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US ECONOMY - The Safehaven In a Choice of the 'Best of a Bad Lot'

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Best of a Bad Lot!

US - “The Ambivalent Superpower”

US ECONOMY - Things worse than slow growth

Most economists expect faster growth. Perhaps so, but there are dark spots in the picture. Concerns about

• unsustainable auto sales,
• weakening exports, and (the big one)
• the mini-housing boom rolling over.

Expectations run high for the US economy, an acceleration from the 2%/year GDP growth we’ve had since the crash. Surveys record optimism among purchasing managers, builders, and consumers. Manufacturing remains strong, with hints of the long-awaited capital expenditures boom.

There are several engines driving the slow growth of US economy. Large among them are automobile sales, housing (both new and existing home sales), and exports. Export growth might fade as the US dollar rises (decreasing competitiveness of US goods) and the Japanese and European economies slow. Automobile sales are driven by mad long-maturity loans to sub-prime borrowers — a boom almost certain to end badly.

REAL ESTATE PROBLEMS AHEAD

Now perhaps its the turn of housing. Top real estate analyst Mark Hanson has been warning since late last year that the housing markets were rolling over — as described in this post, and at his website. Now a second voice speaks up.

Joshua Pollard was Goldman’s lead US housing analyst from February 2009 to March 2013. He’s written a forecast for the US housing market in the form of a letter to the President. It can be downloaded from his website. He has some disturbing conclusions. It’s deeper and more complex analysis than Hanson’s, but comes to similar conclusions.

Summary

House prices are 12% overvalued today. They have already started to decline. Today’s misvaluation matches the excess of 2006-07, just before the Great Recession. Since World War II home prices have been tightly correlated to income and mortgage rates (R2 = 96%). Investors/cash purchasers, which make up 50% of home sales, have driven real estate volatility to unrivaled levels in trackable history. As public policy makers debate seminal decisions on “forward guidance” and unconventional monetary stimulus we note that each 1% increase in rates drops home valuations by another 4%; at a 2% fed funds rate, where fed offi­cials and investors expect to be by the end of 2016, the overvaluation equals 20%.

Respectfully, the United States cannot afford another housing driven recession. The facts and correlations – the tenets of probabilities – suggest it is more likely than not that home prices fall 15% in the next three years.

It’s a complex analysis. A top-down view, unlike Hanson’s ground-level perspective. It’s worth reading in full. If Hanson and Pollard are correct, then America might start a downturn from a position of weakness unique since WW2.

US "DYNAMISM DIED - "KICK-THE-CAN" COMES HOME TO ROOST!

After five years of slow growth, most economist expect accelerated growth. As they do each year, only to see their hopes dashed. Perhaps there is are structural forces at work.

In January 2011 the Federal Research estimated the long-term growth rate of the US economy at 2.5 – 2.8%. This week the Fed’s estimate had fallen to 2.0 – 2.3% — barely above the 2% “stall speed”. Also their forecasts for 2014 – 2016 have steadily dropped.

1. Years of low investment by the private and public sector,
2. A decaying education system,
3. Rising debt levels, and
4. Demographic headwinds (an aging society)

— all these things reduce America’s ability to grow.

The US economy has repeatedly failed to resume normal growth after the crash. But potentially worse is the decline in long-term growth estimates. This is part one; see part two: Has America’s economy entered the “coffin corner”?

1. Our plight: max growth slowing to stall speed
2. New hot research about slowing growth in the US
3. The Economic Cycle Research Institute also sees the problem
4. About The Economic Cycle Research Institute
5. New hot research about slowing growth in the US
6. For More Information

In January 2011 the Federal Research estimated the long-term growth rate of the US economy at 2.5 – 2.8%. By June this year their estimate had fallen to 2.1 – 2.3%. Years of low investment by the private and public sector (see links below), a decaying education system, rising debt levels, and demographic headwinds (an aging society) — all these things are slowing America’s growth.

The potential boost from technology so far remains speculation about the future.

For tangible evidence see the economy’s inability to “take off” since the crash (GDP has limped along at an average of 2.2%). On January 3 JP Morgan forecast 2014 GDP to be 2.8%, the fastest since 2005. Now they expect half that, 1.4% — the slowest since the 2008 crash.

