One and Done Fed is a Wall Street Fantasy

Submitted by Michael Pento – Pento Portfolio Strategies

Cartoon of the Day: Over Fed - Fed cartoon 10.24.2014One of the current myths promulgated by Wall Street is that the Federal Reserve will raise rates once this year, breathe a sigh of relief, and be done until the “12th of never”. But those who are familiar with our central bank’s history are aware that the Federal Open Market Committee (FOMC) has never tightened the Fed Funds Rate just once. A quarter point hiking cycle has no historical basis and is just wishful Wall Street thinking.

In the spring of 1988 fearing a rise in core inflation, the Fed went on a tightening cycle that lasted from April 1988 to March 1989.  During that time the Fed funds rate increased more than 300 basis points. This episode was followed by a recession beginning in 1990, suggesting that the corrective policy actions may have intensified a weakening economy, and that the Fed is prone to being economically tone deaf.

Then, during the fall of 1993, a rise in long rates represented a potential inflation scare and led the FOMC to raise the Funds Rate again another 300 basis points between February 1994 and February 1995.

And finally, as concerns over a potential housing bubble mounted, the Fed began to hike rates in June 2004 and continued through July of 2006, for a total increase of 425 basis points. Soon after, the subprime mortgage crisis was exposed and the Great Recession was in full throttle.

But we don’t have to be Fed soothsayers to predict the planned trajectory of the Funds Rate; the Fed makes its intentions public during four of its eight scheduled meetings. During those meetings the FOMC provides us with a model of the members’ expectations for policy rates in a chart known as the “dot plot.” 

Dot plot

While the FOMC is not bound by its “dot plot” predictions, it does provide insight into committee’s monetary policy plans. The markets are aware of their intentions and will begin to price in future interest rates moves as soon as the Fed begins liftoff. Continue reading

Stock Market Calls Fed’s Bluff

Submitted by Michael Pento – Pento Portfolio Strategies

As the Fed nears its proposed first rate hike in nine years the stock market is becoming frantic.  The Dow Jones Industrial Average is down around 10% on the year, as markets digest the troubling reality that our central bank may be raising interest rates into an emerging worldwide deflationary collapse.

The Fed normally raises rates when inflation is becoming intractable and robust growth is sending long-term rates spiking. However, this proposed rate hike cycle is occurring within the context of anemic growth and deflationary forces that are causing long-term U.S. Treasury rates to fall.

The yield curve spread, specifically the difference between Fed Funds Rate and the 10-year Note, is usually close to 4 percentage points at the start of major tightening cycles. This was the case at the start of the 1994 and 2004 campaigns to curb inflation. However, this go around the spread is less than 2 percentage points and the benchmark 10-Year Note yield is falling. This means the yield curve will invert very quickly and cut off banks’ profitability and incentives to lend; which will greatly exacerbate the deflationary impulses reverberating across the globe.

These deflationary forces will collide head on with a stock market that is already extremely overvalued as measured by Tobin’s Q ratio (the total value of corporate equities/replacement cost) and the total market cap to GDP.
Tobin’s Q Ratio:


Total Market Cap/GDP:

Continue reading

A Streetcar Named Treasuries

Submitted by Michael Pento – Pento Portfolio Strategies

In the 1947 Tennessee Williams play “A Streetcar Named Desire” as she is being carted off to the mental institution Blanche Dubois utters these famous words …I have always depended on the kindness of strangers.”

And like Ms. Dubois, the United States has also come to depend on the kindness of strangers to fund a massive $18.3 trillion in debt.

But that kindness the US Treasury has come to depend upon may be waning. Foreign holdings of U.S. Treasury securities fell in May for a second straight month. The Treasury Department reported total holdings were down 0.1% in May to $6.13 trillion. This comes after an even bigger 0.6% decline in April.

In four of last six months, China has been a net seller of Treasuries.  According to Bloomberg, China sold $180 billion worth of treasuries from March of 2014 to May of this year. China had $1.65 trillion worth of Treasuries at the peak, now they have $1.47 trillion. And Japan also sold $9.4 billion of long-term treasuries in June alone.

