude that the underestimation of the credit risks in both the trust loans and bond markets could induce excessive risk-taking - and warrants extremely close monitoring.

CASH DEPOSITS - Largest Weekly Surge

A Major Crisis Indicator Just Hit Its Highest Level Ever Zero Hedge via BI

HOUSING - Demographics Working Against A Rebound

Charting The Secular Decline (To Come) In Advanced Economy House Prices 11-14-12 Citi via ZH

It would appear that Americans are in general an optimistic bunch. The slightest green shoot of economic growth, or market trend-reversal, or Tigers' home run in the World Series and it is instantly extrapolated into "what could be". The US housing market (among others around the world) is just such a glimmer of hope (and homebuilder stock prices surely provide all the proof you need... just like JCP's 12% jump on 9/19? followed by its 46% decline since...). The trouble is, no matter how much you want something to happen; sometimes, there really is no way it's ever gonna happen. To wit, the young/old dependency ratios in the following six major economies of the world suggest whatever 'Eastman Kodak' bounce some housing markets are experiencing will inevitably be short-lived (no matter how much foreign cash is driven back into these advanced economies).

Economies are becoming a little 'over-burdened'...

which suggests the driver for house price appreciation just won't be there...

Charts: Citi

DEBT SATURATION - Debt Growth Outstrips Income Growth

The great deleveraging continues

US households continue to deleverage as they undergo bankruptcy, foreclosure, and simply paying off existing debts.  The appetite for new debt has been largely capped as the banking system recapitalizes through various subtle bailouts.  The same result has not occurred for US households:

US households are still highly levered with debt.  The system is lubricated by the machinery of debt.  This is why at the core of the crisis the issue of debt was so vital.  If you remember during the heart of the financial panic all the excuses given to bailout banks with blank checks were to “keep the credit markets going.”  But keep them going for what group of people?  The American public has been largely deleveraging to adjust to the new economic reality while the banking sector has the most favorable access to debt in modern history courtesy of the Federal Reserve.

The great stagnation can really be seen if we look at actual household income:

Since the 1970s household income growth has been shrinking year after year.  Proponents of a weak dollar hypothesis need to look at data like this and ask again why a weaker dollar is good for America.  It is clearly good for a select group of people but overall, it has been a crushing blow for the middle class.  Things were heading lower and lower until they have finally stalled out.

The 2000s were a period of reconsideration and people simply did not want to believe that income growth was stalling out so debt was the solution.  You build up credit as a nation.  The US as the biggest economy in the world has latitude here but we went ahead and turned our entire economy into a debt based casino.  The days of yanking money out of homes for vacations and cars was simply a method of spending years of future income in the moment.  That bill is now here and the ability to finance it all with debt is growing weaker and weaker.

One good way of measuring this is looking at household debt and GDP as a ratio:

Since the 1950s the trend was rather clear.  Then we peaked out in the 2000s.  The US has reached a peak debt situation. 

LEI - Leading-To-Lagging Ratio

LEI - Leading-To-Lagging Ratio Lance Street Talk Live, Roberts via ZH

CAPEX - A Long Term Secular Trend

Capital Formation and the Fiscal Cliff 11-26-12 John Mauldin

Jeremy Grantham GMO:

Typically I see less significance than others in debt and monetary factors and more in real factors. When someone says that China is building its trains and houses on debt I think, “No, they are built by real people with real bricks, cement, and steel and whatever happens to the debt, these assets will still be there.” (They may fall down but that’s a separate story; you can build a bad high rise with or without debt). So I take the quality and quantity of capital and people very seriously: they are the keys to growth and a healthy economy. A badly trained, badly educated workforce is a problem we will get to, but reduced, abnormally low capital investment, particularly in the U.S., is the current topic. My friend and economic consultant Andrew Smithers in London has a theory deserving much more attention in my opinion, and that is his concept of the “Bonus Culture.” When I was a young analyst, companies like International Paper and International Harvester would drive us all crazy, for just as the supply/demand situation was getting tight and fat profits seemed around the corner, they and their competitors would all build new plants and everyone would drown in excess capacity. The CEOs were all obsessed with market share and would throw capital spending at everything. It might not have been the way to maximize an individual company’s profit but it was great for jobs and growth. Now, in the bonus culture, new capacity is regarded with great suspicion. It tends to lower profitability in the near term and, occasionally these days, exposes the investing company to a raider. It is far safer to hold tight to the money and, when the stock needs a little push, buy some of your own stock back. This is going on today as I write, and on a big scale (approximately $500 billion this year). Do this enough, though, and we will begin to see disappointing top-line revenues and a slower growing general economy, such as we may be seeing right now.

