INFLATION - Arrived with the Removal of a Gold Standard Discipline and Creditism

US MONETARY- Fed December 2013 FOMC "TAPER"

The Taper In Perspective 12-18-13 Zero Hedge

What We Learned Today

• We learned that the repeated pleadings of the TBAC (starting in May and continuing throughout the year) for a Taper, did not fall on deaf ears, and the Fed finally became aware that it is monetizing US debt at too feverish a pace resulting in an acute lack of liquidity in the bond market.
• We learned that despite the arrival of the taper, Bernanke will end his tenure with the lamentable record of having been the only Fed Chairman never to have started a tightening cycle (remember: according to Bernanke “tapering is not tightening”).
• We learned that even though the Fed has taken its first step toward balance sheet renormalization one year after launching open-ended QE, it will still inject $75 billion in “Flow” into the capital markets, if not the economy, on a monthly basis, an amount which still means the Fed will consume about 0.25% of all outstanding and newly-issued 10 Year equivalents on a weekly basis (and more if the deficit declines further). The side effect of that will be that as Dealers scramble for the last piece of capital appreciation, even more capital will be sequestered into the US capital markets, leading to even more asset inflation, and even more core CPI deflation (which eventually will result in the Untaper).
• We learned that even the Fed does not give much credit to the BLS’ definition of inflation, because while the Fed has now repeatedly observed that the unemployment rate is sliding due to the collapse in the participation rate and hence labor improvements are simply a mathematical mirage, its core lament was the very subpar, and outright disinflationary CPI readings. Readings, however, which if taken seriously, would not have allowed the Fed to taper right here and right now.
• We learned that good news will continue to be bad news, and vice versa, as the faster the economy relapses into a sub-2% growth rate (and Obamacare will promptly help out in that department in the new year), the faster the Fed will take a long, hard look at returning to its baseline $85 billion (or more) per month liquidity injection. Because “data dependent” means that the stronger the data, the faster the Fed’s crutches go away: crutches that have been responsible for 100% of the market upside since March 2009. Or maybe this time the Fed has actually timed the economic recovery flawlessly and indeed a virtuous cycle is emerging. Maybe, maybe not: ask Jean-Claude Trichet who hiked rates at the ECB a few months before the sharpest European crisis flare up forced Bernanke to once again bail out the Old World.
• We learned that over the past year – based on the pace of security monetization - the panic at the Fed regarding the economy has been greater than during QE1 and QE2 (see chart below). The minimal reduction to $75 billion in QE per month, or $900 billion per year, shows that the panic is still as acute and as pressing as ever, even as the cost of balance sheet expansion gets larger, even as the Fed now owns one third of all 10 Year equivalents, and even as the incremental benefits of QE to the economy – if any - decline with every month. The “good” news (if only for corporate insiders and the 1%): in the absence of capex spending, and organic growth, corporate PE multiples will continue to expand in lockstep with the Fed’s balance sheet, pushing the S&P into ever greater, and ever more unsustainable bubble territory.
• Perhaps most importantly, we learned that courtesy of very dovish forward guidance, the thresholds for further flow reduction will be very steep, and the unemployment rate will have to drop to 6% before QE ends let alone unleashes the start of a tightening cycle. Of course with unemployment benefits ending, the US may have an unemployment print of 6.5% as soon as February/March. More importantly, it means that without a firm flow reduction schedule, the current monthly liquidity injection amount will remain unchanged for a long time, as the last thing Janet Yellen will want to do as she carefully settles into her new job will be to accelerate what is already a tightening (because, yes, Flow matters, not Stock, and tapering is tightening) monetary regime.
• Finally, we learned what the difference between $85 billion and $75 billion is in the grand scheme of things. Or, in case we haven’t, here is a chart showing just how “vast” the impact of today’s announcement will be on the Fed’s balance sheet at December 31, 2021 when instead of printing well over $5 trillion at its old monetization pace, the Fed’s balance sheet will be only $4.9 trillion.