With foreign investment demand waning the US may have a harder time funding its debt. The US savings rate is currently around 5%, that is less than half what is was in 1980 and a full 8 percentage points below its level at the end of the Bretton Woods Era. This begs a question: who will be a buyer of our debt if foreign governments stop buying and even become sellers? The answer of course will eventually be a protracted and unlimited amount of Treasury purchases on the part of our central bank.

Adding to this uncertainty is the Fed’s retreat from QE. We can no longer count on the Fed buying $45 billion per month of long-term Treasuries. And now the Fed is promising to start slowly unwinding its $2.5 trillion of government debt. Continue reading

Ignore the Commodity Message at Your Own Peril

Submitted by Michael Pento – Pento Portfolio Strategies

The Thomson Reuters/Jefferies CRB Index (CRB) is back down to the panic lows of early 2009. For those who think the CRB Index says nothing about global growth…invest accordingly at your own peril.


If you believe this commodity crunch is all about some temporary oil supply glut, think again. There are 19 commodities that make up the CRB Index:  Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat. The value of the weighted average of these commodities is screaming one thing loudly: the rate of global growth is plummeting just as it was at the height of the Great Recession.

This is mainly because the synthetic economy of China, which once sucked up the natural resources of the globe in order to create the world’s greatest fixed asset bubble in history, is now in freefall. And it is driving down the price of commodities as global growth grinds to a halt.

For those who think the U.S. and the rest of the world will be somehow immune to a China slowdown should note that foreign sales accounts for about one third of aggregate revenue for the S&P 500. For years China had been a huge growth market for multi-national companies. However, its recent rut is affecting both domestic and international companies around the globe that once provided China with natural resources during its empty-city building bonanza. Continue reading

The Real Message of Plunging Commodities

Submitted by Michael Pento – Pento Portfolio Strategies

The Chinese stock market recently saw its biggest selloff in 8 years as the dramatic 8.5% fall in Shanghai

“A” shares also rattled markets around the world.

For the past few weeks China has been balancing its desire to keep the equity market from a complete meltdown, while still courting the international investment community with hopes of being a dominant player in the capital and currency markets.

But recently The International Monetary Fund (IMF) warned China’s government about its concern over limiting investors’ freedom to take equity out of financial markets. These concerns were raised when the IMF met with officials in to discuss the chances of including the yuan in the fund’s basket of currencies, also known as Special Drawing Rights (SDR).

As China tries to balance the demise of its equity bubble while still keeping the illusion of free markets intact, two delusional narratives have started to circulate around Wall Street.

The first such Wall Street inspired delusion is that the collapsing Shanghai stock market will have no effect on the underlying Chinese economy. However, even though China’s 260 million trading accounts may be a relatively small percentage of its total population, it’s also the richest and most productive portion of its citizenry, which also happens to be equal to the entire U.S. population in 1993. And Chinese GDP growth accounts for 1/3 of total global growth. Therefore, we can already find the manifestation of slowing Chinese growth from the nascent fall in equity prices.  Continue reading

How to Identify a Classic Bubble

Submitted by Michael Pento – Pento Portfolio Strategies

One of the most ironic and fascinating characteristics about an asset bubble is that central banks claim they can’t recognize one until after it bursts. And Wall Street apologists tend to ignore the manifestation of bubbles because the profit stream is just too difficult to surrender.

The excuses for piling money into a particular asset class and sending prices several standard deviations above normal are made to seem rational at the time: Housing prices have never gone down on a national basis and people have to live somewhere, the internet will replace all brick and mortar stores, and perhaps the classic example is that variegated tulips are so rare they should be treated like gold.

I am willing to let the Dutch off the hook; back in the seventeenth century asset bubbles were virtually nonexistent because money was still in specie. But central banks have created the perfect petri dish for asset bubbles over the past three decades. Therefore, it’s imperative for investors to understand the classic warning signs of a bubble so you can avoid the inevitable carnage in the wake of its collapse.

As I identified in my book “The Coming Bond Market Collapse”, there are three classic metrics to determine when an asset has grown into a bubble: it becomes extremely over supplied, over owned and overpriced compared to historical norms.

