Thursday, February 16, 2017

The Fed's Playbook Uncovered: Gaslighting us to recovery

If I was given a dollar for every time I saw a headline, looked at a chart or watched some market guru say something on TV that made me think I had lost my mind over the last 8 years, I’m sure I’d be a zillionaire by now. 

Kyle Bass described the growing gap between fundamentals and investment behavior in a 2011 newsletter entitled, “The Cognitive Dissonance of It All”. In 2014, legendary hedge fund manager Seth Klarman warned “There is a growing gap between the financial markets and the real economy.. and the overall picture is one of growing risk and inadequate potential return almost everywhere one looks…. As every “Truman” under Bernanke’s dome knows the environment is phony”.

While we may indeed be living under a dome with a 'phony economic environment', it's clear that the market is more than happy to surge ahead - fundamentals be damned. The S&P 500 has jumped an additional 25% since Klarman’s warning, and a whopping 77% since Bass described the 'cognitive dissonance of it all'.

So how does this happen? What happens to enable a stock market to disconnect so widely from its underlying fundamentals?

After more than a decade of diving deep into the macro, I've come to the conclusion that the disconnect between economic fundamentals and stock prices is being perpetuated and nurtured by the Federal Reserve. To put it as bluntly as I can, I think the Fed is trying to "gaslight" us towards an economic recovery.

“Gaslighting is a form of manipulation that seeks to sow seeds of doubt in a targeted individual or members of a group, hoping to make targets question their own memory, perception and sanity” 

Using persistent denial, misdirection, contradiction and lying, it attempts to destabilize the target and delegitimize the target’s belief” – (link:

Those of you who will stop reading this article because you think my ‘gaslighting by the Fed’ theory is nothing more than the pointless ramblings of a tin foil hat conspiracy theorist actually help prove my point. (you've already been gaslighted).

There are a ton of examples of the Fed "talking up" the economy while simultaneously ignoring some pretty significant contradictions. First and foremost is there constant reference about the  "strongest jobs market in decades




while it is true that the unemployment rate and jobless claims are indeed at record lows, is it accurate to suggest that it's the "strongest employment picture in decades" as the Fed has described? 

Even a cursory review of the employment statistics by the simplest of macro tourists would raise a few questions. First and foremost would be the precipitous decline in the labor force participation rate:

of course some (the Fed, market bulls and the Whitehouse) tried to explain away the issue by blaming demographics and suggested the decline was "expected".

This flimsy excuse served to placate most of the macro tourists, but the more hard nosed and thorough researcher easily discovered that this explanation falls short. All they needed to do was look a bit deeper into the LFPR -

for example - the labor force participation rate for prime aged workers (25-54) is falling -

while the LFPR for people 65 and older is rising

So given the data available, a 'thorough & objective' review of the information above yields a starkly different perspective about "the best jobs market in decades". In fact, it would suggest that the more accurate unemployment rate in the US is actually closer to 7.00%.

Interestingly the new Fed narrative on the decline in the LFPR emerged a few days ago when Fed member Pat Harker (during a Q&A session) suggested, "opiate abuse is part of the reason for the decline in male employment in the US, also there are people who are just disconnected from the workforce". 

Drug addiction is a big part of the 90m plus people who have left the labor pool? Seriously?

The next noteworthy contradiction is found in the growth in average hourly earnings. Again, a simple macro tourist would just look at the headline and proclaim "this is bullish, the economy is getting better".

But, what the simple headline readers fail to appreciate is that (as with the unemployment rate), 'average hourly earnings' is a ratio. So, when wages stay flat and the hours worked fall, you get a jump in "average hourly earnings" - 

knowing this fact explains why real disposable income isn't reflecting the bullish proclamations made by the Fed, Wall Street and the Whitehouse.  

These are just a few examples of the stark contradictions that exist within the marketplace.

The purpose of this post isn't to highlight ALL of the contradictions at play, as that would require more writing than I am prepared to do at this time (plus I just want to post to my blog, I don't want to write a book). Instead, this post is intended to expand on a theory about what the Fed might be trying to accomplish by misrepresenting the economic facts as they are. 

As I can best surmise, the Fed is trying to project confidence to Americans that the economy is getting better. But rather than have some anonymous macro-nerd, hunk of cheese turned blogger explain, why don't we get the information straight from the horse's mouth.

