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By Liu-Yue (Louie) Lam, Global Investment Strategist, Oxstones Investment Club

To Medicate, or Not to Medicate: That is the $18.5T Question

The Fed is in uncharted territory as it seeks to experiment how the patient will react to less stimulus after eight years of taking emergency medication.  The combination of interest rate hikes and unwinding (quantitative tightening) $4.5T balance sheet may be too much for an economy that is growing at a modest 2% growth rate.  With current capacity utilization at 76% and a work force participation rate (63%) at multi-generational lows the economy is far from overheating.  In addition, current debt to gdp is at 104% and therefore any additional interest rate hike will only add to our government’s debt burden.

There are economic debates whether heavy debt burden leads to slow economic growth and whether debt issues can be mitigated by growing gdp faster than debt but this solution relies on population growth.  Current population growth is a ticking time bomb with aging baby boomers already retiring in full force and younger generations have push off family planning due to the weak economy.  Immigration can be a potential solution to replenish an aging population but current anti-immigration rhetoric and visa restrictions only accelerates negative population trends.

The other component needed to create faster gdp growth is innovation which leads to productivity gains.  Productivity gains will be difficult after years of corporate neglect to invest in R&D and capex.  Corporate executives decided returning capital to investors through stock buybacks and dividends due to lack of growth opportunities to be a less risky management decision.

Market Divergence and Contrarian Indicators

There is a growing disconnect in the equity and the bond markets.  Equity markets continue to price in future growth and hit all-time highs. Bond market yields continue to decline to a current low of 2.1% even as the Feds continue to hike interest rates.  So who is correct?  Bond investors fear economic slowdown while equity investors believe faster economic growth is just around the corner.

One reliable indicator we should observe is the yield curve.  The current yield curve has flattened and signal to corporations to slow down business activity.  Recent commercial bank lending to corporations and commercial real estate have already started to decline.  Margin debt has recently hit another all-time high and is now significantly higher than in 2000 and 2007 market peaks.  Margin debt is a contrarian indicator of a market top.

Other contrarian indicators such as consumer sentiment and confidence have also peaked.  The economy in the 1Q’17 slowed dramatically.  Recent inflation was at 1.5%, and inflation has now missed the Fed 2% target inflation rate for the past five years.  A word of caution – 16 of the past 19 (84%) tightening cycles has led to a recession.

Financial Market Valuation Overview

The stock market appear overvalued by almost every traditional valuation method with current trailing 26x P/E, 3x P/B, and 2x P/S.  Other valuation methods such as the famous Buffett Indicator (130% market cap to gdp) and Shiller CAPE (26x PE) all point to an overvalued market.  However the market can stay irrationally overvalued for much longer than investors can remain solvent.

In addition, global real estate markets and global bond markets also appear overvalued too.  There are currently real estate bubbles in Canada, Australia, and Sweden.  Multiple sovereign debt markets (EU nations and Japan) are extremely overvalued with large proportions of sovereign debt yielding negative rates.  U.S. high yield bond market currently trade at 3.72 yield premium to U.S. Treasuries while the historic range is closer to 500bps-700bps.

The Ultimate Sleight of Hand

Historically business cycles average 60 months and we’re currently in the 94^th month of economic expansion.  There has been a significant lag between the actual U.S. economy and the financial markets for many years.  QE and other global central bank monetary policies such as ZIRP, NIRP, low interest loans from ECB, and JCB yield caps have created significant distortions not only in U.S. Treasury markets but other global risk free benchmarks which have led to higher valuations not only for equities but also for other asset classes.

We usually average a 20% correction every 5 years and we’re currently in eight bull market years which makes this the second longest running bull market in history.  We’re long overdue for a bear market.  We’ll have a severe bear market if the economy goes back into a deep recession or the Fed makes the mistake of tighten credit excessively above inflation rate.

Ironically Trump deregulation of the financial industry just might be the trigger that sets off the gun powder by allowing the money supply to finally seep into the real economy.  The most important question is whether after so many years of dependence on monetary stimulus is the economy really now strong enough to continue to grow even after the withdrawal of stimulus?  This is the great monetary magic act with the final scene still to be written.

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Tags: buffett indicator, business cycles, commercial bank lending activity, contrarian indicators, economic indicators, equity market valuations, global asset bubbles, global central bank actions, high yield bond market valuation, historical monetary tightening cycles, Liu-Yue (Louie) Lam, market valuations, overvalued real estate markets, oxstones investment club, quantitative tightening, Schiller CAPE, sovereign debt markets, The Great Monetary Magicians, valuation methods, yield curve