The real estate market circa 2005 was a great example of a classic bubble. The supply of new homes boomed as new home construction rates peaked around 2 million units per annum in the middle of the last decade.  That’s about 400k units higher than what would be considered the historical average. Continue reading

The Extinction of Markets

Submitted by Michael Pento – Pento Portfolio Strategies

China’s four-week-long stock market rout wiped out nearly 30% off the Shanghai Composite Index since its highs of June. To stem those losses the Chinese government has formulated an interesting hypothesis: stocks won’t go down if you ban sell orders.

Working off this proposition Beijing has ordered shareholders with more than a 5% interest to stop selling shares; directors, supervisors, and senior management personnel are also barred from reducing their holdings.

China has also launched investigations on those it believes engaged in malicious short selling. The threat of imprisonment has proved an effective deterrent to those who may have been contemplating a short in the Chinese markets.

And even if you don’t fall into either of the above categories of sellers you still will have trouble getting your money out of shares because two thirds of the stocks on the exchange have been halted.

It should come as no surprise that the Communist government of China has fallen off the free market wagon. After all, the government is of the belief that economies grow by building empty cities. So why shouldn’t they think markets work best when not allowing participants to sell?

The reaction on Wall Street has been just as alarming. Deutsche Bank and Bank of America Merrill Lynch have applauded the Chinese governments for doing everything necessary to keep the bubble afloat.

But Wall Street’s counterintuitive and ironic bullishness on China is most evident in the powerhouse investment firm Goldman Sachs. Goldman is urging investors to buy stock in China right now! Continue reading

The Potemkin Bank of China

Submitted by Michael Pento – Pento Portfolio Strategies

In the midst of an intense global economic slowdown that began in 2008, China’s economy amazingly appeared to be unaffected. Defying the world-wide real estate collapse, China’s GDP grew by an impressive 8.7% in 2009. Fueled initially by a $586 billion stimulus package, China would end up plowing and additional $20 trillion dollars into a fixed asset bubble that was designed to produce the government’s desired GDP print.

Perhaps inspired by the movie “Field of Dreams”, the Chinese government believed in the adage “If you build it, they will come”.  And for the next 6 years China built empty cities in spades. New construction remains mostly unoccupied to this day; estimates are that 52 million homes are vacant and 90% of those empty units were purchased strictly for investment purposes.

Apartments were snapped up as investments by the nation’s wealthy upper and middle classes, then sat empty as the owners failed to find tenants who could meet the pricey rent.

Investors sat on massive mortgages on unoccupied real estate holdings and home prices began to fall when loans from the shadow banking system started to dry up. This caused the Chinese authorities to quickly search for another bubble to create; one in a more convenient and easily manipulated asset class. If the average citizen could no longer afford to buy a house why not try to create a wealth effect by putting equities in a perpetual bull market?

Substituting empty cities for brokerage accounts with little capital, on-line Chinese lenders set up margin accounts with the same fervor as U.S. sub-prime mortgage lenders in 2006. In addition to conventional brokerage accounts, 40 online lenders helped arrange more than 7 billion yuan worth of loans for stock purchases in the first five months of 2015. Lending volumes surged 44% from April to May alone.

China’s margin finance problem quickly reached epic proportions. Margin trading jumped thirtyfold over the past three years on the Shanghai stock exchange. Chinese margin debt has risen 123% year-to-date, reaching a new record of 2.3 trillion yuan ($370 billion) on June 18.

However, some analysts believe the real amount of money borrowed by Chinese investors is likely to be much higher. The amount of shadow margin financing, which includes umbrella trusts and stock-collateralized loans, in the mainland stock market could easily be double or triple that of the balance of conventional margin financing taken through brokerages.

In addition, unlike other major international stock markets, which are dominated by professional money managers, retail investors account for around 85% of Chinese trading.

For a brief moment it was a magical solution to combat the failed real estate bubble. The Shanghai Composite started 2015 at 3,234 and hit 5,023 on June 4th–a 150% surge from the preceding 12 months, before plunging to 3,800 where it sits today.

But the market is still far from trading at a discount valuation. Despite the recent carnage, Shanghai shares are trading at 57 times earnings. That’s down from the June price to earnings ratio of over 100, but it’s still 3x higher than the PE ratio of the S&P 500.

