Monday, November 30, 2015

On High Alert

This chart warns that stock market investors should be on high alert

Published: Nov 30, 2015 1:05 p.m. ET

Downtrend in high-yield bonds warns that liquidity is drying up, which could hurt the stock market

Lucasfilm Ltd./Courtesy Everett Collection




The continued downtrend in the high-yield bond market is warning that liquidity is drying up, which could bode very badly for the stock market.

When financial markets are flooded with liquidity, investors tend to feel safer about investing in riskier, higher-yielding assets, like noninvestment grade, or “junk,” bonds, and stocks. When the flow of money slows, the appetite for risk tends to decrease as well.

That’s why many stock market watchers keep a close eye on the longer-term trends in the high-yield bond market. If money is flowing steadily into junk bonds, investors are likely to be just as willing, if not more willing, to buy equities. When money is coming out of junk bonds, like the chart below shows, many see that as a warning that investors could start selling stocks.


“High yield corporate bonds are thought by many to behave like the rest of the bond market, but they actually behave a lot more like the stock market,” Tom McClellan, publisher of the investment newsletter McClellan Market Report, wrote in a recent note to clients. “And when high-yield bonds start to suffer, that is usually a reliable sign that liquidity is drying up, and bad times are about to come for the stock market.”

Over the last 15 years, the daily correlation between the Barclays U.S. High Yield Corporate Bond Index and the S&P 500 index SPX, -0.46%  is higher than the correlation between the high-yield index and the Barclays U.S. Aggregate Bond Index, by a score of 0.525 to 0.334, according to a MarketWatch analysis of data provided by FactSet.

The selloff in high-yield debt has accelerated over the last several months, pushing aggregate junk bond yields to the highest levels in about four years, or well before the Federal Reserve opened up the liquidity spigot with its third round of quantitative easing. Read more about quantitative easing.

Don’t miss: Junk bonds follow stocks into loss column for the year.

And investors shouldn’t expect liquidity conditions to improve anytime soon. The minutes of the October meeting of the Federal Reserve’s policy setting committee, released earlier this month, showed that “most participants” were willing to raise interest rates in December. Rising rates tend to sap liquidity, as earnings on cash increase.

On top of that, the Fed voted Monday to limit lending to firms in trouble during a financial crisis.

“High-yield bonds are telling us that liquidity is in short supply already, even ahead of the Fed starting a rate hike series,” McClellan said.

Iron Ore Down 80% from Peak

The Lull Before The Storm—–An Ideal Chance To Exit the Casino, Part 1

by David Stockman • November 30, 2015

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Last night’s Asian action brought another warning that the global deflation cycle is accelerating. Iron ore broke below $40 per ton for the first time since the central banks kicked off the world’s credit based growth binge two decades ago; it’s now down 40% this year and 80% from its 2011-212 peak.

Embedded image permalink

As the man said, however, you ain’t seen nothin’ yet. That’s because the above chart is not merely reflective of too much supply and capacity growth enthusiasm in the iron ore industry or even some kind of worldwide commodity super-cycle that has gone bust.

Instead, the iron ore implosion is symptomatic of a much deeper and more destructive malady. Namely, it reflects the monumental malinvestment generated by two decades of rampant credit expansion and falsification of debt and equity prices by the world’s convoy of money printing central banks.

Since 1994 the aggregate balance sheet of the world’s central banks has expanded by 10X—— rising from $2.1 trillion to $21 trillion over the period. This rise does not measure any kind of ordinary trend which temporarily got out of hand; it represents an outbreak of monetary insanity that is something totally new under the sun.

What it means is that the Fed, ECB, BOJ, People’s Bank of China (PBOC) and the manifold lesser central banks purchased $19 trillion of government bonds, corporate debt, ETFs and even individual equities and paid for it by hitting the electronic “print” button on their respective financial ledgers.

This central bank balance sheet expansion, in fact, represented 70% of the world’s entire GDP as of the time the print-fest began in 1994. Yet as an accounting matter this monumental expansion was inherently suspect .

That’s because the asset side was mushroomed by the acquisition of already existing assets——-financial claims which had originally funded the purchase of real goods and services.

By contrast, the equal and opposite liability side expansion consisted of newly bottled monetary credit conjured from thin air; it represented nothing of tangible value, and most especially not savings obtained from the prior production of real economic output.

Stated differently, the central banks substituted $19 trillion of fiat credit for $19 trillion of real savings from current income that would have otherwise been required to fund debt and equity issued by businesses, households and governments during the last two deades.

Needless to say, this giant substitution drastically falsified the price of money and capital. It represented a big fat bid in the financial markets that drove cap rates to deeply sub-economic levels, meaning that bond yields were far too low and equity prices and PE ratios way too high.

Had the world economy tried to issue trillions of new securities and loans in the absence of this massive central bank balance sheet expansion, interest rates would have soared and PE ratios would have weakened, thereby short-circuiting the reckless expansion of finance which actually occurred.

In short, the torrid pace of central bank bond buying during the last 20 years has caused the global economy to became bloated with over-financialization.

In the case of debt, for example, the expansion ratio was nearly 4X. That is, total worldwide public and private debt outstanding soared from $40 trillion to $225 trillion. This astounding $185 trillion gain compared to just a $50 trillion gain in GDP, meaning that the world’s leverage ratio has soared to unprecedented heights.