In November 2010, the Federal Reserve Bank of San Francisco published a paper entitled, "Confidence and the Business Cycle

here were some of the more noteworthy observations:

"Indicators of consumer confidence have been at depressed levels in recent months. Business sentiment is also low, reflecting uncertainty about U.S. fiscal policy and the perception that economic weakness may be prolonged. This lack of confidence raises the risks that pessimism can become entrenched and self-reinforcing, further dampening the nascent recovery"

"These experiences suggest that optimism about the future helped fuel economic booms and that subsequent buildups of pessimism contributed to the busts."

"In macroeconomic models, this information changes people's expectations about the future and thus their current [emphasis theirs] economic decisions."

 "Clearly, confidence reacts to a host of economic developments. Identifying a causal link between confidence and economic performance is therefore challenging. Is confidence higher because the economy is booming or vice versa?" [emphasis added]

So how would we check to see projecting confidence to consumers is indeed part of the Fed's post crisis playbook?

A recent post and chart by Tyler Durden on Zerohedge inspired this trip down the rabbit hole.

Here's the chart that attracted my attention:

 Curious, I decided to pull the University of Michigan's Consumer Sentiment data and pair it up with the performance of the S&P 500 to see if there were any noticeable correlations out past the chart timeline above.

Here is what I found:

 Zeroing in on the 2009 to 2017 market/sentiment correlation shows there is definitely a relationship

this is a very big departure from the 1978 to 2007 correlation of 0.4985

What does this all mean? Well it certainly helps me feel a bit better as I listen to Janet Yellen talk about a robust U.S. economy, or a strong jobs market, and watch as the Fed leaps to action anytime there is even the smallest correction in the US stock market.

On paper the strategy does make some sense, as confidence (or pessimism/fear) does indeed have a strong impact on the economy. Consider for example how the sniper killing spree impacted the local DC economy in 2002 -


Unfortunately I think the Fed's strategy isn't working, as the consumer has been in serious financial trouble since well before the crisis, something I laid out in my larger macro thesis a few years ago:

While it might sound a bit arrogant to suggest that the Fed is 'wrong' given the brain power that works there, it's important to remember what they were saying just before the sub prime crisis in 2008.

So they either didn't' see it coming, or they did and said nothing. Neither of these two options is particularly comforting to me as an investor. 

Confidence is a great thing, unless of course it leads to wildly unrealistic expectations, which is what I tend to think is happening when you look at the gap between the stock market and the underlying economy.

Obviously based on the correlations I've covered above, it appears as though the Fed's post-crisis  playbook is working hard to gaslight us towards a recovery.

So investors, don't trust your own experience and feelings about the economy. Instead trust Auntie Janet when she says, "don't worry - be happy".

some other work on the 'recovery' by Gubb:

The Post Crisis Combover

The Fed has Created a Prisoner's Dilemma

Paul Tudor Jones and Ray Dalio Channel James Goldsmith

Symbiotic, Parasitic and Parasitoidal Cycles of Finance

Excel fun


Saturday, January 14, 2017

Gubb's observations and view on market

Here’s a theoretical question for you: If someone doesn’t realize they are standing on thin ice, are they in a risky position if the ice doesn’t break? 

This might sound like an odd, semi-obvious question, but when you apply the same basic concept to investing (i.e. “Does the stock market need to fall before there is any ‘risk’ in holding stocks?”) you might have a better understanding about some of the challenges we as portfolio managers confront on a daily basis. Namely, what should I advise my clients to do if I see dangerous levels of "thin ice" building within the stock market? 

I mention this theme as a follow up to the note that I sent out at the beginning of 2016. In that message, I took a bit of time to discuss the state of the stock market (which was down a whopping 12% in the first 15 days of 2016), and provided some observations about the health of the economy, numerous interventions by the central banks and my concern about the expanding gap that persists between underlying fundamentals and share prices. 

 In my note sent January 15, 2016 I pointed out: 

 “…. Central bank bailouts (by the Federal Reserve, Bank of England, European Central Bank, Bank of Japan and the People’s Bank of China) were attempting to solve a complex economic problem by simply burying it under a mountain of money and a rising stock market.