That’s far too close to the economy’s stall speed of 2%, below which it’s at risk of falling into recession — much like an airplane going too slow, generating insufficient lift to stay aloft (this is a controversial theory; now we’re testing it). Perhaps the US economy cannot accelerate by much from current growth rates (without undesirable rates of inflation), and it cannot slow without falling into recession (ruinous under current conditions, with monetary policy tapped out (ZIRP), fiscal deficits and unemployment still too high (but falling).

This will make economic management quite difficult for the foreseeable future. Persistent slow speed will create pressure for stimulus (perhaps with long-term ill consequences). Failure to quickly stimulate to even small mistakes might easily trip the economy into recession.

Excerpt from “Cognitive Dissonance at the Fed?“, ECRI, 30 May 2014:

Federal Open Market Committee (FOMC) members have long submitted their projections of U.S. real GDP growth for the “longer run,” to which they expect it “to converge over time – maybe in five or six years – in the absence of further shocks and under appropriate monetary policy.”

… So what is being gradually acknowledged – without any publicity or fanfare – is that long-term U.S. GDP trend growth is converging towards its 2% stall speed. If so, almost every time GDP growth experiences a slowdown that carries it below trend, it will also fall below the recessionary stall speed. This is an implicit endorsement of ECRI’s longstanding “yo-yo years” thesis, which predicts more frequent recessions for the advanced economies than we have seen in past decades.

Separately, a recent ECRI report (click to download) demonstrates how the yo-yo years are already a fact.

The ECRI is an independent research institute. Their indicator systems predict the timing of changes in an economy’s direction, before the consensus of economists. For information about their approach, see their About page.

(a)  “Declining Business Dynamism in the United States: A Look at States and Metros“, Ian Hathaway and Robert E. Litan, The Brookings Institution, May 2014 — Abstract”

Business dynamism is the process by which firms continually are born, fail, expand, and contract, as some jobs are created, others are destroyed, and others still are turned over. Research has firmly established that this dynamic process is vital to productivity and sustained economic growth. Entrepreneurs play a critical role in this process, and in net job creation.

But recent research shows that dynamism is slowing down. Business churning and new firm formations have been on a persistent decline during the last few decades, and the pace of net job creation has been subdued. This decline has been documented across a broad range of sectors in the U.S. economy, even in high-tech.

… we show that dynamism has declined in all 50 states and in all but a handful of the more than 360 U.S. metropolitan areas during the last three decades. Moreover, the performance of business dynamism across the states and metros has become increasingly similar over time. In other words, the national decline in business dynamism has been a widely shared experience. While the reasons explaining this decline are still unknown, if it persists, it implies a continuation of slow growth for the indefinite future, unless for equally unknown reasons or by virtue of entrepreneurship-enhancing policies (such as liberalized entry of high-skilled immigrants), these trends are reversed.

(b)  “Productivity and Potential Output Before, During, and After the Great Recession“, John G. Fernald, Federal Reserve Bank of San Francisco,
June 2014 — Abstract:

US labor and total-factor productivity growth slowed prior to the Great Recession. The timing rules out explanations that focus on disruptions during or since the recession, and industry and state data rule out “bubble economy” stories related to housing or finance. The slowdown is located in industries that produce information technology (IT) or that use IT intensively, consistent with a return to normal productivity growth after nearly a decade of exceptional IT-fueled gains.

(a)  Watch America burning its future by consuming much, investing little:

1. Two pictures show an important difference between China and America, 2 February 2022
2. Why America’s growth is slowing, and a solution, 28 January 2022
3. Portraits of a nation in decline. An unnecessary and easily fixed decline., 14 February 2021
4. Four graphs showing a nation in decline. An unnecessary and easily fixed decline., 1 November 2021
5. Watch corporations strip-mine their future (and ours), 18 April 2021

(b)  About America’s growth potential:

1. Has America grown old, and can no longer grow? Or are wonders like the singularity in our future?, 28 August 2021
2. Is America on the road to zero growth?, 29 November 2021
3. Why America’s growth is slowing, and a solution, 28 January 2022
4. Will 21st Century USA have a surprise boom, as did the 19th Century UK?, 23 October 2021
5. Looking at America’s future: economic stagnation, or will computers take our jobs?, 7 January 2022

US ECONOMY - Public Policy Failure

The Ponzi Economy 09-22-14 John Hussman

In the decade and a half since the late-1990’s, the U.S. economy has undergone a fundamental shift. The signs of this shift can be observed at the foundation of our standard of living, as both

1. Accumulation of productive capital and
2. Participation in the labor force have buckled.  

What obscures this fundamental deterioration is that activity at the surface still appears quite stable. It’s important to understand why this is so.

The standard of living of a country is measured by the amount of output that individuals are able to consume as a result of their work.

The productivity of a country is measured by the amount that individuals are able to produce as a result of their work.

Over time, growth in the standard of living is chained to and limited by growth in productivity. Productivity, in turn, rests on two factors: a productive capital base, and an active pool of productive domestic labor.

The accumulation of productive factors is what drives long-term growth.

When the most persistent, most aggressive, and most sizeable actions of policymakers are those that discourage saving, promote debt-financed consumption, and encourage the diversion of scarce savings to yield-seeking financial speculation rather than productive investment, the backbone that supports a rising standard of living is broken.

With respect to the U.S. capital base, real gross domestic investment has crawled at an annual growth rate of just 1.4% since 1999, compared to 4.9% real annual growth in the preceding half-century. During that same 15-year period, the U.S. labor force participation rate has collapsed from a record high to the lowest level since the 1970’s, wages and salaries have plunged to a record low share of GDP, and real median household income has contracted by a cumulative 9%.

But there are wrinkles in this story, which make present conditions feel better than this deterioration would suggest.

A country can insulate itself from its own deteriorating productivity, for a time, if continued consumption is financed by the accumulation of debt (and its partner, the printing of money).

The U.S. has gone from the largest creditor nation in the world to its largest debtor by shifting from accumulation to dissaving.

Statistics reflecting modest 2.1% growth in output per hour since 1999 also make us feel somewhat better about declining labor force participation, but as I detailed more than a decade ago in The U.S. Productivity Miracle (Made in China), our measures of productivity growth are heavily influenced by U.S. imports and foreign labor outsourcing. We import intermediate goods we would have produced at home, but at cheaper prices, meaning that the deduction from GDP on account of imports is proportionally smaller than the corresponding loss in U.S. employment.

As Fabrizio Galimberti noted in the Economist, foreign outsourcing has the effect of artificially raising productivity figures because subtracting imports from GDP does not adequately correct for their impact on final output, yet foreign labor is not counted in the denominator, so measured output per U.S. worker increases.

Meanwhile, financial repression by the Federal Reserve has held interest rates at zero, discouraging savings while encouraging and enabling households to go more deeply into debt. Various forms of deficit-financed government assistance and unemployment compensation have also been used to make up the shortfall, allowing consumption, and by extension, corporate revenues and profits, to be sustained. As long-term economic prospects have deteriorated, the illusion of prosperity has been maintained through soaring indebtedness, coupled with yield-seeking speculation in risky assets that has repeatedly (albeit not always immediately) been followed by crashes throughout history.

Distribution, diversity, and winner-take-all markets

That’s not to say that this apparent prosperity must be, or has been, evenly distributed. As I observed in Broken Links: Fed Policy and the Growing Gap Between Wall Street and Main Street,

• the misallocation of scarce savings from productive purposes to speculative ones;
• the thinning of the domestic capital base;
• the weakening of local linkages between lenders, borrowers, producers and consumers;
• the “massive macro” focus of policymakers,
• the sausage-factory securitization of locally originated loans by remote Wall Street institutions;
• the expansion of information technology; and
• our broadening foreign trade with low-wage countries that lack many of the human rights protections that we take for granted,

... have all contributed to the emergence of “winner-take-all” features in the U.S. economy.

