Dear Diary,
New England is stunning this time of year. Just what you’d expect. The leaves turn brown, yellow and red, putting on their best outfits and strutting their stuff in the cool autumn air.
Autumn, especially in New England, is the loveliest time of the year. The sun barely clears the tops of the trees, even at noon. The light, filtered through the colored leaves, gives the earth the rich and heavy air of a funeral parlor.
Perhaps that is why there are market crashes in the fall. Investors feel the approach of death.
The stock market fell hard on Thursday… and then kept falling on Friday. Before the week was over, investors were worried.
Inflated by Debt
Last week, we talked about the increase in volatility. Our friend and former World Bank economist Richard Duncan predicted this would happen.
As the Fed’s QE comes to an end, he said, so will the EZ money supporting the stock market.
Shrewd investors are looking ahead. Without the Fed behind it, what is the likely return from the US stock market over the next 10 years?
“Negative,” says equity analyst Stephen Jones.
Stock prices are high. From these heights, stocks typically fall more than they rise – even without the withdrawal of QE. That’s because stock prices regress to the mean. This could bring 10 years of losses for stock market investors.
Wait a minute, you might say, these prices are supported by earnings.
But Stephen insists that corporate earnings have been inflated by debt. The money had to come from somewhere. And it could only have come from debt. So if the credit expansion stops, those earnings will deflate.
That’s why the feds are so desperate to keep interest rates low and liquidity high. When rates rise, the jig is up. Earnings will fall. Stocks will fall. Credit will contract… and the economy with it. Tax revenues will shrink. Bonds will crash.
Have we forgotten anything?
Oh, yes… the entire model of modern government and finance will collapse, too.
In fact, it will be the end of the world as we have known it.
Drooping Leaves
We (your editor is speaking for himself) were born at the beginning of the biggest boom in history.
In Phase I, that boom was fueled by output – of babies, autos, TVs and genuine economic growth.
But in Phase II, it was fueled by credit. From 1964 to 2014, credit in the US increased 50 times, as the economy shifted from manufacturing to finance – that is from making things to buying them with borrowed money.
Now, 66 years later, the leaves are beginning to droop on the whole shebang.
Last week, the IMF announced that the Chinese economy is now larger than that of the US, on a purchasing-power parity basis. In US dollar terms, Chinese output may still be below the US. But when you adjust for what the local currency will buy, China is bigger… and getting bigger all the time.
Another interesting feature of the report: Since the beginning of the financial crisis in 2008, the Chinese economy has grown not twice as fast as the US, but nine times as fast.
But China is not immune to the seasons either. From Chongqing province comes the following news, via the Wall Street Journal:
About 1,000 workers at a Foxconn plant in southwest China assembling printers and computers for companies went on strike for several hours this week demanding higher pay.
The Taiwan-based company, formally known as Hon Hai Precision Industry Co., said the workers walked off the job for four hours Wednesday at its production site in Chongqing. About 20 workers went on strike Thursday morning but further details on that stoppage weren’t available.
Foxconn is working with its labor union and workers to resolve the dispute, the company said Thursday in a statement. The company said the strikes didn’t disrupt production.
Why is this important?
It’s another leaf turning yellow, says former Reagan budget adviser David Stockman. Chongqing is on the western edge of China’s productive landmass and population centers.
Go further west and you run into the Gobi Desert – lots of sand but few people. If China is running out of cheap labor there, it’s running out everywhere.
Last of the Summer Wine
A key component of Phase II of the great credit expansion was the entry of about 500 million workers into the international labor pool.
Gradually, as American shoppers went to Walmart, they found more and more “Made in China” labels and “Everyday Low Prices.” This phenomenon largely offset the Fed’s inflation.
In short, the US found that it could inflate credit all it wanted without causing an alarming rise in prices or interest rates.
But now, the summer is over. The strikes in Chongqing suggest that, even on the furthest fringes of China, bargaining power is shifting to workers. The well of cheap labor from impoverished Chinese peasants has been pumped dry. If that is so, labor rates will rise in China… and prices won’t be far behind.
Don’t expect an immediate markup of flat-screen TV prices. This is a big boat the Chinese are turning. It will take years to manifest.
Besides, it is just October. There are still November and December ahead. And don’t be surprised if stock market volatility spooks the Fed so that it goes back into QE mode – or worse.
Relax. Enjoy the season. Leaves – like wine and women – can be at their best just as they begin their decline. And as a passenger on the Titanic was heard to remark after the ship hit an iceberg, “the band never sounded better.”
Regards,
Bill
A Brutal Week for the Bulls
Last week was brutal for US stock market bulls…
The heavy selling left the S&P 500 down -3% for the week. And it left the Dow in negative territory for the year.
But the selling was even worse in riskier small-cap stocks. The Russell 2000 index of small-cap stocks fell -4.5% for the week. And it’s down nearly -10% for the year.
And the growth-sensitive energy sector got crushed. The Energy Select Sector SPDR ETF (NYSE:XLE) plunged -5.2%. And the United States Oil Fund LP ETF (NYSE:USO), which tracks the price of light, sweet crude oil futures traded on the New York Mercantile Exchange, was down -4.6% for the week.
In fact, the only bright spots were defensive plays gold and silver – up 2.7% and 3.3% respectively for the week – and long-dated Treasury bonds. The iShares Barclays 20+ Year Treasury Bond ETF (NYSE:TLT) rose nearly 2% last week. And it’s now up nearly 18% for the year.
This makes long-dated Treasury bonds the best-performing asset class so far this year outside of Indian stocks (up 21.5% year to date).
It’s hard to put a bullish spin on any of this. We believe it’s time to make sure your portfolio is prepared for a significant correction.
This is not a market timing call. It’s simply an acknowledgement that this market is trading bearishly after a long period of bullish calm and complacency.
Investors should tread carefully… and pay equal attention to the risks involved with owning stocks as they do to the potential rewards.