The totalitarian regime is making daily policy modifications in a desperate attempt to stem the fall.  But, interest rate reductions by the People’s Bank of China (PBOC), cuts in reserve ratio requirements and relaxations in margin trading rules have done little to calm investors so far.

Brokerage firms and fund managers have now vowed to buy massive amounts of stocks aided by a direct line of liquidity from the PBOC, which is directly monetizing securitized loans from China Securities Finance Corporation (China’s state-backed margin finance company.) Continue reading

Greece and Puerto Rico: Previews of Coming Attractions

Submitted by Michael Pento – Pento Portfolio Strategies

Governor Alejandro García Padilla of Puerto Rico said this week he does not think the Commonwealth will be able to pay back the $73 billion in debt owed to bondholders. I find this rare bit of honesty totally refreshing. For the past three years some had speculated about the possibility of a Puerto Rican default, but most believed it to be a farfetched notion. Now the question of solvency is no longer in doubt: Puerto Rico is officially broke and is unable to pay all of its debt obligations.

The White House has firmly attested that a Puerto Rican bail out is not in the cards. The U.S. territory is requesting that the Federal government allow them access to chapter 9 bankruptcy, like Detroit used when it was unable to pay its bills. At the moment, only cities, towns and other municipalities are able to declare bankruptcy.

Like Detroit Michigan in 2014 and Stockton California in 2013, we can choose to look at Puerto Rico as an isolated incident. A blip on the debt radar that will only affect Puerto Ricans and about half of all municipal bond funds.

We can continue to delude ourselves into believing that Puerto Rico doesn’t make a larger statement about the solvency of municipalities around the United States; or even the solvency of the United States in total. Investors can just view this as another buying opportunity; much like they were convinced the Country Wide Credit and Indy Mac bankruptcies provided a great buying opportunity. Because, after all, wasn’t the real estate crisis supposed to be contained within the realm of just the 1% sub-prime mortgage borrowers.

But before investors mistakenly press the buy button once again they have to realize that P.R. is simply emblematic of a much larger problem. Puerto Rico is not an anomaly, it is more likely to be the “Bear Sterns” of the inevitable municipal debt crisis in the United States.

And then we have Greece. One thing is clear: Greece will default either through restructuring or debt monetization. The Greeks can remain in the European Union and submit to the austerity dictated to them by their German masters; or they can opt for self-imposed fiscal and monetary disciple under their own currency. In either case, this is a nation with a debt to GDP ratio north of 170%, and which suffers from sharply contracting revenue growth. Chaos and default in Greece is unavoidable; but is best dealt with on its own terms. Continue reading

Bubbles Never Pop Painlessly

Submitted by Michael Pento – Pento Portfolio Strategies

Investors are obsessed over predicting the timing of the Fed’s first interest rate hike. Will it raise the Fed Funds rate in September, or wait until next year? But it is far more important to get a grasp on the pace of rate hikes. Will it be a one and done move, or does this mark the beginning of an incremental tightening cycle?  Those of us who are not in the inner circle are forced to only speculate.

But one thing is certain: If history is any guide, whatever they do the Fed will get it wrong.  Most market commentators place unfounded belief in the Fed’s acumen. But the truth is: I wouldn’t trust the Fed to tell me what the weather is going to do in the next 30 seconds–even if they were looking out the window.

Once you understand the nature of bubbles—how they are created and how they burst—you can be assured this latest manifestation will also end in disaster.  If the Fed raises rates in the manner in which the dot plots currently suggest it will quickly burst the bubbles already created in the real estate, stock and bond markets. On the other hand, if the Fed opts to only make a small token move higher in the cost of money it will allow asset bubbles to spin out of control until inflation destroys the vestiges of economic growth.

Our Central Bank has been deluding itself into believing it can easily escape from its nearly $4 trillion expansion of the monetary base and 7 years of virtually free money. But that is a spurious belief. Bubbles never die slowly and always bring about dire consequences. The bigger the bubbles the worse the backlash–and never before in the history of economics have central banks distorted market prices to this extent.