FED TAPER - The Last Time A Major Central Bank "Tapered" QE

What Happened The Last Time A Major Central Bank "Tapered" QE? 12-18-13 Zero Hedge

After having followed a zero interest rate policy strategy and facing a further deteriorating economy in an environment of falling prices (deflation), the Bank of Japan (BoJ) announced the introduction of QE on 19 March 2021 and kept it in place until 9 March 2021. The BoJ chose for a very orderly and gradual unwinding of its government securities portfolio, by continuing its regular purchases of these securities (i.e a taper and not sale).  The market rejoiced at the normalization for a week or 2... before dropping 24% in the following 2 months. Of course, that was a "policy mistake"; the Fed knows this time is different.

Think 24% is ok and Fed will just rescue stocks again?... things "esclated"...

to end -75%.

Awkwardly that lines up with the 1920/30s analog we have previosuly noted...

US FISCAL - Political Budget Cowardice and Capitulation

Peter Schiff Bashes "Feeble And Fictitious" Budget Deal 1215-13 Peter Schiff via ZH

David Stockman's exclamation at the "betrayal" realized within the latest so-called "festerng fiscal" budget deal is taken a step further with Peter Schiff's head-shaking diatribe on Congress' inability to show that it is truly "capable of tackling our chronic and dangerous debt problems." So America blissfully sails on, ignoring the obvious fiscal, monetary, and financial shoals that lay ahead in plain sight. I believe that will continue this dangerous course until powers outside the United States finally force the issue by refusing to expand their holding of U.S. debt. That will finally bring on the debt and currency crisis that we have created by our current cowardice.

Submitted by Peter Schiff via Euro Pacific Capital,

They Bravely Chickened Out

Earlier this week Congress tried to show that it is capable of tackling our chronic and dangerous debt problems. Despite the great fanfare I believe they have accomplished almost nothing. Supporters say that the budget truce created by Republican Representative Paul Ryan and Democratic Senator Patty Murray will provide the economy with badly needed certainty. But I think the only surety this feeble and fictitious deal offers is that Washington will never make any real moves to change the trajectory of our finances, and that future solutions will be forced on us by calamity rather than agreement.

There can be little doubt that the deal resulted from a decision by Republicans, who may be still traumatized by the public relations drubbing they took with the government shutdown, to make the 2014 and 2016 elections a simple referendum on Obamacare. Given the ongoing failures of the President's signature health care plan, and the likelihood that new problems and outrages will come to light in the near future, the Republicans have decided to clear the field of any obstacles that could distract voters from their anger with Obama and his defenders in Congress. The GOP smells a political winner and all other issues can wait. It is no accident the Republican press conference on the budget deal was dominated by prepared remarks focusing on the ills of Obamacare. 

Although he had crafted his reputation as a hard nosed deficit hawk, Paul Ryan claimed that the agreement advances core Republican principles of deficit reduction and tax containment. While technically true, the claim is substantively hollow. In my opinion the more honest Republicans are arguing that the Party is simply making a tactical retreat in order to make a major charge in the years ahead. They argue that Republicans will need majorities in both houses in 2014, and the White House in 2016, in order to pass meaningful reforms in taxing and spending. This has convinced them to prioritize short term politics over long term goals. I believe that this strategy is wishful thinking at best. It magnifies both the GOP's electoral prospects (especially after alienating the energetic wing of their party) and their willingness to make politically difficult decisions if they were to gain majority power (recent Bush Administration history should provide ample evidence of the party's true colors).

Their strategy suggests that Republicans (just like the Democrats) have just two priorities:

• Hold onto their own jobs, and to
• Make their own party a majority so as to increase their currency among lobbyists and donors.

This is politics at its most meaningless.  I believe public approval ratings for Congress have fallen to single digit levels not because of the heightened partisanship, but because of blatant cowardice and dishonesty. Their dereliction of responsibility will not translate to respect or popularity. Real fiscal conservatives should continue to focus on the dangers that we continue to face and look to constructive solutions. Honesty, consistency and courage are the only real options. 

In the meantime we are given yet another opportunity to bask in Washington's naked cynicism.

Congress proposes cuts in the future while eliminating cuts in the present that it promised to make in the past!