My colleagues have put together Exhibit 5, which shows the long-term history of capital spending for the U.S. (The savings and investment rate has a 25% correlation with longrun GDP growth.) Mostly the data in Exhibit 5 reflects a lower capital spending rate responding to slower growth. The circled area, though, suggests an abnormally depressed level of capital spending, which seems highly likely to be a depressant on future growth: obviously you embed new technologies and new potential productivity more slowly if you have less new equipment. This currently reduced investment level appears to be about 4% below anything that can be explained by the decline in the growth trend. If this decline is proactive, if you will, and not a reflection of earlier declines in the growth rate, then based on longer term correlations it is likely to depress future growth by, conservatively, 0.2% a year.

STUDENT DEBT - Delinquency Rate Goes Parabolic

Student Debt Bubble Officially Pops As 90+ Day Delinquency Rate Goes Parabolic 11-27-12 Zero Hedge

We have already discussed the student loan bubble, and its popping previously, most extensively in this article. Today, we get the Q3 consumer credit breakdown update courtesy of the NY Fed's quarterly credit breakdown. And it is quite ghastly. As of September 30, Federal (not total, just Federal) rose to a gargantuan $956 billion, an increase of $42 billion in the quarter - the biggest quarterly update since 2006.

But this is no surprise to anyone who read our latest piece on the topic. What also shouldn't be a surprise, at least to our readers who read about it here first, but what will stun the general public are the two charts below, the first of which shows the amount of 90+ day student loan delinquencies, and the second shows the amount of newly delinquent 30+ day student loan balances. The charts speak for themselves.

This is how the Fed described this "anomaly":

Outstanding student loan debt now stands at $956 billion, an increase of $42 billion since last quarter.  However, of the $42 billion, $23 billion is new debt while the remaining $19 billion is attributed to previously defaulted student loans that have been updated on credit reports this quarter. As a result, the percent of student loan balances 90+ days delinquent increased to 11 percent this quarter.

oh and this from footnote 2:

As explained in a Liberty Street Economics blog post, these delinquency rates for student loans are likely to understate actual delinquency rates because almost half of these loans are currently in deferment, in grace periods or in forbearance and therefore temporarily not in the repayment cycle. This implies that among loans in the repayment cycle delinquency rates are roughly twice as high.

We'll let readers calculate on their own what a surge in 90+ day delinquency from 9% to 11% (or as footnote 2 explains: 22%) in one quarter on $1 trillion in student debt means. For those confused, read all about it in this September article: "The Next Subprime Crisis Is Here: Over $120 Billion In Federal Student Loans In Default" which predicted just this.

And so it's official: Pop goes the student loan bubble, as just confirmed by the Fed.

Luckily student debt is dischargeable in bankruptcy. Oh wait. It isn't.

Source: Quarterly Report on Household Debt and Credit, Household Credit Excel Source

STUDENT LOANS - An Unrecognized Crisis

Growth In College Tuition Vs. Growth In Earnings For College Graduates 11-28-12 Citi via BI

This is a great chart from Citi (just tweeted by Tracy Alloway) that says a lot about why people are worried about student debt.

Citi

The New York Fed reported yesterday that student debt loads have now hit $956 billion, up $42 billion from last quarter.

Federal Student Lending Swells 11-28-12 WSJ

U.S. student-loan debt rose by $42 billion, or 4.6%, to $956 billion in the third quarter, the Federal Reserve Bank of New York said Tuesday. Overall household borrowing fell during that period.

Since the end of 2007, just before the financial crisis hit, total student debt has grown by more than 56%, adjusted for inflation, the new Fed data show. During that time, overall household debt—including mortgages, student loans, auto loans and credit cards—fell by 18%, to $11.31 trillion as of Sept. 30.

Payments on 11% of student-loan balances were 90 or more days behind at the end of September, up from 8.9% at the end of June, a rate that now exceeds that for credit cards. Delinquency rates for all other consumer-debt categories fell or were flat. Nearly all student loans—93% of them last year—are made directly by the government, which asks little or nothing about borrowers' ability to repay, or about what sort of education they intend to pursue.

PATTERNS - Market Not Prepared for Fiscal Cliff Disappointment!