Local interactions, local recycling of economic resources, and economic multiplier effects have progressively weakened as the economy moves toward a system that favors remote interactions that channel resources out of local economies and up the food chain toward a few dominant players. The largest initial public offering of stock in history, Friday’s IPO of a Chinese business-to-business e-commerce site, is an example of such winner-take-all dynamics. This process can also be observed in the form of too-big-to-fail banks, an “all eyes on the Fed” financial system, an enormous widening in the distribution of income, and a hollowing out of the U.S. middle class.

There are additional risks in “winner-take-all” and “too-big-to-fail” monocultures. From the study of complex adaptive systems, we know that local and diverse relationships contribute to stability, while

remote and overspecialized relationships invite greater disruption as a result of crises or single points of failure.

The reason that species go extinct is that they overspecialize in ways that are highly adaptive in one particular state of the world but prove to be insufficiently flexible when the environment changes. As we discovered in the most recent economic cycle, the notion that “all real estate is local” was turned on its head as Fed-induced yield seeking, pooling of mortgages in complex securities, and excessive reliance on too-big-to-fail banks all collaborated to create a single point of failure that propagated through the global economy as the deepest collapse since the Great Depression. One would be naïve to imagine that the Fed-enabled entrenchment of enormous financial institutions and the “massive macro” focus of economic policy have done anything to enhance our long-term resilience.

Alongside the deterioration in the U.S. capital base and labor market has been an increasing and perpetual reliance on various forms of “stimulus” through government deficit spending and monetary intervention. What’s essential to understand is that these forms of “stimulus” are not just additional symptoms of this economic shift. They have become the causes and the guardians of it.

Suppressed interest rates have encouraged a continuous diversion of scarce savings toward what is effectively debt-financed gambling.

Meanwhile, cheaply financed deficit spending anesthetizes the consequences of deteriorating productive factors, allowing the U.S., for a time, to feast on the geese that could lay its golden eggs. 

To be clear, deficit spending and monetary stimulus can be appropriate as a sort of short-run “kindling” to ease constraints on the economy that would otherwise be binding. But it is important to measure the impact of these policies not simply on the basis of subsequent economic activity, but also on the basis of observed capital formation. The accumulation of debt cannot ultimately be repaid without accumulating the productive means to do so. Instead, since the late-1990’s, we’ve moved to an economy where stimulus is sought at every turn, and a blind eye is cast toward issues of speculation and financial stability, in the belief that stimulus itself can be the wood that sustains the fire and can be applied perpetually without consequence.

The Ponzi Economy

The central point is this. The U.S. economy has shifted course from one of productive capital accumulation to a reliance on continuous expansion of debt in excess of the economic ability to repay it. Call this the Ponzi Economy.

The U.S. Ponzi Economy is one where:

1. domestic workers are underemployed and consume beyond their means;
2. household and government debt make up the shortfall;
3. corporate profits expand to a record share of GDP as revenues are sustained by household and government deficits;
4. local employment is replaced by outsourced goods and labor;
5. companies refrain from productive investment, accumulate the debt of other companies and issue new debt of their own, primarily to repurchase their own shares at escalating valuations;
6. our trading partners (particularly China and Japan) become our largest creditors and accumulate trillions of dollars of claims that can effectively be traded for U.S. property and future output;
7. Fed policy encourages the yield-seeking diversion of scarce savings toward speculation in risky securities; and
8. as with every Ponzi scheme, everyone is happy as long as nobody seeks to be repaid.

If you wonder why the economy feels “fine” despite the persistent thinning of the U.S. capital base and the hollowing out of its middle class, it’s because we are covering the shortfall at every turn with the endless issuance of cheap debt that needs to be rolled forward forever.

Of course, not all debt should be treated equally. From my perspective, until we observe inflationary pressures, U.S. Treasury debt will remain a safe-haven that is likely to be more in demand than not at points of crisis. Over the longer-term, we may very well observe inflationary outcomes (or the need for inflationary outcomes) that reduce the real value of this debt, but I continue to believe that any significant inflationary cycle is much more likely to follow the next cyclical economic downturn than it is to precede it. While debt accumulation often leads to default in countries that cannot print their own currencies, and can produce currency crises in countries with fixed exchange rates, U.S. government debt is likely to result – probably late in this decade – in a more conventional inflationary cycle that reduces its real value.