The Congressional Budget Office (which many believe is too optimistic) projects that over the next 10 years the Federal government will create $6.38 trillion in new publicly held debt (intra-governmental debt is excluded from the projections). This week's deal is projected to trim just $22 billion over that time frame, or just 3 tenths of 1 percent of this growth. This rounding error is not even as good as that. The $22 billion in savings comes from replacing $63 billion in automatic "sequestration" cuts that were slated to occur over the next two years, with $85 billion in cuts spread over 10 years. As we have seen on countless occasions, long term policies rarely occur as planned, since future legislators consistently prioritize their own political needs over the promises made by predecessors.

The lack of new taxes, which is the deal's other apparent virtue, is merely a semantic achievement. The bill includes billions of dollars in new Federal airline passenger "user fees" (the exact difference between a "fee" and a "tax" may be just as hard to define as the difference between Obamacare "taxes" and a "penalties" that required a Supreme Court case to decide). But just like a tax, these fees will take more money directly from consumer's wallets. The bigger issue is the trillions that the government will likely take indirectly through debt and inflation.

The good news for Washington watchers is that this deal could finally bring to an end the redundant "can-kicking" exercises that have frustrated the Beltway over the last few years. Going forward all the major players have agreed to pretend that the can just doesn't exist. In making this leap they are similar to Wall Street investors who ignore the economy's obvious dependence on the Federal Reserve's Quantitative Easing program as well as the dangers that will result from any draw down of the Fed's $4 trillion balance sheet.

The recent slew of employment and GDP reports have convinced the vast majority of market watchers that the Fed will begin tapering its $85 billion per month bond purchases either later this month or possibly by March of 2014. Many also expect that the program will be fully wound down by the end of next year. However, that has not caused any widespread concerns that the current record prices of U.S. markets are in danger. Additionally, given the Fed's current centrality in the market for both Treasury and Mortgage bonds, I believe the market has failed to adequately allow for severe spikes in interest rates if the Fed were to reduce its purchasing activities. With little fanfare yields on the 10 year and 30 year Treasury bonds are already approaching multi-year highs. Few are sparing thoughts for yield spikes that could result if the Fed were to slow, or stop, its buying binge.

So America blissfully sails on, ignoring the obvious fiscal, monetary, and financial shoals that lay ahead in plain sight. I believe that will continue this dangerous course until powers outside the United States finally force the issue by refusing to expand their holding of U.S. debt. That will finally bring on the debt and currency crisis that we have created by our current cowardice.

US FISCAL - Political Budget Cowardice and Capitulation - 2

Who Needs The Debt Ceiling? Russell Lamberti of the Ludwig von Mises Institute via ZH

US lawmakers reached a budget deal this week that will avert the sequester cuts and shutdowns. These fiscal “roadblocks” supposedly damaged investor confidence in 2013, although clearly no one told equity investors who’ve chased the S&P 500 up 26 percent this year. But even so the budget deal is seen by inflationists as only half the battle won, because it doesn’t deal with the pesky debt ceiling. Unsurprisingly, the old calls for a scrapping of the debt ceiling are being heard afresh.

Last week, The Week ran an opinion piece by John Aziz which argues that America (and all other nations for that matter) should keep borrowing until investors no longer want to lend to it. To this end, it is argued, the US should scrap its debt ceiling because the only debt ceiling it needs is the one imposed by the market. When the market doesn’t want to lend to you anymore, bond yields will rise to such an extent that you can no longer afford to borrow any more money. You will reach your natural, market-determined debt ceiling. According to this line of reasoning, American bond yields are incredibly low, meaning there is no shortage of people willing to lend to Uncle Sam. So Washington should take advantage of these fantastically easy loans and leverage up.

Here’s part of the key paragraph from Aziz:

Right now interest rates are very low by historical standards, even after adjusting for inflation. This means that the government is not producing sufficient debt to satisfy the market demand. The main reason for that is the debt ceiling.