Global Debt and GDP- 1994 and 2014

The expansion of equity capital on the traded stock markets of the world showed the same trend. Global equity market cap rose by $60 trillion or at a 11% annual rate during the two decades through the May 2015 peak. That was more than double the 5.0% growth rate of nominal GDP, meaning that the implicit capitalization rate of world income was soaring——even as the world economy was being bloated and deformed by the greatest credit bubble ever imagined.

World Stock Market Capitalization

At the recent peak, therefore, worldwide finance stood at $300 trillion ($225 trillion of debt plus $75 trillion of market equity) compared to just $60 trillion ($40 trillion of debt and $20 trillion of equity) in 1994. Needless to say, this 5X gain fueled, among other things, the greatest CapEx binge the world has ever seen.

But is was not healthy, sustainable CapEx because the underlying debt and equity which financed it—– a 5X surge in listed company investment during this period—– was drastically under-priced. Consequently, the world is now drowning in uneconomic, excess capacity along the entire food chain of production—–mining, bulk shipping, manufacturing, warehousing, containerships and air freight and downstream distribution.

The collapse of iron ore mining in Australia and shale drilling in North Dakota alike, therefore, denote not just traditional commodity cycles in petroleum and steel. They mark the arrival of what will be a long-running CapEx depression that will shrink final demand for energy and steel products for years to come.

Global Capex- Click to enlarge

Global Capex- Click to enlarge

The chart below  purports to show a difficult outlook for iron ore prices in the next several years owing to an expected further reduction of demand, while supply is expected to grow by another 5% through 2017 owing to the completion of projects already in the pipeline.

But that is wishful mainstream thinking. In fact, all the major sources of steel demand are in deep contraction. World shipbuilding is coming to a screeching halt; industrial infrastructure building in Brazil, Turkey and throughout the EM economies is in freefall; and China’s credit Ponzi, which generated massive overinvestment in apartment buildings, industrial production and public infrastructure, is visibly toppling.

Accordingly, global iron-ore demand is likely to plunge by 20%, not 2% as shown in the graph. Prices are therefore heading far lower, perhaps into the $20 per ton range. There will be unprecedented, sweeping bankruptcies in the global metals industries and a multiplier effect among adjacent supplier sectors.


This implosion of demand cannot be remedied with another round of central bank money printing because the world is already at peak debt. Consequently, the global corporate profit cycle is heading into a deep downturn——just as the equity markets go into a final spasm of levitation based on a handful of still rising big cap stocks.

(Part 2: The Massive Stock Market Bubble Is Hiding Behind A Handful of Big Cap Momentum Names)

Elliott Wave Analysis of SPX

Elliott Wave Analysis of SPX

Will Oil’s Debt Bring us Down

Debt Debacle In The Oil Patch—-The Big Collapse Is Coming Soon

by ZeroHedge • November 30, 2015

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By Tyler Durden at ZeroHedge

As the crude industry has been wrestling with low oil prices that declined by over 50 percent since its highest close at $107 a barrel in 2014, many exploration and production companies worldwide and in the U.S., in particular, have faced large shortfalls in revenue and cash flow deficits forcing them to cut down on capital expenditures, drilling and forego investments in new development projects.

High debt levels taken on by the U.S. oil producers in the past to increase production while oil prices soared, have come back to haunt oil and gas companies, as some of the debt is due to mature by the end of this year, and in 2016.Times are tough for U.S. shale oil producers: Some may not make it, especially given that this month, lenders are to reassess E&P companies’ loans conditions based on their assets value in relation to the incurred debt.


Throughout the oil price upturn that lasted until the middle of 2014, companies sold shares and assets and borrowed cash to increase production and add to their reserves. According to the data compiled by FactSet, shared with the Financial Times, the aggregate net debt of U.S. oil and gas production companies more than doubled from $81 billion at the end of 2010 to $169 billion by this June

In the first half of 2015, U.S. shale producers reported a cash shortfall of more than $30 billion. The U.S. independent oil and gas producers’ capital expenditures exceeded their cash from operations by a deficit of over $37 billion for 2014.

In July – September 2015, after a couple months of a rebound, a further slump in crude futures prices fluctuated between $39-47/bbl, thus putting more strain on the oil-and-gas producers, and making them feel an even tighter squeeze.

As The Wall Street Journal reported in August, Exxon Mobil Corp. and Chevron Corp. stated they were cutting stock-buyback programs, while Linn Energy LLC announced it would stop paying dividends to its shareholders. Meanwhile, several small U.S. oil and gas producers have filed for chapter 11 bankruptcy protection this year. Companies with persistently negative free cash flow fall into the trap of borrowing, as they have to incur more debt to repay what they have already borrowed before. This makes such companies vulnerable to default and bankruptcy.

As shared by Edward Morse, Citigroup Global Head of Commodities Research with, smaller independent U.S. E&P companies are in the worst position now: they are already highly leveraged and are trying to use increased leverage while having to bear high debt pressure.

“They also are in the worst cash flow positions of all of the E&P firms per barrel of liquids production relative to the larger and even the mid-cap firms. However, they also tend to account for a much smaller share of overall production. For example, the large North American E&P companies produce around 5.0-million b/d of oil; mid-sized firms produce just short of 1-m b/d. But the small and smallest U.S. E&Ps combined produce only 500-k b/d, 100k b/d of which comes from the smallest U.S. firms,” stated Morse .