 I followed that observation with: 

 “Investors took the central bank’s pledge to “do whatever it takes” to heart, and share prices rose quickly off their 2009 lows to all-time record levels a few years later. But, as stocks raced to higher and higher levels, a problem was building whereby either the economy would have to “catch up” to the level of the stock market, or the stock market would have to “catch down” to a more realistic measure of the underlying economy.”

As bleak as the beginning of 2016 looked for investors, the year ended with a bang and the S&P/TSX Composite Index, the S&P 500 Index and the Dow Jones Industrial Average closed up at 17.5%, 9.5% and 13.4% respectively. As with previous years (since 2009), the gains in the stock market weren’t earned thanks to dramatically improving economic growth or a strong rise in corporate earnings (earnings have fallen by 18% since the start of 2015). Instead, the gains enjoyed in the stock market were helped along by the promise of more central bank support and intervention. Consider these comments from a news story (U.S. Stocks Rally Along With Global Markets as Brexit Worries Ease, Wall Street Journal, June 29, 2016) that discussed the sharp, three day 6.75% decline in the U.S. and Canadian stock markets that immediately followed the shocking “Brexit” vote results from June:  
“Many investors now expect major central banks to act to counter a potential drag on the global economy after the Brexit vote, with some predicting rate cuts from the Bank of England and further stimulus from the European Central Bank. Some also expect the Brexit vote to derail the U.S. Federal Reserve’s plans to raise interest rates this year.”
Perhaps I am guilty of being too cautious and cynical with regards to my confidence that the global central banks will be able to find a solution to our ongoing macroeconomic problems, but I feel as though I come by my distrust and skepticism honestly. Consider the comments made by the Federal Reserve and U.S. Treasury Secretary a few months BEFORE the sub-prime housing crisis started: 

As you can see in the chart above, the Federal Reserve was on the record stating that investor concerns about the housing and financial sectors (i.e. thin ice) were greatly overblown mere MONTHS before the Great Financial Crisis started in earnest. Any investor who relied on the promises of the U.S. Central Bank and remained ‘fully invested’ saw the value of their holdings fall dramatically over the coming year. A recovery in the stock market was only made possible via an unprecedented number of coordinated central bank interventions (QE1, QE2, QE3, and Operation Twist, European Central Bank QE, Bank of Japan QE and a move to negative interest rates, just to name a few).

Successful investing requires people to buy good companies at cheap prices and sell those shares when prices are high, thus inspiring the popular expression “Buy low and sell high.”  Unfortunately, markets saturated with seven plus years of central bank accommodation and intervention have become so distorted that it’s virtually impossible to invest in stocks based on traditional fundamentals. Given the gap between stock prices and fundamentals, investors are now hoping to “Buy high and sell higher,” a strategy that history has proven countless times to be highly ineffective.

I don’t think a single trader can tell you what the appropriate price of an asset he buys is, if you take out all this central bank intervention.”
-Alex Weber, former head of the Bundesbank (CNBC, October 10, 2016)

How substantial is the gap between current share prices and underlying fundamentals? That is, how thin do I think the ice is in today’s stock market? A comprehensive reply would require hundreds of pages of charts and graphs drawn from some of the more than two dozen economic models that I have built from scratch over the years and maintain on a regular basis. Perhaps the most succinct & simple perspective comes from a chart using Robert Shiller’s CAPE (Cyclically Adjusted Price Earnings) data. The CAPE uses a 10-year moving average of S&P 500 earnings to try and smooth out business cycle volatility in an effort to provide a clearer view of stock valuations. As you can see from the chart below, current CAPE valuations suggest that the S&P 500 is currently at the 3rd most expensive level in history, trading almost two standard deviations above its long-term (126 year) average. Only the periods just before the crashes of 1929 and the bubble were higher than valuation levels today. 

Some quick math puts the current market valuation in context:

For earnings to ‘catch up’ to the stock market, and push CAPE valuations back down to their 16.72x average, we would need to see earnings rise by 56.2% (from their current level of $87.26 USD to $136.30 USD).