What this fails to appreciate is that interest rates are a heavily controlled price in all of today’s major economies. This is particularly true in the case of America, where the Federal Reserve controls short-term interest rates using open market operations (i.e., loaning newly printed money to banks) and manipulates long-term interest rates using quantitative easing. By injecting vast amounts of liquidity into the economy, the Fed makes it appear as though there is more savings than there really is. But US bond yields are currently no more a reflection of the market’s demand for US debt than a price ceiling on gasoline is a reflection of its booming supply. Contra the view expressed in The Week, low rates brought about by contrived zero-bound policy rates and trillions of dollars in QE can mislead the federal government into borrowing more while at the same time pushing savers and investors out of US bond markets and into riskier assets like corporate bonds, equities, exotic derivatives, emerging markets, and so on.

Greece once thought that the market was giving it the green light to “produce” more debt. Low borrowing rates for Greece were not a sign of fiscal health, however, but really just layer upon layer of false and contrived signals arising from easy ECB money, allowing Greece to hide behind Germany’s credit status. As it turned out, a legislative debt ceiling in Greece (one that was actually adhered to) would have been a far better idea than pretending this manipulated market was a fair reflection of reality. Investors were happy to absorb Greece’s debt until suddenly they weren’t.

This is the nature of sovereign debt accumulation driven by easy money and credit bubbles. It’s all going swimmingly until it’s not. And there is little reason to think this time the US is different. Except that America might be worse. The very fact of the Fed buying Treasuries with newly printed money proves Washington is producing too much debt. China even stated recently that it saw no more utility accumulating any more dollar debt assets. If the whole point of QE is to monetize impaired assets, then the Fed likely sees Treasury bonds as facing considerable impairment risk. Theory and history are clear about the reasons for and consequences of large-scale and persistent debt monetization.

Finally, it is wrong to assert that the debt ceiling is the main reason for America’s fiscal deficit reduction. The ceiling has never provided a meaningful barrier to America’s borrowing ambitions, hence the dozens of upward adjustments to the ceiling whenever it threatens to crimp the whims of Washington’s profligate classes. America’s rate of new borrowing is falling because all the money it has printed washed into the economic system and found its way back into tax revenues. Corporate profits are soaring to all-time highs on dirt cheap trade financing. Corporate high-grade debt issuance has set a new record in 2013. Companies are rolling their short-term debts, now super-cheap thanks to Bernanke’s money machine, and issuing long, into a bubbly IPO and corporate bond market. The last time corporate profits surged like they’re doing now was during the credit and housing bubble that preceded the unraveling and inevitable bust in 2008/09.

These are money and credit cycle effects. The debt ceiling has had precious little to do with it. Moreover, US debt is neither crimped nor the US Treasury Department austere. Instead, the national debt is soaring, $60,000 higher for every US family since Obama took office and rising. Add to this the fact that the US Treasury’s bond issuance schedule is actually set to rise in 2014 due to huge amounts of maturing debt needing to be rolled over next year, and the fiscal significance of the debt ceiling fades even further.

The singular brilliance of the debt ceiling however, is that it keeps reminding everyone that there is a growing national debt that never seems to shrink. That is a tremendous service to American citizens who live in the dark regarding the borrowing machinations of their political overlords. Yes, politicians keep raising the debt ceiling, but nowadays they have to bend themselves into ever twisty pretzels trying to explain why to their justifiably skeptical and cynical constituents. Most people don’t understand bond yields, quantitative easing, and Keynesian pump-a-thons too well, but they sure understand a debt ceiling.

Conclusion

Those who adhere to the don’t-stop-til-you-get-enough theory of sovereign borrowing, and by extension argue for a scrapping of the debt ceiling, couldn’t be more misguided. In free markets with no Fed money market distortion, interest rates can be a useful guide of the amount of real savings being made available to borrowers. When borrowers want to borrow more, real interest rates will rise, and at some point this crimps the marginal demand for borrowing, acting as a natural “debt ceiling.” But when markets are heavily distorted by central bank money printing and contrived zero-bound rates, interest rates utterly cease to serve this purpose for prolonged periods of time. What takes over is the false signals of the unsustainable business cycle which fools people into thinking there is more savings than there really is. Greece provides a recent real-world case study of this very phenomenon in action. In these cases we are likely to see low rates sustained during the increase in government borrowing, only for them to quickly reset higher and plunge a country into a debt trap which may force default or extreme money printing.