The chart from the U.S. Energy Information Administration below, based on second-quarter results from 44 U.S. oil-and-gas companies, demonstrates the rising share of the companies’ operating cash flow used to service debt.

For the previous four quarters from July 1, 2014 to June 30, 2015, 83 percent of these companies’ operating cash had been spent on debt repayments, the highest since at least 2012.


Source: U.S. Energy Information Administration, based on Evaluate Energy
Note: Each quarter represents a rolling four-quarter sum.

Debt Worries for Small Companies

According to Forbes, among U.S. E&P companies ranking high on the verge of bankruptcy are Goodrich Petroleum (GDP), Swift Energy (SFY), Energy XXI (EXXI), Halcon Resources (HK) among others. “These companies have all lost more than 90 percent of their market value since 2014, are larded up with too much debt, and would be lucky to survive the bust,” Forbes wrote.

According to FINRA data cited by Forbes, the yield of Goodrich’s issue of 2012 bonds for U.S. $275 million jumped up to 58.66 percent from 8.88 percent during trade sessions this August. The Goodrich’s stock that previously sold at $29 in June 2014 traded at 88 cents. The company has a high leverage ratio (debt to EBITDA): in the first half of 2015, the company’s revenues amounted to U.S. $50 million while its interest expense on servicing of a long-term loan of U.S. $622 million was $27 million.

Energy XXI (EXXI) is snowed under in $4.6 billion in debt. As Forbes reported, the company was negotiating terms for extending maturities on their bonds with creditors; it also managed to find an investor who bought another U.S. $650 million worth of debt from EXXI.

Another company staggering under a heavy debt load is Swift Energy (SFY). According to Forbes, Swift’s equity market capitalization is $27 million against long-term debt of $1.1 billion. As The Wall Street Journal reported in July, the company was trying to find an investor to come up with funds to repay loans by issuing a $640 million bond.

Halcon Resources (HK) is also on the brink of insolvency. 40 percent of Halcon Resource’s revenues this year have been expended on making interest payments on its U.S. $3.7 billion debt. The company did two equity-for-debt swaps earlier this year, and sold more debt for U.S. $700 million, Forbes reported.

As Virendra Chauhan, Oil Analyst at Energy Aspects discussed with, the smaller independent U.S. producers are the ones taking the most risk, particularly the ones that have been outspending cash flows quarter-on-quarter for the better part of the last three years. “The debt maturities vary, but the key factor is an over 50 percent fall in oil prices. Whilst costs have come down, they are no way near 50 percent; and so the reliance on external funding, be it through, debt, equity, asset sales or by other means, has increased, which is certainly impacting investor sentiment,” he said.

Hedges Expiring

Although quite a few U.S. shale oil producers have reported substantial increases in their productivity per well drilled, the amount of rigs drilling for oil in the U.S. has dropped by 59 percent since its peak in October 2014, according to the EIA datashared by the Financial Times.

In the Eagle Ford shale of South Texas, the volume of oil produced from new wells for every operational rig, has risen by 42 per cent over the past year, from 556 barrels per rig per day to 792, EIA reported.

“Profitability and returns in the U.S. tight oil space is a moving target – many producers claim to be profitable and generate healthy returns, yet their cash flow situation has shown no signs of improving,” pointed out Chauhan. According to the analyst, producers in the Permian are likely to be better positioned than in other areas, as this basin is the least developed of the three major basins, and Pioneer Resources (PXD), which has the largest acreage in the basin is 75 percent hedged for this year with a floor of $67 and a ceiling price of $77 per barrel.

According to the IHS Energy North American E&P Peer Group Analysis Report, the weighted-average hedged prices for 2016 are $69.04 per barrel of oil and $3.83 per thousand cubic feet (MCF) of gas. The midsize E&Ps have hedged 26 percent of estimated 2016 total production. Financially distressed companies with low hedge protection and high risk in 2016 include SandRidge Energy and Ultra Petroleum.

“The small North American E&Ps have hedged 25 percent of estimated 2016 total production and continue to have the weakest balance sheets. With high debt and little hedging, EXCO Resources and Comstock Resources are at risk of serious liquidity issues if low prices prevail,” stated Paul O’Donnell, principal equity analyst at IHS Energy and author of the report.

Liquidity Problems

Many investment banks and financial services companies are already facing losses on substantial investments in E&P companies, as they have committed hundreds of millions of dollars to lend to energy companies on top of the loans provided to them at the time when oil prices were surging.

Among such investment funds taking a hit on their positions in the financially distressed E&P companies listed above (Goodrich Petroleum Co. Energy XXI Ltd, Swift Energy, etc.) are Franklin Resources Inc., Oaktree Capital Group LLC, Lazard Ltd and others.

Financial experts and analysts point out that some E&P companies have managed to refinance their debt, however, it becomes increasingly more difficult for them to do so as their stock and bonds lose value and the high yield return they have to offer to lenders to get financing is higher than in any other business sector.

According to Marketwatch, the energy industry Liquidity Stress subindex has pointed to a high-risk debt weighing on U.S. E&P companies, as it surged up to 16.9 percent in September from 12.7 percent in August, the highest level since it reached 19.2 percent six years ago in July 2009.