In contrast, we view corporate and junk yields as insufficient to justify their additional credit risk at present levels, and we are particularly concerned at the increasing issuance of corporate debt to obtain what amounts to leveraged exposure to equities at historically extreme valuations (either through share buybacks or acquisitions). Buybacks are not a return of capital to shareholders – they are partly a leveraged speculation on shareholder’s behalf, partly a strategy to enhance per-share earnings by reducing share count, and partly a way to reduce the dilution from stock-based compensation to corporate insiders. Moreover, repurchases move in tandem with corporate debt issuance, which is another way of saying that the history of stock buybacks is one of companies using debt to buy their stock at overvalued prices.

Keep in mind also that corporate share repurchases have no tendency to concentrate at points of depressed valuation, and but have instead been disproportionately aggressive at points that have historically represented severe overvaluation. The chart below (h/t Thad Beversdorf) illustrates this regularity. See The Two Pillars of Full-Cycle Investing for additional data.

Given that the majority of corporate debt issuance is shorter than 8 years, and we estimate nominal S&P 500 total returns to be negative at that and shorter horizons (with our estimates rising to just 1.5% annually on a 10-year horizon), my view is that issuing corporate debt to repurchase equity presently represents value destruction, and also weakens corporate balance sheets. Credit spreads are widening already, and the history of credit spreads (as with equity risk premiums) is that they normalize in abrupt spikes. We don’t expect a massive wave of defaults, but we do believe that junk yields in particular are lower than the default rates that investors are likely to observe on those securities in the coming years.

The next decision

Though a certain amount of disruption resulting from overvalued financial markets, compressed risk premiums, and excessive debt issuance is baked-in-the-cake, there is also a ray of hope. Regardless of the point the U.S. economy has arrived to, there is room to improve matters by making each next decision well. Those next decisions should include

• policies that increase bank capital requirements (particularly through the use of convertible debt that would automatically convert to equity if existing capital becomes insufficient);
• investment tax credits, job training credits, and other incentives to deepen the domestic base of productive capital and labor;
• an abandonment of financial repression by the Federal Reserve and a gradual normalization of interest rates that would increase savings, discourage speculative yield-seeking, and allow the markets to signal supply and scarcity without distortion;
• the enhancement of local enterprise zones; and
• policies that discourage the endless expansion of too-big-to-fail institutions and massive leveraged transactions in favor of traditional, local banking institutions and greater availability of capital to small businesses that create two-thirds of all U.S. jobs. Despite the short-term enjoyment that comes from living within an ever-growing Ponzi scheme, our long-term economic future relies on ending it.

PATTERNS - Since the Financial Crisis Retail Investors No Longer Trust Financial Markets

PATTERNS - Earnings versus EPS (The Buyback Distortion)

Bottom-Up Ugly

While the constant jibber-jabber on business media proclaims 'earnings are awesome... in fact everything is awesome', the truth is an oddly divergent reality. Net earnings revisions have been positive only 12 times in the last 104 weeks...

Top-Down Hockey Sticks

Despite these chronic historical downward-revisions, Forward S&P 500 EPS estimates continue to surge(driven by large market cap effects and the hockey-stick hopes and dreams)

Keeping The Dream Alive

Which leaves, the disconnect between 12-month forward index P/E and consensus EPS growth rates getting a little extreme...

PATTERNS - Breadth

Why then does this rally feel somewhat underwhelming?

The main reason that this rally feels somewhat underwhelming is because the number of stocks participating has been contracting since May 2013. Let's start by looking at the percentage of stocks making 52-week highs. The latest reading is only 15%. So 93 out of 620 stocks are making 52-week highs even though the MSCI USA only closed 1 point off it's all-time high on Friday. As you can see in the first chart below, the percentage of stocks making new 52-week highs has been narrowing for 16 months. On the flip side, only 3% of stocks (18 out 620) are making 52-week lows. This level was reached on August 1st and on May 19th when the MSCI USA index was 4.1% and 6.5% lower, respectively. Amazingly, the last time at least 5% of MSCI USA stocks were making 52-week lows was in November 2013. The second chart below shows that in true corrections or cyclical bear markets, the percentage of stocks making 52-week lows rises to 30% (August 2011) to 84% (October 2008).