Debt monetization has a proven track record of ending badly. It is after all the implicit admission that no one but your monopoly money printer is willing to lend to you at the margin. The realization that this is unsustainable can take a while to sink in, but when it does, all it takes is an inevitable fat-tail event or crescendo of panic to topple the house of cards. If the market realizes it’s been duped into having too much before the government decides it’s had enough, a debt crisis won’t be far away.

GERMANY - Merkel's Third Chancellorship Challenges

Germany's new coalition government -- consisting of German Chancellor Angela Merkel's center-right Christian Democratic Union party, its Bavarian sister party, the Christian Social Union, and the center-left Social Democratic Party -- officially took power on Dec. 17 after the German parliament voted to confirm Merkel's third chancellorship. There were two surprises among a host of familiar faces in the revamped 16-member Cabinet: Christian Democrat Ursula von der Leyen as defense minister and Social Democrat Joerg Asmussen as deputy labor minister (he will need to leave the European Central Bank's Executive Board). Christian Democrat Wolfgang Schauble will retain his post as finance minister. The Social Democrats' most prominent appointments will be Frank-Walter Steinmeier as foreign minister and Sigmar Gabriel as vice chancellor and economy and energy minister.

It took three months to form the new German coalition -- longer than it took to construct Germany's two previous governments under Merkel in 2009 and 2005 -- mainly because the Social Democrats had to decide whether they wanted to be the subordinate party in this "grand coalition." While the current arrangement will likely make domestic decision-making more efficient, Berlin's actions will still be guided by the strength of external demand, the need to maintain cohesion in the European Union and its bilateral relations with Russia. Thus, despite having strong parliamentary backing, Germany may not be any more effective at navigating Europe's economic crisis than it has been since 2009.

Stratfor has been analyzing the short- and long-term realities that any German government would face since before the Sept. 22 federal election. Below is a compilation of our forecasts for Germany's new grand coalition.

German Involvement With the Ukrainian Opposition

Dec. 12, 2013

• Germany has built relatively strong ties over the past years to one of the main Ukrainian opposition parties. However, given how sensitive Russia is to Western involvement in Ukraine, Germany is likely to settle for a balance in Ukraine between East and West to ensure the stability of the German-Russian relationship.
• Germany's new government likely has not formulated a strategy regarding Ukraine. Merkel's party has been the main one seeking political ties with the Ukrainian Democratic Alliance for Reform, but the Social Democratic Party prefers favorable ties with Russia and will likely argue against interfering too much in Ukraine.
• Berlin will not commit the same resources to Ukraine as will Moscow, and it will not seek to reorient Ukraine toward Europe. More likely, it will try to ensure that Ukraine maintains its balance between Europe and Russia.

Germany's Relationship With Russia Under a New Government

Nov. 27, 2013

• Apart from preserving the cohesion of the European Union, Germany's main foreign policy challenge over the coming years will be managing its relationship with Russia during a period of European structural weakness and Russian resurgence.
• The European Union will likely pressure Russia in the first quarter of 2014 through an investigation into the activity of Russian state-owned energy firm Gazprom in a number of Central and Eastern European countries. Germany is unlikely to openly interfere in this ordeal so as not to impair its good relations with Russia or undermine the European Union.
• Berlin will defend its strong bilateral energy relationship with Russia at the EU level and try to ensure the pressure on Gazprom does not affect their relationship.
• At the same time, Russia will likely make greater efforts next year to strengthen its industrial base and decrease its dependence on the energy sector. Given Germany's industrial competitiveness, Russia will likely try to partner with -- and potentially buy -- German companies to try to acquire technical expertise and set up production sites in Russia.