As Chauhan of Energy Aspects pointed out, it is fair to say that most oil and gas companies are not generating free cash flow at current oil prices, as these prices are below full-cycle costs for most regions in the world, with the exception of the Middle East, which is the lowest cost producer globally.

Larger Companies Faring Better

“The IOC’s are likely to be better positioned during a downturn because they have higher credit ratings and therefore are more accessible to debt markets. They also have a hedge built into their business because they will benefit from downstream profitability from improved margins,” the analyst added.

As Paul O’Donnell shared in the IHS report, only six percent of the large North American E&P production volume for 2016 production has been hedged, as these companies have stronger balance sheets to withstand the low prices. “No oil-weighted large E&Ps have any significant hedging in place for 2016”, O’Donnell said.

According to Morse, the large North American E&P companies should be able to survive and thrive, given their high production base and their free cash flows as a cover for liquids production.

“They have roughly three times the cash flow coverage as the smaller companies in terms of cash flow per barrel of oil, and they are still increasing production as a group,” commented the Head of Commodity Research.

According to Ernst & Young U.S. Oil and Gas Reserves Study 2015, the total capital expenditures of 50 largest U.S. oil-and-gas companies reached $200.2 billion in 2014.

As the study reveals, some of the large E&Ps’ capital expenditures in 2014 were:


O’Donnell of IHS expects capital spending for the North American E&P group to drop 25 percent in the second-half 2015, as compared with the first-half of 2015, from approximately $60 billion to $45 billion.

As cited by Natural Gas Intelligence in September, “according to EIA, U.S. oil and gas E&Ps had reduced their capex budgets by $38 billion in 2Q2015 (to about $95 billion) compared to the preceding second quarter (about $130 billion), “the difference between cash from operations and capex was almost zero in 2Q2015.”

*  *  *

As Energy Intelligence concluded:

“The US E&P sector could be on the cusp of massive defaults and bankruptcies so staggering they pose a serious threat to the US economy. Without higher oil and gas prices — which few experts foresee in the near future — an over-leveraged, under-hedged US E&P industry faces a truly grim 2016. How bad could things get?

“I could see a wave of defaults and bankruptcies on the scale of the telecoms, which triggered the 2001 recession.”

Source: Can The Oil Industry Really Handle This Much Debt? – ZeroHedge

Hussman on Valuations

John Hussman, Hussman Funds

Rarefied Air: Valuations And Subsequent Market Returns

Nov. 30, 2015 11:17 AM ET  

The atmosphere is getting thin up here, and every ounce counts triple when you're climbing in rarefied air. While near-term market dynamics are more likely to be impacted by Friday’s employment report than any other factor, our broad view remains that stocks are in the late-stage top formation of the second most extreme episode of equity market overvaluation in U.S. history, second only to the 2000 peak, and already beyond the 1929, 1937, 1972, and 2007 episodes, not to mention lesser extremes across history.

On the economic front, much of the uncertainty about the current state of the economy can be resolved by distinguishing between leading indicators (such as new orders and order backlogs) and lagging indicators (such as employment). It’s not clear whether the weakness we’ve observed for some time in leading indicators will make its way to the employment figures in time to derail a Fed rate hike in December, but as we’ve demonstrated before, the market response to both overvaluation and Fed actions is highly dependent on the state of market internals at the time. Presently, we observe significant divergence and internal deterioration on that front. If we were to observe shift back to uniformly favorable internals and narrowing credit spreads, our immediate concerns would ease significantly, even if longer-term risks would remain.

Having reviewed the divergences we observe across leading economic indicators and market internals last week (see Dispersion Dynamics), a few additional notes on current valuations may be useful.

As I’ve noted before, the valuation measures that have the strongest and most reliable correlation with actual subsequent market returns across history are those that mute the impact of cyclical variations in profit margins. If one examines the deviation of various valuation measures from their historical norms, those deviations are rarely eliminated within a span of a year or two, but are regularly eliminated within 10-12 years (the autocorrelation profile drops to zero at that point). As a result, even the best valuation measures have little relationship to near-term returns, but provide strong information about subsequent market returns on a 10-12 year horizon. Among the most reliable valuation measures we identify, those with the strongest relationship with subsequent 12-year nominal S&P 500 total returns are:

Shiller P/E: -84.7% correlation with actual subsequent 12-year S&P 500 total returns

Tobin’s Q: -84.6% correlation

Nonfinancial market capitalization/GDP: -87.6%

Margin-adjusted forward operating P/E (see my 8/20/10 weekly comment): -90.7%

Margin-adjusted CAPE (see my 5/05/14 weekly comment): -90.7%

Nonfinancial market capitalization/GVA (see my 5/18/15 weekly comment): -91.9%

MarketCap/GVA is presented below to provide a variety of perspectives on current valuation extremes. The first chart shows this measure since 1947. We know by the relationship between MarketCap/GVA and other measures (with records preceding the Depression) that the current level of overvaluation would easily exceed those of 1929 and 1937, making the present the most extreme point of stock market overvaluation in history with the exception of 2000. In hindsight, the only portion of 2000 when stocks were still in a bull market was during the first quarter of that year.