Conversely, if the stock market had to ‘catch down’ to fundamentals, thereby re-converging at the long-term average of 16.72x, the S&P 500 would have to fall from today’s level of 2,280 to approximately 1,458, suggesting a possible decline of 36%  just to get back to the long-term average

This is just some of the ‘thin ice’ that has me concerned as a portfolio manager. While this thin ice hasn’t broken (yet), it certainly doesn’t mean that the risks I’ve discussed here aren’t present. Given my mandate is to not only invest to generate suitable returns, but also to mitigate undue risk, I feel as though a cautious, defensive stance continues to be warranted at this time, even as the market continues its rapid ascent to new record highs. 

I leave you with a wonderful quote from Seth Klarman (, May 5, 2013), who is regarded as one of the best hedge fund (and risk) managers in the world:

Only a small number of investors maintain the fortitude and client confidence to pursue long-term investment success even at the price of short-term under performance. Most investors feel the hefty weight of short-term performance expectations, forcing them to take up marginal or highly speculative investments that we shun. When markets are rising, such investments may perform well, which means that our unwavering patience and discipline sometimes impairs our results and makes us appear overly cautious. The payoff from a risk-averse, long-term orientation is just that - long term. It is measurable only over the span of many years, over one or more market cycles.
Our willingness to invest amidst failing markets is the best way we know to build positions at great prices, but this strategy, too, can cause short-term under performance. Buying as prices are falling can look stupid until sellers are exhausted and buyers who held back cannot effectively deploy capital except at much higher prices. Our resolve in holding cash balances - sometimes very large ones - absent compelling opportunity is another potential performance drag.
But we know that in a world in which being anti-fragile is good, what doesn't kill you can make you stronger. Short-term under performance doesn't trouble us; indeed, because it is the price that must sometimes be paid for longer-term out performance, it doesn't even enter into our list of concerns. Patience and discipline can make you look foolishly out of touch until they make you look prudent and even prescient. Holding significant, low or even zero-yielding cash can seem ridiculous until you are one of the few with buying power amidst a sudden downdraft. Avoiding leverage may seem overly conservative until it becomes the only sane course. Concentrating your portfolio in the most compelling opportunities and avoiding over-diversification for its own sake may sometimes lead to short-term under performance, but eventually it pays off in out performance.”

I wish you all the very best in 2017!


Friday, June 24, 2016

The Post Crisis Comb Over

From Wikipedia:A comb over or combover is a hairstyle worn by bald or balding men
in which the hair is grown long and combed over the bald area to minimize the evidence of baldness.Sometimes the part is lowered so that more hair can be used to cover the balding area."

 Bad comb overs. We’ve all seen them, and there is a very good chance that someone in your immediate family sported one of these unfortunate hairstyles at some point in their life (for me, it was my Grandpa). While some comb overs have enjoyed “reasonable” success in creating the desired effect of creating confusion about the actual existence of male pattern baldness (think Donald Trump), most attempts fail miserably.

It would seem logical then that the relative success or failure of a bad comb over is therefore determined more by two main things:

1.       the proximity of a viewer to the comb over and
2.       the level of attention and interest paid to the person sporting the comb over

Obviously, the closer the proximity to the disingenuous hair style (and the higher the level of interest) the more the illusion of hair gives way to the bald, sad truth. It’s probably at this very point in the discussion that you start to wonder, “What a very odd thing to talk about. Where exactly are you going with this?” Stay with me – it will make sense in a second!

You see, it is my belief that the ‘recovery’ and the ‘fundamentals’ that have been driving the stock market higher since the end of the crisis in 2009 are in effect, very bad comb overs that can only be seen from a distance. As such, these comb overs are making it very difficult for regular people to see what’s really going on.

To add to the confusion, Wall Street, Central Banks, Financial Reporters on TV and the paper, have all been very active in pushing a narrative that supports the view of a strong recovery and healthy market. It seems like every week someone ‘of influence’ is out there bragging about what a full head of beautiful hair the US economy and stock market. They assure you that given their exclusive access (which is much closer than you or I can get), they can confirm that all is well and growth is present.

For years now, the Federal Reserve has referred to the decline in the unemployment rate as proof positive that the US economy is back on track after the crisis. In May of this year Janet Yellen was quoted as saying “we are close to an unemployment rate that most economists would associate with our full employment goal”.  
And if we look at the unemployment rate from across the room, it certainly does look impressive.