EU Issues Ahead for Germany's Next Government

Oct. 23, 2013

• The next German government might be more efficient in its decision-making, but that does not mean it will be more effective in steering Europe through the ongoing economic crisis.
• Once the grand coalition has defined a common position, it could implement policies with strong parliamentary backing. This will probably prove valuable in the coming years of the European crisis.
• Germany can do little to mitigate the threat that Euroskepticism poses to the European Union as an institution. Berlin will allow moderate parties in Britain or France to adopt more Euroskeptical policies to prevent them from losing votes to nationalist parties, in hopes that many of the proposed policies remain largely rhetorical.
• The next government in Berlin will likely find itself arguing at times to both weaken aspects of European integration and to strengthen the eurozone.
• Germany is aware that it likely will have to provide more financial assistance to EU countries in the next few years. Thus Berlin will try to couple new aid promises with stronger oversight of national budgets and the strengthening of the eurozone as a fiscal union.
• As one of the primary destinations for immigrants, Germany will be inclined to introduce stronger immigration controls and to crack down particularly hard on illegal labor and immigration. At the same time, Berlin will try to quell calls for aid from Europe's periphery by providing financial and technical assistance to these countries to deal with migration and long-term labor reform.
• Germany's new government will continue to have trouble implementing a grand German strategy for Europe and will remain largely a reactionary power.
• Berlin's central challenge in the coming years will be using its position as a creditor and economic power to strengthen its role in defining the EU integration process. This will continue to be difficult for Germany to achieve.

In Germany, Merkel Will Seek a New Coalition

Sept. 23, 2013

• A new coalition government in Germany will have to find a way to cope with rising domestic Euroskepticism and continuing economic difficulties throughout the eurozone.
• The next four years are likely to be more challenging for Berlin, given that the effects of Europe's unemployment crisis have yet to be fully felt.
• Popular reluctance to help other countries will likely be a growing concern for Germany's political elite; Euroskepticism and opposition toward the established parties' strategies is likely to rise when unemployment increases.

Europe: What to Expect After Germany's Elections

Sept. 18, 2013

• Any government in Berlin will continue to aid countries afflicted by the European crisis because Germany's economy relies on the free trade zone and on exports, which the rest of Europe can buy only if it can afford to do so.
• The new German government will have three priorities: strengthening domestic demand, addressing Germany's immigration issue and re-evaluating Germany's energy strategy.
• Ensuring unfettered access to Russian natural gas and oil will remain a foreign policy priority, though relations with Moscow will sometimes conflict with Germany's goal of integrating Europe.
• Continued financial assistance is a crucial element in Germany's national strategy of ensuring cohesion in Europe and preserving the currency union. Although German aid to struggling countries will still only come as a reaction to pressure from financial markets and threats of political instability, Berlin will almost certainly continue providing funds.
• To ensure the survival of the eurozone, Germany will also continue to try to preserve the Franco-German alliance.

The Stock Market in PPI Dollars

US ECONOMY - A self-destructive path toward oblivion

QE - FOMC Meeting

Why the Federal Reserve must taper quantitative easing before Christmas 12-15-13 UK Guardian Larry Eliott

Wall Street still uses QE to play global markets, but recovery – and risks – are calling time on this questionable experiment

"this Wednesday is as good a time as any for the Fed to make a start on its taper. The US economy is recovering; QE has been of questionable use; there are long-term risks in keeping the programme in place for too long; the financial markets are calm. The reasons for further delay are not especially good ones.

The decision the Fed is making this week is not about whether to tighten policy. It is not even about removing the stimulus. It is about reducing the amount of stimulus, bit by bit. The Fed will probably start by cutting its asset-buying programme by $10bn a month. The difference will be imperceptible, not least because the judgment on QE will be that it was worth a try and helped initially to put a floor under the economy but has delivered less than promised."

ECONOMIC GROWTH- Based Significantly on Credit Growth

From the moment Richard Nixon toppled the US dollar from its golden foundation and ushered in the era of pure fiat money (oxymoron though that may be) on August 15, 1971, there has been a ubiquitous and dangerous synonym for "growth": credit.

The world embarked upon a multi-decade credit-fueled binge and claimed the results as growth.

From the moment Richard Nixon toppled the US dollar from its golden foundation and ushered in the era of pure fiat money (oxymoron though that may be) on August 15, 1971, there has been a ubiquitous and dangerous synonym for "growth": credit.

The world embarked upon a multi-decade credit-fueled binge and claimed the results as growth.

EARNINGS - The Coming Retreat in Corporate Earnings

The Coming Retreat in Corporate Earnings 12-16-13 John Hussman

The iron law of investing is that an investment security is nothing more, and nothing less, than a claim on some expected stream of future cash that will be delivered into the hands of investors over time.