To be as clear as possible: Over the near term, broad improvement in market internals and credit spreads would suggest a return to risk-seeking speculation that might defer the unwinding of this obscene Fed-induced speculative bubble, or could even extend it. But with market internals presently negative and credit spreads continuing to widen, the market remains vulnerable to an air-pocket, panic or crash, here and now. In either case, our expectation is that the completion of the current market cycle will involve a market loss of at least 40-55%; a loss that would merely take the most historically reliable valuation measures to run-of-the-mill pre-bubble norms, not materially below them.

Investors should remember from the 2000-2002 and 2007-2009 collapses that in the absence of investor risk-seeking - as conveyed by market internals - even aggressive Fed easing does not support stocks. The reason is that once investors become risk-averse, safe, low-interest liquidity is a desirable asset rather than an inferior one. So creating more liquidity fails to achieve what the Fed does so successfully and perniciously during a risk-seeking bubble: drive investors to chase yield and speculate in risk-assets.

I should be the first to point out my own errors in the recent bubble, and the central lesson to be drawn. In market cycles across history, the emergence of extreme overvalued, overbought, overbullish conditions was typically either accompanied or closely followed by a deterioration in market internals (signaling that investors had shifted to risk aversion), and market collapses followed in short order. I responded to the emergence of those syndromes directly by taking a hard-defensive outlook. If the Federal Reserve’s unprecedented recklessness did one thing in this cycle, it was to disrupt that overlap; extreme overvalued, overbought, overbullish conditions were followed by further speculation rather than any shift toward risk-aversion among investors. One had to wait until market internals had explicitly deteriorated before taking a hard-defensive market outlook. We imposed that requirement on our discipline in mid-2014.

If you’re not familiar with this narrative, see The Hinge. We know exactly what we got wrong in this half-cycle, exactly how we’ve addressed it, and exactly how those adaptations would have performed across a century of market history, including the most recent cycle. That historically-informed perspective is the basis for our confidence here. In contrast, many speculators seem to have no clue that they are about to experience the same consequences that followed the 2000 and 2007 speculative extremes. They’ve learned no lesson from either, so they’ll have to live through similar outcomes again.

The chart below places MarketCap/GVA on an inverted log scale (blue line, left scale), along with the actual S&P 500 nominal annual total return over the following 12-year period (red line, right scale). Note that current valuations imply a 12-year total return of only about 1% annually. Given that all of this return is likely to come from dividends, current valuations also support the expectation that the S&P 500 Index will be lower 12 years from now than it is today. While that outcome may seem preposterous, recall that the same outcome was also realized in the 12-year period following the 2000 peak.

(click to enlarge)

The following scatter plot shows the data in a slightly different way, but to the same effect.

Valuations and returns; real and nominal

One of the questions we’re periodically asked is why we use equity valuation measures to project nominal returns rather than real returns. In theory, a higher level of inflation should raise the growth rate of fundamentals, but should also increase the required rate of return on a security, resulting in a valuation ratio that is actually independent of inflation. In that kind of “Fisher-effect” world, any change in equity valuations would correspond to a change in expected real returns, not nominal ones, because the impact of inflation would wash out of the calculation.

In order for that to hold, the requirement is that expected nominal stock returns (i.e. the discount rate applied to future cash flows) and nominal growth in fundamentals must be identically impacted by inflation, so that stock valuation multiples remain independent of inflation. One can show this using a discounted cash flow approach. For any security - stocks or bonds - if investors respond to inflation by changing the discount rate in a way that’s not identical to the change in the future growth rate of fundamentals, there will not be a one-to-one relationship between the valuation multiple and the subsequent real return.

As the simplest example, consider a Treasury bond: since the cash flows are fixed, any change in the valuation “multiple” (e.g. bond price/coupon payment) must represent a change in the discount rate alone. As a result, changes in valuation are perfectly correlated with subsequent nominal returns.

How closely do U.S. financial markets resemble a perfect Fisher-effect world? Let’s take a look at data since 1947. One of our first expectations would be that interest rates should respond to changes in expected inflation. It’s not surprising at all that 10-year Treasury yields are strongly related to the rate of inflation over the prior decade.

In a nice, Fisher-effect world, however, nominal interest rates would respond to past inflation just enough to compensate for likely future inflation, leaving expected real future Treasury returns unchanged. In practice, investors tend to respond much more strongly, and as a result, high past inflation tends to be followed by high real returns, not just high nominal returns. Likewise, low past inflation tends to be followed by low real returns, not just low nominal ones.

(click to enlarge)

The same regularity extends not only to inflation, but nominal economic variables like gross domestic product. Since we’ve been using MarketCap/GVA as our preferred valuation metric, we’ll continue with that measure here. Notice first that there is a very strong positive relationship the 10-year Treasury bond yield and the nominal growth rate of corporate gross value added over preceding decade.

(click to enlarge)

Stop and think about this chart for a moment. Many investors like to assume that interest rates will still be low a decade from now, thinking that this would support higher end-of-decade valuations for stocks and avoid poor market returns in the interim. Unfortunately, the only reason one would assume that interest rates will remain as low as they are now is if growth in the economy, revenues, GVA and other fundamentals turns out to be dismal over the coming years. In that event, low interest rates might support higher terminal valuation multiples for stocks, but on much lower fundamentals than otherwise. Across history, these effects of growth rates and terminal valuation multiples systematically wash out.

As it happens, neither past nominal nor real growth in GVA is well-correlated with nominal or real growth over the subsequent 10-year period. Variations in nominal growth over the past decade affect discount rates more than they affect the expected future growth of cash flows. As a result, more rapid nominal growth in the past tends to be associated with lower stock valuations, while slower nominal growth in the past tends to be associated (though not quite as reliably) with higher stock valuations.