The average stock is also only 8% off it's 52-week high and is 26% higher than it's 52-week low. We are approaching distances from 52-week lows that were last reached in 2012 and 2011. The market was able to rally then but we are suspicious that it will be able to do so this time as breadth as deteriorated. The equity market will need much broader participation if the equity market is to have further gains from where we stand today. 

HIGHS

LOWS

RISK - Rising CBOE Skew Index

On The Lookout For Black Swans - Skew Index On The Rise Again 09-23-14 GaveKal

The 1-quarter moving average of the Put/Call ratio is on the rise as well. It is approaching levels which has been consistent with the 1-quarter price returns for the S&P 500 turning negative. The 1-quarter change in the S&P 500 currently is at 1.61%.

DR COPPER - Breaking Down

PATTERNS - Global Markets

Keeping Up With Global Relative Performance Trends 09-22-14 GaveKal

EMERGING MARKETS

CANARIES - Warnings Signs Are Everywhere

The Glaringly Obvious Guide to the Next Crash - 09-21-14 FT Opinion

Hindsight is a wonderful thing, especially when it comes to explaining market crashes. Six times in the past 50 years US equities dropped more than 30 per cent in 12 months. After most of them investors looked back at glaring warning signs and were baffled that they missed them.

If the S&P 500 were to plunge from 2,000 to 1,400 in the next year, what screaming sell signals would future generations gaze at in the history books and wonder at our ability to ignore the obvious?

1. LEVERAGED LOANS TO PRIVATE EQUITY: Leveraged loans to private equity are not just flashing red but have a wailing siren and a man walking in front waving a flag. The loans are even bothering the see-no-evil officials at the Federal Reserve, who have been trying to persuade banks that excessively leveraged loans are risky. More than a third of leveraged loans this year have lent more than six times earnings before interest, tax, depreciation and amortisation, only slightly below the proportion at the peak of the 2007 credit bubble, according to S&P Capital IQ. Bank exuberance is shown by loans with less lender protection than usual.
2. COV-LITE LOANS: The proportion of “covenant light”, or cov-lite, loans is above 60 per cent, the highest ever. If and when things go wrong, it will be harder for lenders to demand their money back.
3. HY BONDS: Junk bonds may be known as high yield but offer an extraordinarily low yield. The benchmark Merrill Lynch index yields 6.3 per cent, lower than any time before April – although after a summer wobble it is up from the record low of 5.7 per cent in June. The spread over government bonds, reflecting the extra reward for the risk of lending money to the companies with the lowest credit ratings, is still below 4 percentage points, too. This is not at all-time lows, but a rise in the default rate from its near-record low below 2 per cent towards the average since 1993 of 4.5 per cent would be disastrous for investors. Buyers of junk bonds are loosening the purse strings in a similar way to those in leveraged loans. Last year was the best for risky payment-in-kind bonds (where interest can be rolled up) since 2008, although they make up a smaller proportion of what is now a far larger junk market.
4. FLOTATIONS: A boom in flotations is running at a pace not seen since the dotcom bubble burst. Companies are rushing to raise money, and the quality of the protections being offered to shareholders has declined markedly in the hottest sectors of biotechnology and dotcoms. Friday’s Alibaba offering, the biggest-ever US IPO, has experienced phenomenal demand for shares that give investors zero say in how the company is run or who it is run by. Shareholders will not even own some of the vital operating assets. Typically companies choose to sell themselves when investors are overexcited. When a sector is in great demand, entrepreneurs find ways to create supply: more and more companies are created from scratch or carved out of existing businesses until prices tumble. The longer this goes on, the lower the quality of the new companies. Only with hindsight will we know if this has gone on too long.
5. M&A: Alongside the IPO boom, a wave of takeovers looks similar to 2000 and 2007. Takeovers are largely financed by debt, as companies see bonds as even more overpriced than equity, and so easy to sell.
6. BORROWING FOR BUYBACKS: As companies gear up to buy shares in rivals, they are also borrowing to buy shares in themselves. Both takeovers and buybacks reduce the share count, pushing up prices and making earnings per share grow faster at the expense of the balance sheet. Overall, Société Générale points out that companies are borrowing more than at the 2007 peak and buying back about the same, although cash flows are a little stronger now (perhaps because super-low rates are keeping down borrowing costs). Investors are rewarding corporate buybacks. The S&P 500 Buyback index, which measures the 100 stocks buying back the most, outperformed the S&P by 4 percentage points over the past 12 months, about equal to its outperformance in the period up to June 2007, when the credit crunch began – although this is down from the 16 point outperformance last year.
7. VALUATIONS: Everything in the US is expensive. Valuation is no guide to short-term returns, but big losses almost always come when the market is overpriced. Even using Wall Street’s favoured measure, the multiple of price to estimated operating earnings, shares are more expensive than in 2007 or 1987. The forward PE has been more expensive only during the dotcom bubble and its aftermath.
8. TAPER ENDING: The Fed will end support for markets next month when it stops buying bonds. It is also discussing when to end the longest period of low rates in history, and many – including central bankers – have been warning of the danger that preparation for rate rises may bring higher market volatility, and so lower prices. Many investors have bought shares because bonds offer such meaningless yields. A sharp rise in yields is likely to persuade some to switch back, hurting demand for shares just as companies are finding it harder to borrow to buy back. Yet central bankers might keep yields down, or markets may prefer rose-tinted spectacles to the benefit of hindsight.