Only The VIX Gets The Fiscal Cliff 11-28-12-Scott Barber, BlackRock via BI

EARNINGS - In a Few Tired Hands

4 Fun Facts On 2012/2013 Earnings 11-28-12 Morgan Stanley via ZH

It's that time of year when 2013 outlooks and strategy pieces bog down an otherwise already overloaded inbox. Some are wise; some not so much. We thought the following four wise fun facts noted from Morgan Stanley's Adam Parker would brighten-up an otherwise dull Wednesday evening. Full details below but: just 10 S&P 500 stocks accounted for 88% of 2012 EPS growth; those same 10 will account for only 34% of the growth next year; 5 stocks are projected to account for one-quarter of the entire S&P 500's EPS growth in 2013; and of the 20 firms expected to grow earnings faster in 2013 than in 2012, 8 of them will be swinging from major slumps to miraculous gains. It seems that once the fiscal cliff is behind us then the whole world is fixed, equities can initiate ramp-mode, and analysts' expectations have a chance of coming true. Parker, however, like us remains more stoic of reality with his 1434 end-2013 S&P 500 target (with downside 1135 possible).

Fun Fact 1: These 10 stocks accounted for 88% of the Earnings growth of the S&P 500 in 2012 - so much for diversification...

Fun Fact 2: those same 10 names will account for only 34% of EPS growth next year (still 2% of the names accounting for 34% of the growth is remarkable)

Fun Fact 3: These 5 firms are forecast to account for 25% of the S&P 500's EPS Growth in 2013!!

Fun Fact 4: And the following names will see 2013 earnings growth faster than 2012, some will be entirely miraculous in their resurgence...

So, all in all, the numbers remain highly concentrated, highly hopeful, and highly extrapolated...

as it appears 2013 expectations have a long way to fall back to reality (as many learned in 2012...)

Charts: Morgan Stanley

EARNINGS - Overstated Due to the Magnitude of One Time Write-Offs

14% Of S&P 500 Earnings Is "One Time Write Off" Vaporware 11-27-12 Zero Hedge

With everyone now well aware that revenues of S&P 500 companies have taken a turn for the worse and are declining for the second consecutive quarter (with well over a majority missing sellside estimates and trimming Q4 guidance), many are wondering: how can corporate EPS continue to grow, even if nominally? Are there really so many people left to be laid off? The answer, to the latter, is no, for the simple reason that it is not layoffs that have driven the upward persistency in corporate earnings. Then what has? Simple: when in doubt, "charge it" - this axiom seems to work not only for cash strapped consumers, but for corporations who know very well that when unable to satisfy earnings estimates using regular way earnings, companies can just write off "one time charges" and get the going concern EPS benefit for such an action.In fact, as the table below shows, a whopping 14% of all 'pro forma' 2012 EPS will be due to "one time write offs" - the highest proportion of total earnings since 2009!

Quarterly corporate write-offs since 2010 and projected:

And the long-term chart:

What is very clear is that of the 104 in pro forma EPS, a whopping 14% of this, or 14.06, is in accounting "one time write off" fudges which are merely creative accounting ways to get benefit for deteriorating operations, and which never manifest in the form of actual earnings or cash flows.

In other words, far from the touted adjusted EPS growth from 97.88 to 104 in 2012, which implies the S&P is oh so cheap at 1400, or under a 14x multiple, when one looks at real earnings pre-write offs which are not and have never been earnings, but are merely an accounting gimmick used and abused by every company since time immemorial, the real earnings in 2012 will be 89, which in turn means that the implied forward PE multiple is roughly 16x at the current market level: above historical average.

It also means that in 2012, GAAP EPS will grow by a tiny 2.7%, the bulk of which can be attributed to financial firm's loan loss reserve release, which is also a form of one-time EPS adjustment.

Finally, and proving that the real EPS trend has caught up with the decline in revenues, is that Q4 GAAP EPS of 22.00 are going to be down from Q3's 23.29, dashing all hopes of a surge in Q4 earnings net of every GAAP fudge imaginable.

And this is how companies perpetuate the myth that all is well on the bottom line, since top line growth is now dead as the twinkie, and only endlessly recurring "one time" adjustments are left.

PATTERNS - Divergences

Just A Reminder... 11-26-12 Zero Hedge

As you glare hopefully at the critical 1400 level on the S&P 500, we thought a gentle reminder of that vertically challenged relative performance of economic fundamentals would be worthwhile...