In some cases, the future payment is simple, like a bond that promises to pay a lump sum of $100 ten years from today. Pay $38.55 for that bond today, and you can expect a 10% annual rate of return on your money. Pay $67.56 for that bond today, and you can expect a 4% annual rate of return. Pay $82.03 and you can expect a 2% annual rate of return over the next decade. The more you pay today for an expected future amount, the lower your implied rate of return. Conversely, given any “required” rate of return you seek on your investment, you can work backwards and figure out the “present value” that you’re willing to pay.

In some cases, the future payment is complicated, like an option that promises to pay you the difference between the price of a stock and some “strike price,” provided that the actual price gets past the strike price in the next few months. For that security, you have to compute the payoff that the option might deliver at every price beyond the strike price, multiply each of those values by the estimated probability the price will get to that particular point, and then discount everything back to present value. To simplify all of that, option pricing models make various assumptions about probability distributions, volatility, and other considerations.

But simple, or complex, or anywhere in the middle, an investment security is nothing more, and nothing less, than a claim on some expected stream of future cash that will be delivered into the hands of investors over time.

In practice, few investors want to estimate a whole stream of future cash flows, so they take shortcuts. Those shortcuts, however, are entirely dependent on the assumptions one is willing to make. Suppose you have a security that is expected to produce a very smooth stream of future payments over time, growing at some constant rate. In that case, the current payment is really all you need to value the security because it is representative of the whole stream. On the other hand, if the current payment is not representative of the whole stream, you’re in trouble.

That warning applies to price/earnings ratios, price/10-year earnings ratios, price/forward earnings ratios, and virtually every other valuation measure that takes any shortcut whatsoever. Treat your “fundamental” as representative when it’s not, and it doesn’t matter which measure you’re using – you’re going to get a misleading estimate of valuation.

Applying a seemingly “reasonable” price/earnings multiple to cyclically elevated earnings is a repeated mistake, and is unfortunately exactly the same one that I waved my arms to warn about in

2000 - “One of the hard lessons that investors will learn in the coming quarters is that technology stocks are actually cyclicals”

2007 - “You wouldn't buy a lemonade stand by extrapolating the profits it earns in August”

– to no avail.

In our own work, we rely on a broad range of valuation measures. Many of them embed various adjustments to capture the fact that earnings, dividends and other value-drivers are often not very representative of the entire future stream. A few very simplified models that still have a near-90% correlation with actual subsequent market returns are presented in Investment, Speculation, Valuation and Tinker Bell. Because the Shiller P/E (the S&P 500 divided by the 10-year average of inflation-adjusted earnings) is simple to calculate and broadly quoted, I often mention it in these weekly comments – at least it has the virtue of being less vulnerable to year-to-year swings in earnings over the course of the business cycle. But our work is emphatically not driven by the Shiller P/E, our valuation approaches go far beyond the Shiller P/E, and even the Shiller P/E is at best a shorthand measure of market valuations.

To understand our deeper concern, it’s important to focus on the word “representative.” Any valuation measure like “price/X” is only useful to the extent that X is representative of the very long-term stream of future cash flows. As I’ll detail below, the problem at this moment is that profit margins are about 70-80% above their historical norms; there is a century of history (including the experience of the most recent decade) to demonstrate that elevated profit margins have always normalized over time; we know why they normalize over time; and we already observe pressures that are likely to force this sort of normalization over the coming 2-4 years.

In short, the earnings measures typically used in Wall Street’s valuation work are more unrepresentative than at any time in history, and investors are vastly overpaying for stocks as a result. In this context, remember that stocks are presently 50-year duration instruments. Even if margins were to remain elevated for several years more (which is unlikely), it would not follow that present earnings are representative of the long-term stream that is actually relevant for pricing stocks.

The coming retreat in corporate earnings

We should begin with an observation. If one examines the historical data, there is a very weak relationship between year-to-year changes in earnings and year-to-year changes in the stock market. This lack of relationship partly reflects the fact that stock prices often recover from recessions quite briskly well before earnings advance, and stock prices often collapse well before earnings do. But even accounting for these leads and lags, the relationship between cyclical fluctuations in the S&P 500 and S&P 500 earnings is simply not very strong.