(click to enlarge)

In summary, investors across history have systematically responded to high rates of inflation and past growth by driving up bond yields and driving down equity valuations, to the point where subsequent real and nominal investment returns have been quite strong. Conversely, investors have systematically responded to low rates of inflation and past growth by driving down bond yields and driving up equity valuations, to the point where subsequent real and nominal growth have been extremely poor.

The main instance when this inverse relationship between prior growth and terminal valuations did not hold as tightly was during the Depression and its aftermath. During that period, investors became conditioned to expect dismal economic growth, and responded by awarding the stock market with lower terminal multiples than they did in the post-war period. As a result, between 1926 and 1940, actual subsequent 10-year market returns ended up being weaker than one would have projected on the basis of post-war valuation relationships. Given the current environment of persistently sub-par economic growth, if there’s a risk to our projection of near-zero total returns in the S&P 500 over the coming 10-12 years, it’s likely that our expectations will turn out to be too optimistic.

Allow me just two minutes to formalize some of this. Remember how valuations, growth rates and investment returns are related. In the two equations below (skip over them if they send you into math panic) P is price, V is the valuation ratio of price to some fundamental, and g is the nominal growth rate of that fundamental over the following T years. We can then write the future capital gain precisely as:

P_future / P_today = (1+g)^T x (V_future / V_today)

Or in log terms:

log(P_future/P_today) = T x log(1+g) + log(V_future) - log(V_today)

All this says is that your future investment return is positively affected by: the holding period T, the growth of fundamentals g (assuming that growth is positive), and the future valuation multiple. In contrast, your future return is negatively affected by the current valuation multiple. Because departures of valuations and nominal growth from their historical norms tend to mean-revert over time, one can obtain reliable estimates of prospective 10-12 year market returns by using historical norms for g and V_future (see Ockham’s Razor and the Market Cycle for an illustration using a variety of valuation measures).

What may be less obvious is that those market return estimates are just as accurate even when actual growth and terminal valuations depart from their historical norms. Go back to the previous scatterplots, and you’ll notice something. The terminal valuation multiple is inversely related to nominal growth over the preceding decade, meaning that variations in the first two terms (from their historical norms) tend to offset each other. This isn’t random - it’s systematic. The reason, again, is that investors respond to high rates of inflation and past nominal growth by driving interest rates higher and equity valuations lower. Conversely, they respond to low rates of inflation and past nominal growth by driving interest rates lower and equity valuations higher (partly due to the kind of yield-seeking speculation we’ve seen in recent years).

What remains? A nearly direct inverse relationship between current equity valuations and subsequent nominal returns in market cycles across history. You can see that inverse relationship in the second graph of this weekly comment, which plots the log of MarketCap/GVA on an inverted scale, versus actual subsequent 12-year S&P 500 nominal total returns.


A quick side note. I generally ignore anonymous critics - open debate can be constructive, and provides a chance to learn from others, but my impression is that unless one is defending human rights in a politically hostile climate (where writing under pseudonym has worthy precedents), using anonymity as a veil to criticize others reflects the kind of intellectual cowardice that makes mice of men. Still, the foregoing may address the suggestion that the relationship between valuations and subsequent market returns is mere coincidence or curve-fitting. It should also be evident that the inverse (and generally offsetting) relationship between nominal growth and end-of-period valuations is quite systematic. If one wishes to imagine a parallel universe where these regularities don’t exist, and to dismiss the historical relationship between valuations and actual subsequent equity market returns across a century of data on that basis, by all means, be my guest.

Finally, it’s worth making clear that the relationship between reliable equity valuation measures and subsequent real returns is also significant. The red line on the chart below shows the current level of valuations. As the chart indicates, investors should presently expect unambiguously negative real returns in the S&P 500 over the coming decade from current valuation extremes.

(click to enlarge)

As usual, investors who follow a passive buy-and-hold discipline, who don’t believe that valuations have meaningful implications for subsequent market returns, who would experience distress over missing potential market gains regardless of the valuation extremes in which they occur, who have carefully considered the actual depth of losses that the stock market has regularly experienced over the completion of market cycles, and who have aligned their investment exposure consistent with their actual investment horizon and risk tolerance - these investors can reasonably do nothing here, and we don’t at all encourage them to deviate from their discipline. Investors who could not reasonably tolerate a loss in the S&P 500 on the order of 50% (as the market has experienced in prior cycles), or who would abandon their discipline in that event, should recognize that such a loss is actually the run-of-the-mill expectation from current valuations.

For our part, despite the speculative challenges that have resulted from the most extreme monetary interventions in history, we remain convinced that valuations are informative about long-term returns, and we have adapted to insist on explicit deterioration in market internals in order to support a hard-defensive market outlook. Given both obscene valuations and clearly unfavorable market internals and credit spreads at present, we see extreme market losses as not only an immediate risk, but also as the predominant likelihood over the next few years.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.

Friday, November 27, 2015

Buy Gold!