EARNINGS - 10 Tired Generals Carrying the Market

10 Stocks Account For 88% Of S&P 500 Earnings Growth 11-26-12 Morgan Stanley via BI

PATTERNS - Volumes Continue to Warn

NYSE Volume 11-26-12 Zero Hedge

The lowest Monday-after-Thanksgiving Day NYSE volume since 1996!

S&P 500 - Between 40-70% above pre-bubble valuation norms

Overlooking Overvaluation John P. Hussman, Ph.D.

Stocks are overvalued, and market conditions have moved in a two-step sequence from overvalued, overbought, overbullish, rising yield conditions (and an army of other hostile indicator syndromes) to a breakdown in market internals and trend-following measures. Once in place, that sequence has generally produced very negative outcomes, on average. In that context, even impressive surges in advances versus declines (as we saw last week) have not mitigated those outcomes, on average, unless they occur after stocks have declined precipitously from their highs. Our estimates of prospective stock market return/risk, on a blended horizon from 2-weeks to 18-months, remains among the most negative that we’ve observed in a century of market data.

On the valuation front, Wall Street has been lulled into complacency by record profit margins born of extreme fiscal deficits and depressed savings rates.

Profits as a share of GDP are presently about 70% of their historical norm,

and profit margins have historically been highly sensitive to cyclical fluctuations. So the seemingly benign ratio of “price to forward operating earnings” is benign only because those forward operating earnings are far out of line with what could reasonably expected on a sustained long-term basis.

It’s helpful to examine valuations that are based on “fundamentals” that don’t fluctuate strongly in response to temporary ups and downs of the business cycle. The chart below compares historical price/dividend, price/revenue, price/book and Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) to their respective historical norms prior to the late-1990’s market bubble - a reading of 1.0 means that valuations are at their pre-bubble norm.  

Note that outside of the bubble-era, major bull market peaks tended to occur with valuations about 30-50% above the historical norm, while bear markets regularly brought valuations back to the historical norm and often well below that level. “Secular” lows generally occurred at valuations about half the historical norm. The 2000 market peak (which the S&P 500 remains below, more than 12 years later) reached valuation multiples more than three times the historical norm.

Presently, on the basis of smooth fundamentals such as revenues, book values, dividends and cyclically-adjusted earnings, the S&P 500 is somewhere between 40-70% above pre-bubble valuation norms, depending on the measure. That’s about the same point they reached at the beginning of the 1965-1982 secular bear period, as well as the 1987 peak. Stocks are far less overvalued than they were in the late-1990’s, but it is worth noting that nearly 14 years of poor market returns have resulted simply from the retreat from those bubble valuations to the current rich valuations. If presently rich valuations were to retreat again to undervalued levels that have accompanied the start of secular bull markets (see 1982 for example), stocks would produce yet another extended period of dismal returns. That prospect certainly isn’t the reason for our present defensiveness, but it’s worth understanding the dynamic that has produced the pattern of market returns we’ve observed over time.

The defining feature of dividends, revenues, book values and the 10-year average of inflation-adjusted earnings (the denominator of the Shiller P/E) is that they are smooth and insensitive to cyclical fluctuations in profit margins over the business cycle. In contrast, standard price/earnings ratios generally seem very reasonable when profit margins are elevated, and seem extreme when profit margins are depressed. Needless to say, that is no small risk for investors who are enamored with seemingly “reasonable” P/E ratios based on forward operating earnings (which assume that companies will indefinitely earn profit margins about 70% above historical norms).

While we prefer to explicitly model the stream of expected future cash flows in our own valuation work, these multiples can be converted into 10-year total return estimates for the S&P 500 using a fairly “model free” rule of thumb, by associating “fair” value with a 10% prospective return. If we write the normalized price-fundamental ratio as “NPF”, and assume that deviations are gradually corrected over a period of 10 years, we have:

Estimated prospective 10-year S&P 500 total return = 1.10/(NPF^.1) – 1

So for example, an NPF of 1.0 corresponds to a 10% 10-year prospective return. An NPF of 0.5, which we might see at the start of a secular bull market, would correspond to a 10-year prospective return estimate of 1.10/(0.5^.1)-1 = 17.9%.

As a more concrete example, with the S&P 500 price/dividend ratio presently about 43, versus a historical norm of 26, the NPF on dividends is about 43/26 = 1.65. That figure translates into a 10-year prospective return estimate of 1.10/(1.65^.1)-1 = 4.6%.