My concern at present is emphatically not simply a concern about the near-term direction of earnings, or any assumption that stocks must closely follow earnings. Rather, my present concern is much more secular in nature. It can be expressed very simply:

investors are taking current earnings at face value, as if they are representative of long-term flows, at a time when current earnings are more unrepresentative of those flows than at any time in history.

The problem is not simply that earnings are likely to retreat deeply over the next few years. Rather, the problem is that investors have embedded the assumption of permanently elevated profit margins into stock prices, leaving the market about

80-100% above levels that would provide investors with historically adequate long-term returns.

An equivalent way to say this is that stocks are currently at levels that we estimate will provide roughly zero nominal total returns over the next 7-10 years, with historically adequate long-term returns thereafter

There are several ways to look at profit margins, with varying implications – though all negative – for the extent of retrenchment that can be expected in corporate earnings in the coming 2-4 year period. The first chart below presents a rather pure mean-reversion argument. The blue line shows the ratio of corporate profits to GDP, which is currently more than 80% above its historical norm. The red line shows the annual growth in profits over the following 4-year period (inverted). Put simply, high profits/GDP are associated with weak subsequent profit growth, while depressed profits/GDP are associated with strong subsequent profit growth. At present, the extreme profit/GDP ratio we observe here is consistent with expectations of a 22% annual contraction in profits over the coming 4-year period – which would imply a roughly 63% cumulative contraction in profits from present levels. My impression is that’s probably too aggressive an expectation except as a temporary trough. A more reasonable expectation, in my view, would put corporate profits down about 10% annually over the next few years.

Part of the reason we would expect a more muted contraction in profit margins is the recognition that government budget deficits are likely to remain relatively high in the coming years. A simple way to think of the circular flow of the economy is that corporations produce output and pay salaries, while worker/households use that income to purchase output and consume. In recent years, weak employment paired with massive government deficits have introduced a wedge into the circular flow, allowing wages and salaries to fall to the lowest share of GDP in history, even while

Households have been able to maintain consumption as the result of

• Deficit spending,
• Reduced household savings,
• Unemployment compensation and the like.

The deficits of one sector emerge as the surplus of another. As a result, deep deficits in combined government and household saving have created a mirror-image surplus of corporate profits in recent years. The chart below shows the relationship between 3-year changes in government and household savings versus 3-year growth in corporate profits (partly overlapping, but partly subsequent as inventories and other factors can induce slight lags). The upshot of this chart is that recent improvements in government and household savings are already working their way through the economy, and are likely to be observed as a contraction of corporate profits in the next few years.

Yet another way to think about corporate profits is presented below. Here, we observe that corporate profits are linked to the difference between output prices and input costs, where the majority of those inputs represent labor. The blue line in the chart below shows the annualized 6-quarter growth of the GDP deflator (an economy-wide price index for output) less the growth of unit labor costs (the amount that must be paid as labor cost in order to produce one unit of output). The red line shows the 6-quarter growth of corporate profits. The relationship here should be clear. Since 2009, and until recently, increases in the GDP deflator over and above unit labor costs were nicely supportive of corporate profit growth. Those growth rates have reversed, with unit labor costs now growing faster than the GDP deflator. This places downward pressure on corporate profits, consistent with what we expect from based on an analysis of profits from other, complementary perspectives.

Given this context, it may not be a great surprise that we’re observing an enormous surge of negative earnings pre-announcements from companies that will shortly be reporting earnings for the fourth quarter (chart h/t ZeroHedge). Last week, Thomson-Reuters reported: “The 11.4 negative to positive guidance ratio is the most negative on record by a wide margin.” While the deterioration in the earnings outlook is paced by a surge in the number of negative pre-announcements, the spike in the negative/positive ratio is aggravated by a collapse in the number of positive earnings pre-announcements to a relatively small handful of S&P 500 companies. While we shouldn’t interpret the spike too strongly, it’s difficult to find much encouragement in the imbalance between negative and positive surprises.