Gold Plunges Below "Crucial Level", Lowest Since Oct 2009 On $2 Billion Notional Flush

Tyler Durden's picture

Submitted by Tyler Durden on 11/27/2015 08:28 -0500

With the world closest to World War 3 since the cold war era and Russia about to unleash escalating sanctions of Turkey, it makes perfect sense that 'investors' would want to purge themselves of precious metals. Someone decided that Friday after Thanksgiving would be the perfect time to dump over 18,000 contracts (around $1.9 billion notional) sending the price of gold futures to their lowest since Oct 2009, below what Goldman called a "crucial level."

Over 18000 contracts dumped...

Sending gold futures prices to Oct 2009 lows...

As Goldman notes, in Gold, the critical level is 1,068-1,066. In Silver, support spans 13.98-13.83.
Gold Daily/Weekly – The level to watch in Gold is 1,068-1,066. This includes an ABC equality target off the January high and the trend across the lows since Dec. ’13.

The fact that oscillators are diverging positively suggests that price may be attempting to stabilize. Failure to break this support area confirms that the setup is still corrective; that a 5-wave sequence from ’11 highs ended in July. Alternatively, a break lower would warn that the market hasn’t yet completed its impulsive decline.

This would open potential to extend towards 966 (a 1.618 extension target from the January high).

Silver Daily/Monthly – The level to watch here is 13.98-13.83. This includes the previous low from Aug. 26th and the trend across the lows since Jun. ’03.

Although the wave count on Silver is a lot less evident than the one for Gold, it is apparent that rallies have all met ABC targets insinuating that rallies lack impulse. On a more positive note, daily oscillators are crossing higher from the bottom of its range.

Put another way, the balance of signals seems mixed; 13.98-13.83 does however look significant.

Flying into the Coffin Corner

Fabius Maximus website

Recession Watch: the economic indicators to watch to see what’s coming

Summary: As the expansion ages and growth slows, we should begin to watch for signs that the next recession approaches. Here are some tips for doing so without spending much time at it.



What should we watch among the blizzard of economic data? Journalists tend to focus on the numbers most frequently reported, usually about manufacturing and housing. Such as this week’s existing home sales volume (oddly, we don’t similarly obsess over NYSE volume). It’s important for people in that biz, but tells us little about the US economy.

Also big in the news are new home sales, building permits, mortgage applications, and many other housing datapoints. For a simple measure of this industry see total residential construction spending. It shows a continued strong expansion. Tune in next month to see if anything has changed.

Residential Construction Spending

What are the most important economic numbers?

But the often dramatic graphs don’t tell us the importance of those numbers. Here’s one perspective on the big picture…

  • Construction value added: 4% of GDP (housing is 1/3 of this).
  • Goods-producing value added: 19% of GDP (manufacturing is 12% of this).
  • Services value added: 68% of GDP.

Another way to see this relationship: manufacturing new orders were 15% of GDP in 1995; now they’re only 10%. Manufacturers employed 30% of all non-farm workers in 1955; they employ only 9% today. Manufacturing was once the key swing sector of the economy; now we are a services economy. Unfortunately there are few good leading indicators for the service sector. Creating Purchasing Managers Indexes for Services was a creative idea, but untested — and doesn’t make much sense to me: what do they PM’s of service corps do that gives them special insight about the economy?

Another perspective

Watch labor, one of the — or perhaps the — major engine of the economy. New claims for unemployment are a sensitive indicator of labor markets, a powerful leading indicator, and hard numbers reported in real time — but they’re noisy. Claims have given a tentative warning, as their rate of improvement slows.

A lesser-known indicator should also be near the top of your watchlist: the Fed’s Labor Markets Conditions Index. Like GDP, it is a mind-bendingly complex indicator — a useful single number providing one aspect of the broad economy. Unlike GDP they report it monthly. It’s flat-lined after five years of slow improvement. Not in decline, but giving a clear warning.

Labor Markets Conditions Index

The bottom line

If you want to follow just one indicator, watch the Atlanta Fed’s GDPnow model. It’s roughly as accurate as economists’ forecasts, but It is updated 5 or 6 times per month.

Atlanta Fed's GDPnow


The US economy has flown into what pilots call the “coffin corner” — unable to accelerate, but much slowing probably would cause a crash. But economists remain confident, as they were before the 2001 and 2007-09 recessions. With their eyes firmly on the rear view mirror, they see that the usual causes of recessions are absent.

We are in a new era. Don’t assume history will repeat. Watch the economic data to see the unexpected turbulence that will end this already old expansion.

Thursday, November 26, 2015

Letting Facts Speak for Themselves

‘Silk Road’ Countries’ Gold Reserves and Demand Accumulation Has Grown 450% Since 2008, The Greatest Increase Has Been Since The Global Financial Crisis

Submitted by IWB, on November 26th, 2015

by Jesse

Silk road total demand, including the growth of official reserves and commercial imports, has risen from 1,493 tonnes in the year 2000 to over 27,087 tonnes in 2015.

The greatest increase has been since the global financial crisis in 2008 with an astonishing increase of 450% over the total amounts accumulated until then.

As you may recall, gold was ending its long bear market with a price bottom and a long climb higher shortly after the currency crises of Asia and Russia in the 1990’s.

Silk Road demand has easily exceeded total global mine production for the last two years. And quite  Therefore, in addition to mining, other sources of gold have had to be found.  This may include scrap, and gold held by other entities.

Has this surge in gold demand been an uniquely Chinese government phenomenon?  Hardly.