 But here’s the problem: when you take time to learn HOW the unemployment rate is determined, you will recognize that it too is a ratio, one that measures the number of unemployed people divided by the Labor force. So – as we do a little investigating, and look closely at the labor force participation rate – we see something odd.

What would cause the labor force participation rate to decline to such low levels? To understand that, we need to look more into what this data point measures. As the name suggests, the labor force participation rate is yet ANOTHER ratio that measures the “number of people who are either employed or are actively looking for work” versus the number of total people in the labor pool. One important aspect to note about this rate is that “people who are no longer actively searching for work would not be included in the participation rate”. So, going back and reviewing the rate, we can see that much of the decline in the unemployment rate discussed above has been a function of an unusually large number of people who have left the workforce.

Now when presented with this information some in the “comb over crowd” will suggest that the decline in the labor force participation rate is because of demographics, and therefore the drop is merely a function of baby boomers starting to retire.
 Here’s an example from Barrons (link:

So, as someone who is motivated to get to the truth of the matter, we take a bit of time to investigate the validity of the story.  To accomplish this we go to one of the best macroeconomic sites on the internet: The St. Louis Federal Reserve FRED

When you go here and search the database for “labor force participation rate” – you will find that FRED has already done the hard work for you, and has divided the labor pool into various age categories: 25 to 54, 55 to 64, 16 to 19, etc.

So let’s look at the labor force participation rate of the prime retirement age, 65:

 That’s odd, the labor force participation rate for people 65 years and older is INCREASING. It probably explains why we are reading stories like this more often (link:

 Okay, let’s put the 65 year old cohort aside for a moment. What about workers in the 55 and over category, maybe they are the ones leaving the labor pool.

Again, we see a huge increase. So if the overall labor force participation rate is declining, but it’s not coming down from the 55 to 65 age group (where one would expect it to decline given the “baby boomers are retiring” narrative), then where is the labor pool seeing leakage? Let’s take a look at the prime working age, which is the 25 to 55 category:

 Hello! There is the source of your labor pool shrinkage and it certainly fits the stories we have been reading since the crisis started. As such, this would seem to confirm that the “strong job market” narrative spun by Janet Yellen and the rest of the members of the Federal Reserve is not exactly accurate.

What we’ve learned here is that when you read reports discussing the ‘strong jobs market’ where the unemployment rate is used as ‘proof’, you can be fairly certain that you are looking at a pretty bad economic comb over.

 That was fun! Are there any other comb overs out there? Well if you’ve ever walked around the streets you know there is always more than one bad comb over out there. Let’s take a look at another possible comb over of the ‘economic recovery’ narrative: The US consumer.
 The US consumer has long been cited as a key component of economic growth.
 Consider these two recent stories -




(PS: did you notice in the quote above they mention an already identified comb over in the labor market?? You will find that comb overs tend to serve as positive feedback loops to other comb overs)

 So apparently the significant increase in auto sales we’ve seen since the crisis in 2009 suggests the consumer is back on track financially, and therefore we should expect the US economy to begin firing on all cylinders very soon.

Now, as you can see below, there is no denying that auto sales have been very robust (link:

 Not only are the car companies selling more, the transactions per vehicle are increasing significantly as well –

 So logically it should follow that the US consumer has indeed recovered from the crisis, and their financial health is back to pre-crisis levels. Maybe all of the bullish news is correct!

Then why do we keep reading stories like this?


 Or this – taken from Federal Reserve’s “2014 Report on the Economic Well-Being of US Households” – link:

 So 66% of Americans have “no savings” and 47% say they couldn’t cover an emergency bill of $400.00 without selling something or borrowing? What? How you can afford to buy a $33,000 vehicle but NOT have enough money to cover an unexpected $400 bill? This sounds very much like a comb over, so let’s investigate!

First – let’s look at how auto sales are happening. Given people have “no savings” and can’t cover an unexpected bill of $400, it makes sense that consumers are finding other ways to finance the purchasing of their vehicles.


Our instincts were correct: what's driving auto sales? A big jump in loans! And there is one loan in particular whose name you might remember from my letters from a few years ago -

Sub prime loans - remember them? Well they've made a comeback, only this time it’s in the auto market.