The warnings are clear, but history teaches that markets can ignore sell signals for years. Only with hindsight can we know for sure.

CANARIES -Hindenburg Signals a Warning

These are hard facts based what happened previously based on two and a half decades of pure Hindenburg Omen history:

 Major Crash - 27% probability. (In the last 27 years there has never been a crash without a preceding Hindenburg).
 Selling panic of at least 10-15% - 39% probability
 Sharp decline of at least 8-10% - 54% probability
 Meaningful decline of at least 5-8% - 77% probability
 Mild decline of at least 2-5% - 92% probability
 The HO signal is an outright miss - 7.7% probability (one out of 13 times)

RISK - MSCI Europe Stocks Down More than 10% Diverging from Price

Something's Gotta Give 09-19-14 GaveKal

RISK - Deteriorating Market Internals

The Ponzi Economy 09-22-14 John Hussman

Market internals continue to deteriorate

An important note on the equity markets: we’re observing a continued deterioration in market internals at extremely elevated valuations, much as we observed in July 2007 (see Market Internals Go Negative). Credit spreads have widened in recent weeks, breadth has deteriorated (resulting in weakness among the average stock despite marginal new highs in several major indices), and downside leadership is also increasing. As a small example that illustrates the larger point, despite the marginal new high in the S&P 500 last week, the NYSE showed more declines than advances, and nearly as many new 52-week lows as new 52-week highs. About half of all equities traded on the Nasdaq are already down 20% from their 52-week highs and below their 200-day averages. Small cap stocks have also weakened considerably relative to the S&P 500.

Indeed, though it’s not a signal that factors into our own measures of market internals (and we also wouldn’t put much weight on it in the absence of deterioration in our own measures), it’s interesting that Friday also produced a “Hindenburg” signal as a result of that lack of internal uniformity: both new highs and new lows exceeded 2.5% of issues traded, the S&P 500 was above its 10-week average, and breadth as measured by advance-decline line is deteriorating. One can certainly wait for greater internal divergence before raising concerns, but my impression is that this confirmation is likely to emerge in the form of a steep, abrupt initial decline (which we call an “air pocket”). That isn’t a forecast, but an observation based on prior instances of deteriorating uniformity following extended overvalued, overbought, overbullish periods. This time may be different. Needless to say, we aren’t counting on that.

The chart below shows the cumulative NYSE advance-decline line (red) versus the S&P 500. While the divergence is not profound, similar and broader divergences are appearing across a wide range of asset classes and security types, and it’s the uniformity of those divergences – not simply the extent – that contains information that suggests that investor risk preferences are subtly shifting toward risk aversion.