The chart below compares 10-year total return estimates using this rule-of-thumb with the actual subsequent 10-year total returns (nominal) achieved by the S&P 500. While explicitly modeling cash flows generally produces tighter results in our experience, these “model free” estimates have aligned well with subsequent outcomes. It should be evident that smooth fundamentals such as dividends, revenues, book values, and long-averaged earnings can provide a reasonable basis for long-term return expectations. As always, past relationships between fundamentals and subsequent market returns don't ensure the future reliability of these relationships.

It’s interesting to note both the broad correlation between the estimates and the subsequent returns, as well as the periods where they don’t match. In general, points where the actual 10-year return on the S&P 500 (SPX10YR_TR) shoots well beyond the projected return are points where the terminal valuation at the end of the 10-year period was well out of line with historical norms. Examine 1964 for example – the actual subsequent 10-year return significantly undershot the expected 10-year return. That outcome reflects the fact that the terminal valuation at the end of the 10-year period (1974) was deeply below the norm, so stocks lost more during that period than one would have expected. Similarly, examine 1990. In that case, the actual return substantially overshot the expected return. That outcome reflects the fact that the terminal valuation at the end of the 10-year period (2000) was dramatically above the norm. At present, the return of the S&P 500 over the past decade – though below average – has actually overshot what would have been expected in 2002. This reflects the fact that valuations today are still well above their norms. Unless we assume that valuations will remain rich forever, this doesn’t portend well for returns going forward.

Emphatically, the rule-of-thumb cannot be accurately used with fundamentals like “forward operating earnings” that are sensitive to expansions and recessions. When the denominator of your valuation multiple is affected by cyclical economic fluctuations, the multiple often says more about where you are in the business cycle than where you are in terms of valuation. Likewise, the proper historical “norm” for a valuation multiple is the level that is itself associated with “normal” subsequent returns. We sometimes see analysts using valuation “norms” where nearly half of the data represents bubble valuations since the mid-1990’s. We are now nearly 14-years into a period where the S&P 500 has underperformed Treasury bills. It is lunacy to consider the valuations that produced this outcome as the “norm.”

To illustrate this point, notice that while Shiller P/Es below 12 have historically been associated with subsequent returns averaging about 15% annually over the following decade, Shiller P/Es about 22 or higher have been followed by nominal returns averaging only about 3.6% annually over the next decade, on average (the present multiple is 21.2). With little respite, the Shiller P/E has been above 22 since 1995, and the average Shiller P/E since that time has been over 27. To load that stretch into the calculation of the “normal level” destroys the whole concept of a norm: the valuation norm should be the level that is reasonably associated with “normal” subsequent market returns.

We remain convinced that stocks are richly valued here. A fairly run-of-the-mill normalization of valuations in the course of the present market cycle would imply bear market losses of about one-third of the market’s value, without even establishing significant undervaluation. Then again, there’s no assurance that valuations will normalize, or that stocks will experience a bear market here. Maybe Wall Street is correct that profit margins will remain forever elevated and The New Global Economy™ will never again witness “normal” valuations on these measures at all. There’s no shortage of analysts who effectively embrace that view by focusing only on forward-operating earnings.

Still, it’s worth a moment’s consideration that “secular” lows (which we typically observe every 30-35 years, most recently in 1982, and that serve as launching pads for long-term market advances) have usually been associated with declines in normalized price-fundamental ratios to about half of their historical norms. Such an event even 15 years from today would be associated with an estimated annual total return of just 2.7% for the S&P 500 between now and then. Such an event a decade from now would be associated with a negative expected total return for the S&P 500 in the interim. And while it’s not our expectation, such an event in the present market cycle would make “S&P 500” not just an index, but a price target.

[Geek’s Note: The more general version of this rule of thumb is: Estimated prospective 10-year S&P 500 total return = 1.10/([NPF_current/NPF_future]^(1/T)) – 1. So moving from an NPF of 1.4 to an NPF of 0.5 over a period of 15 years would produce an estimated prospective return of 1.10/([1.4/.5]^(1/15))-1 = 2.7%].