One thing I puzzled over for a while was how a consumer who has zero savings and can't absorb a $400 emergency bill is able to swing buying a $33,000 car. Surely the payment on such a vehicle via a typical 4 or 5 year car loan would be rather onerous would it not? A little digging finds the answer to my puzzle -

96 months (that’s EIGHT years!!!) on a "gently used" car?

But yes (sadly) despite the warnings, this is indeed happening

apparently people want a new car more than they worry about their finances - so loans and terms are rising.

Ironically given the low interest rate environment, the securitization of sub prime auto loans has been a very hot commodity of late. Given the demand for these kinds of loans, there is a very similar kind of ‘frenzy’ going on, as loan demand is high, and puts pressure on finance companies to reduce lending standards to borrowers with lower and lower credit scores…. (stop me if you’ve heard this one before).

So, the big driver of auto loans is not the “health’ of the consumer per se, it is the accessibility of credit. But if the consumer is borrowing more, surely they must be MAKING more, right? A simple look at the FRED data on 'real median household income" confirms what we had already assumed: income is not growing, it’s still well below it’s high. In reality the “strong consumer” is yet another example of a horrible economic comb over.

Okay we will play one more game of “spot the bad comb over” and then I will leave you alone to enjoy the sunshine! One of the most important components that investment managers use to determine the suitability of a particular stock, or a stock market is earnings. Obviously the more profitable a company, the more attractive the company would be to invest in. Conversely, most investors would not be as excited to invest in a company that was losing money year after year.
Here is a fantastic graph of the earnings of the S&P 500 group of companies going back to 1981 (the black line) versus the performance of the S&P 500 (red line). It’s clear that there is a very close correlation between the two inputs: as earnings increase, the market increases – and as earnings decline, so too does the market.

Given the stock market was sitting yesterday at over 2,100 points, within 35 points of the highest level in recorded history, a look at the relationship above might lead a person to assume the EARNINGS on the S&P 500 are rising and approaching “all time record highs” as well. Hmm, could this be an economic comb over?

Let’s investigate! A look at the Factset data

(link here:

shows that earnings fell from $1400 per share in June 2007 to a low of $875 by June 2009. They then bounced back significantly to approximately $1800 a share in late 2014.

But – one thing to note is that earning referenced here is “earnings PER share” – exciting, another ratio! So let’s dig into this a bit more.

One thing we've discussed before is how many companies are using their cash, or raising debt to buy back their shares. Factset has done an exceptional job of tracking this over the years - here is their latest chart to Q1 2016


as per the report - the magnitude of the buybacks of late are not insignificant levels -

in fact many research reports suggest that the amount of corporate share buybacks could top a whopping $2 trillion dollars since 2009!


and, knowing what we do about ratios, a company buying back shares in an aggressive fashion might be doing a bit of a 'comb over' when it comes to earnings per share growth.

Consider the share count on the S&P 500

Now as with the question we asked above relating to the financing of auto sales, I think it would be helpful if we investigated how these companies are raising funds to buy back their stock. Is the cash coming from profits, it is excess cash? How have they raised almost $2 trillion? The clip above already states that companies were "on pace to spend 95% of their earnings on repurchases and dividends" - but another report tracks debt issuance -

clearly this is beginning to resemble the Mother of all comb overs: Over $2 trillion dollars has been poured into the market by companies in an effort to improve the appearance of their "earnings per share", which in turn makes it 'appear' as though there is organic business growth when in fact there is none (which as we pointed out earlier is the exact definition of a comb over!). So here is what is troubling, over the last 5 or six quarters both revenues AND earnings have been declining.

As per factset:

5 or 6 quarters of declining revenues and earnings is a big deal. You will recall the graph at the top of this section that showed the close correlation between GAAP earnings and the performance of the S&P 500? Well here is a closer look at what's been happening since late 2014

Earnings declines of this nature are not typical, and should serve as a huge red flag to investors that there may be "danger ahead". Given the exercise we've just gone through in learning how to investigate and identify 'economic comb overs', the last thing we want to do is be caught by an unexpected gust of wind (you know, like an unexpected Brexit vote where the UK leaves the EU) that exposes the secret that the comb overs that the market is so desperately trying to conceal..

which of course is......

(there is NO GROWTH!)