In the second chart I show all the gold reserve increases for China AND Russia from the year 2000. They account for only about 11.4% of the growth in gold demand from the ‘Silk Road’ countries.

It is interesting to match this with the steady declines in Western gold vaults and the increased leverage in gold trading, what some call ‘synthetic gold,’ that became apparent in 2013.

I show that in the third chart vis a vis the Comex, and the fourth chart for the London Vaults.

The fifth chart compares the relative physical deliveries on the Shanghai Exchange and the NY Comex.

I am not trying to persuade or convince anyone, or argue with anyone, and certainly not sell anything.
Here are the facts as I have been able to discover them, and I cannot control what people may choose to think or not to think about them.

The data suggests that the volume of gold increased dramatically in 2013, when measures seem to have been taken to dampen the large increase in price up to the $1900 level, through rather clumsily determined selling programs in quiet hours.

This increased flow of bullion may be the result of Gresham’s Law, which states that ‘when a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation.’

The data suggests that gold is very underpriced in US dollars because of an effort to make the dollar appear to be strong and gold to be disreputable as an alternative store of wealth.  Why should gold be more favored than cash money in their own currencies, which central bankers would also like to eliminate to smooth the way for further policy blundering and experimentation.

They are hardly without better alternatives to this.  Except of course for their pride, and insular group thinking, and of course the credibility trap that does not allow for frank discussions of what the problems really are and how we might move along.  But alas, that is not favored by The Banks and the moneyed interests.  And so the very serious people are loathe to even raise the subject of genuine reform in a serious conversation, except in some mockery of a charade.

And the Congress is no better.  The Congress may not know when it is talking nonsense about the economic situation, but the financiers, the Banks, and their hired hands do, but don’t care.

Whatever else someone may say about this, it is apparent by any examination of the figures that gold bullion is flowing from West to East, and in some fairly consequential and increasing volumes.

The Silk Road has added over 25,000 tonnes of gold in the last fifteen years.  The gold miners are hardly in a position to increase production and search for new supply.  A gold mine takes four or more years to bring into production.

According to Nick Laird’s figures, monthly global mining production is about 260 tonnes, and monthly demand is about 357 tonnes.  I have included a list of the top gold producing countries  in chart six.

Where will the supply for the Silk Road demand come from over the next five years, as it continues to grow faster than mining and even scrap production?

These two charts are from Nick Laird at, with my annotations.

Wednesday, November 25, 2015

The tide (liquidity) goes out on Corporate Bonds

To Junk Bond Traders "It Almost Feels Like 2008"

Tyler Durden's picture

Submitted by Tyler Durden on 11/25/2015 21:00 -0500

Despite distressed-debt funds suffering their worst losses since 2008, mainstream apologists continue to largely ignore the carnage in the credit market (even though veteran bond managers have urged "it's not just energy, it's everything.") With the number of loan deals pricing below 80 (distressed) at cycle peaks, and "a less diverse group of investors holding a lot more bonds," price swings continue to be wild but as DB's Melentyev warns, initially "all of this looks random when there is no underlying news to support the big moves. But eventually a narrative emerges -- maybe we have turned the corner on the credit cycle."

Investors are shunning the lowest-rated junk bonds.

That is underscored by the extra yield that investors are demanding to hold CCC rated credits relative to those rated BB. This has jumped to the most in six years.

As Bloomberg reports,

With confidence slipping in the strength of the global economy, there are fewer investors to take the opposite side of a trade in the riskiest parts of the market, according to Oleg Melentyev, the head of U.S. credit strategy at Deutsche Bank.

"These are all small dominoes in one corner of the market," Melentyev said. "In the early stage, all of this looks random when there is no underlying news to support the big moves. But eventually a narrative emerges -- maybe we have turned the corner on the credit cycle.

One sometimes-overlooked element that’s contributing to the big price swings is the increasing concentration among investors, according to Stephen Antczak, head of credit strategy at Citigroup Inc.

Mutual funds, insurance companies and foreign investors make up 68 percent of corporate bondholders compared with 52 percent at the end of 2007.

That means that if one mutual fund investor wants to sell some holdings, there isn’t another one that’s ready to step in. That’s because they typically have similar mandates from investors and often need to sell for the same reasons.

"A less diverse group of investors hold a lot more bonds," Antczak said. "The difference between incremental buyer is more now than it used to be. It takes a bigger move to get people interested."

Bonds of smaller companies that carry a high amount of debt relative to earnings are most susceptible to falling quickly after earnings are reported, said Michael Carley, a co-founder of hedge-fund firm Lutetium Capital.

Money managers looking at the bonds of those types of companies aren’t spending time examining the issues in those businesses before selling because they’ve got their “own wounds to lick,” said Carley, the former co-head of distressed debt at UBS AG. “And the dealers are saying, ‘I don’t own it; I don’t care.’ So it just plunges.”

As we noted previously, for the first time ever, primary dealers' corporate bond inventories have turned unprecedentedly negative. While in the short-term Goldman believes this inventory drawdown is probably a by-product of strong customer demand, they are far more cautious longer-term, warning that the "usual suspects" are not sufficient to account for the striking magnitude of inventory declines... and are increasingly of the view that "the tide is going out" on corporate bond market liquidity implying wider spreads and thus higher costs of funding to compensate for the reduction is risk-taking capacity.

*  *  *

One wonders when stock investors will wake up again?