CANARIES - Cash Going to the Sidelines

"The Cash On The Sidelines" Is The Smartest Money... 11-27-12 Zero Hedge

GMO, Boston's $104bn asset-management firm, has 'given-up' on the bond market. However, this is not a clarion call for equity bulls, as the FT reports, GMO's head of asset-allocation Ben Inker notes the only time he has held more cash was in late 2007, before the financial crisis. Today's equity valuations, he notably points out, are predicated on today's profit margins being sustainable and he thinks US corporate profits are set to fall - even if growth picks up. Critically, this smart-money cash-hoarder rightly sees the problem as one prominent during the presidential election - that of income inequality. "One of the things that happens as profits grow as a per cent of gross domestic product is income becomes more and more unequal because the ownership of capital is extraordinarily uneven. And there's a natural tension that forms there from a societal perspective." So far, Inker adds, government spending has supported the economy and so profits. But a pick-up in growth requires higher consumption, and the only way to get that is through higher incomes, which must come from profits. So that's where the dry powder is Maria - in the smartest investors' hands.

Via FT:

But his dislike of fixed income does not mean he is a fan of stocks...

Rather, Mr Inker says that he is waiting for better times; forty per cent of a benchmark free asset allocation hedge fund he oversees is in “dry powder”.

The only time it has held more cash was in late 2007, ahead of the financial crisis, he says. A tenth of the portfolio is in emerging market and asset-backed paper and the rest is in stocks for want of anywhere safer.

...

However, he thinks US corporate profits are set to fall even if growth picks up, in part because of an issue that was prominent in the presidential election – growing income inequality.

“One of the things that happens as profits grow as a per cent of gross domestic product is income becomes more and more unequal because the ownership of capital is extraordinarily uneven. And there’s a natural tension that forms there from a societal perspective.”

He says that since the financial crisis, government spending has supported the economy and so profits. But a pick-up in growth requires higher consumption, and the only way to get that is through higher incomes, which must come from profits.

...

A disorderly break-up of the euro remains the big “undiversifiable risk”, says Mr Inker. Emerging markets are fairly valued but “scary” due to the unknown path for China.

INTEREST RATES - Determined by Future Inflation & Growth

Chart That Debunks What Everyone Says About The National Debt 11-25-12 BI

Paul Krugman posts a simple chart that makes a profound point. It compares the yield on UK debt vs. US debt.

What should stand out for you, instantly, is that the two countries borrow at virtually identical rates, and have for years.

What this should show to people is that much of the popular stories that people tell about sovereign debt is a myth.

Countries that borrow in their own currencies and can "print" at will don't have default risk, so their borrowing costs are an expression of expectations of future interest rates and growth.

The US has been notably profligate since the crisis. The UK (under Cameron) has been prematurely austere. The upshot: it hasn't mattered much on the yield front.

The fact that the UK borrows so cheaply also undermines the idea that somehow the US' reserve currency status is a big game changer it's not.

If you want to get cute, you can throw in German, Japanese, and Australian rates on their too, all of which have moved similarly, and all of which have pursued different monetary/fiscal approaches.

Trying to tell a good story about why this or that country has low borrowing costs tends to become difficult.

That being said... as Krugman acknowledges, each of these countries has seen interesting currency fluctuations, the more realistic avenue for global markets to express their "vote" on a country's policy.

STATISM - Bureaucratic Despotism

Bureaucratic Despotism 11-28-12 Bob Hoye via SafeHaven.com via ZH

"A great civilization is not conquered from without, until it has destroyed itself from within. The essential causes of Rome's decline lay in her people, her morals, her class struggle, her failing trade, her bureaucratic despotism, her stifling taxes, her consuming wars."

- Will Durant, The Story Of Civilization III, Epilogue, 1944

A number of sources list this as a quote, but it is a synthesis of the Epilogue "Why Rome Fell". It is valid then as well as now. America as we know it won't collapse, but Americans have been unusually successful in dealing with "bureaucratic despotism". They will be successful again. Bankruptcy of another experiment in bureaucratic despotism will prompt a refreshing turn to reform of bullying politics.

The election was a big day for the implacable forces of big bureaucracy, main stream media and big unions. There is no change from before the election.

Read this one over slowly and absorb the facts that are within this definition! I love this word and believe that it will become a recognized English word. Finally, a word to describe our current political situation...

* * * * *

"The king has erected a multitude of New Offices, and sent Swarms of Officers to harass our People and eat out their substance."

- U.S. Declaration of Independenc

LOST DECADE - Standard of Living

America's Lost Decade In One Simple Chart 11-27-12

Forget the stock market's dismal decade of much-ado-about-nothing and ignore the USD Dollar's declination; when it comes to reflection on what this once great nation has 'created' since 2001, the following chart from Pennsylvania's Department of Public Welfare sums it up better than most.