All bubbles share the conditions of the asset being overpriced, over-supplied and over-owned when compared to historical norms. And all bubbles are built on a massive increase in debt. For examples; the Tech Bubble was fueled by a rapid increase of margin interest, and the housing bubble was fueled by the ownership of properties with little to no equity. Bubbles always sit atop a humongous pile of borrowed money. Today we have a tremendous amount of margin and leverage in both equities and fixed income assets.

For example, we see in this chart from the NYX data website that the percentage growth rate of margin debt vastly outstripped S&P 500 returns in real terms just prior to the collapses of 2000 and 2008.

Continue reading

Rates Are Rising for All the Wrong Reasons

Submitted by Michael Pento – Pento Portfolio Strategies

Wall Street carnival barkers are relishing in the fantasy that the economy has finally achieved escape velocity. Therefore, they accept with alacrity that this is the primary reason why interest rates have started to rise. However, the fact still remains for the first half of 2015 GDP growth will probably be less than 1%.

GDP contracted by 0.7% in the first quarter of 2015.  The Atlanta Fed, whose GDP Now calculation has been on the money, now sees second quarter growth at 1.9%. Therefore, it is prudent to conclude the most optimistic case for growth in the first half of the year will be about 1%.  Of course, the perpetually upbeat economists on Wall Street are always convinced the economy will skyrocket in the second half of each year. But still, if the Atlanta Fed is correct—and it looks like it will be spot on given the anemic data already released for April and May—annualized GDP for the first two quarters of 2015 will be running at a pace that is less than half of the 2.2% growth averaged since 2010.

Perpetual optimists will highlight the recent positive data in housing as evidence of a robust recovery. But most of the upbeat numbers in housing are a result of front running the inevitable mortgage rate increases, as people rush to lock into low rates while they still can. And even with this, housing data has been mixed at best. U.S. housing starts in May fell 11.1%, to an annual rate of 1.04 million units from a revised 1.17 million units in April. This rate of new home construction is far below the 1.5 million rate seen in the year 2000, and light years away from the 2.2 million rate at the height of the housing bubble.

And we also have some encouraging data in retail sales, courtesy of the booming auto market. But sales in cars have been driven by the resurgence of the infamous liar loans, loose lending standards and virtually free money that led to the collapse in Mortgage Backed Securities in 2007.

Yet, despite booming car sales and slightly better new home construction rates, the nation’s manufacturing base remains literally in the basement. For example, the Empire State’s business conditions index unexpectedly dropped to -1.98 in June and Industrial Production decreased 0.2 percent in May after falling 0.5 percent in April. May is the fourth negative reading in the last six months on I.P., with the other two readings being flat. Continue reading

Why the Fed Is Afraid To Raise Interest Rates

Submitted by Michael Pento – Pento Portfolio Strategies

Even though the major stock market averages are flat for the first six months of the year, by nearly every measure the stock market is still extremely overvalued. This point is not lost on Ms. Yellen and company, as the Fed Chair herself has recently asserted that the current value of stocks are “quite high”. Given this, the Fed must privately be afraid that even a small change in the Fed Funds Rate could serve as the needle that pops the massive bubble in the stock market.

Exactly How Overvalued Is This Market?

First, the median Price to Earnings (PE) multiple on New York Stock Exchange (NYSE) equities is currently off the charts. Using this measure, the 2,800 NYSE stocks are at the highest level since records began since 1945.

Adding to this, the cyclically adjusted PE ratio (CAPE) for the S&P 500, which uses real per-share earnings over a 10-year period, is at a current level of 27.17. This is far higher than the long term average of 16.61, and only slightly below the 32.56 level achieved at the start of the Great Depression in 1929.

And then we have the Q ratio: the total price of the market divided by the replacement cost of company’s assets. Historically this measure averages around .68. Today this ratio sits at 1.14, the highest level recorded since the dotcom bubble, and an increase of 100% from its value in 2009. Using this metric, the value of U.S. equities is more than 10% higher than the cost to replace all of the underlying assets.

Finally we have the Total Market Cap to GDP Ratio, which represents the value of all stocks in the Wilshire 5000 divided by total U.S. output. This value indicator, at 125% of GDP, is higher than any other time in history outside of the dot.com era. And is about 75 percentage points greater than it was throughout the period 1975-1995. Continue reading