Sunday, November 26, 2017

The Euphoric Rise and Inevitable Fall of Dr. Feelgood

“I got me a man named Doctor Feelgood
Yeah! Yeah!
That man takes care of all of my pains and my ills”
Aretha Franklin,”Dr. Feelgood” -  1967

Before Aretha Franklin sang about “Dr. Feelgood” there was a German doctor named Max Jacobson who ran a thriving medical practice in New York City. Dr. Jacobson’s office catered specifically to high profile celebrities such as Truman Capote, Eddie Fisher, Thelonious Monk, Anthony Quinn and Judy Garland. He also served as the physician of choice for U.S. President John F. Kennedy from 1960 to 1962. Jacobson’s patients nicknamed him “Dr. Feelgood” in response to the feelings of euphoria and energy they experienced after the doctor administered his ”specialized” vitamin injection therapy.
What most of the patients didn’t realize was that Jacobson’s magical cure actually contained between 30 and 50 milligrams of amphetamines, a mood elevating neural energizer that goes by the street name “speed.” The drugs were then combined with a jumble of other ingredients including multivitamins, steroids, enzymes, hormones, bone marrow, animal organ cells and solubilized placenta.
Obviously, given the true contents of the injections, the patient’s symptoms were never really “cured” but rather masked by the powerful psychotropic effects of the amphetamines. Thus, patient relief was artificial in nature and short term in duration as once the drugs wore off, the unaddressed ailments would inevitably return.
As one would expect, reality finally came crashing down on Max Jacobson and his fake remedies. In December 1972, Jacobson’s practice was exposed in a New York Times 1972 piece entitled “Amphetamines Used by a Physician to Lift Moods of Famous Patients.” As a result, Jacobson was charged with 48 counts of unprofessional conduct, and in 1975 the State Department of Education revoked his license to practice medicine. Jacobson died a few years later in 1979.
During his heyday, Jacobson bragged that his patients “went out the door singing,” which may have been exactly what inspired Aretha Franklin to sing about him in 1967.
Financial Parallels:
Ever since the start of the “Great Financial Crisis” in 2008, global central banks, including the Federal Reserve, have aggressively resurrected the role and unconventional remedies of “Dr. Feelgood.” Using a dangerous mix of liquidity, monetary accommodation, asset purchases and risk suppression, central banks have managed to create a sense of confidence and euphoria within the stock market that has served to mask the ongoing ailments within the U.S. economy. Put plainly, the economic recovery we “feel” today has been vastly overstated thanks to the regular financial amphetamine injections that have taken place since 2009.
In my 2014 macroeconomic thesis, “The View from 30,000 Feet, The US Economy Was Sick before the Crisis,” I showed how middle and lower income earners tend to hold fewer, if any, financial assets. As such, they have not been able to participate or benefit from the rising stock market as much as the extremely wealthy.

The growing gap between the wealthy and lower income earners is called “income inequality” and it is just one example of the many negative side effects that inevitably arise when a stock market is subjected to nine continuous years of aggressive drug therapy. 
While central banks believe wholeheartedly in their amphetamine therapies, and regard the record level of the stock market as definitive proof that their injections are working, a more granular and thorough inspection of the global economy reveals continued sickness.
For example, Gross Domestic Product (GDP) in the United States continues to trend WELL below its’ historical norm. Absent central bank” injections,” it would be highly unlikely that these anemic levels of economic growth would result in the same kinds of stock market gains we’ve enjoyed since 2009.

If there were no dangerous side effects to using amphetamines over the longer term, there would be no need for the government to strictly regulate its use. Doctors would be free to use injections regularly to suppress their patient’s underlying symptoms and all would be well. Unfortunately, this is not the case. Instead, physicians must focus on the health of the patient over the LONGER TERM, which suggests these extreme forms of drug therapies must be used sparingly, and over very short periods of time.
I believe we will eventually realize the central bank’s heavy handed and extended use of financial amphetamines did not result in a ”miracle cure” for the global economy at all. It instead created a false sense of wellness and euphoria within the stock markets that served to mask and suppress the ongoing problems that continue to exist within our economy. 
As a portfolio manager, it is my job to obsess about stock market fundamentals and capital preservation for my clients over the longer term. The biggest concern I have today is that the vast majority of the stock market’s rise since 2009 has been a direct result of a drug induced state of euphoria that has been created and maintained by central bank monetary policy. I believe that as central banks begin to wean the stock market off their aggressive nine year drug program, these feelings of euphoria will fade and once again expose the true economic pain that’s been suppressed for all of these years.
It is for these reasons that I continue to invest with a very conservative and defensive bias. I am not allowing my strategies and investment advice to be influenced by the central bank induced hallucinations that I believe exist within the stock market and underlying global economy.
With the benefit of hindsight, the and sub-prime housing bubbles are now considered two periods where underlying fundamentals were usurped by a similar sense of strong stock market euphoria. In both “bubbles,” euphoria ultimately gave way to reality and the stock markets corrected sharply. When one looks at the stock market’s relentless rise since 2009, it’s very hard not to wonder if we aren’t perhaps falling for Dr. Feelgood’s short term ”cure” once again.

Friday, April 7, 2017

The Federal Reserve's Recovery Playbook - a Theory

After spending more than 8 years arguing and providing data to back up my view that there has been no discernible economic recovery in the US (of the traditional "escape velocity" variety), I've decided to stop my focus on this subject and move on to other issues. Thankfully I'm no longer making these charges on my own. As such I'm going to let the far more eloquent and technical writers like Jeff Snider from Alhambra Partners continue the fight to hammer that message home.
Despite the clinging narrative, the "economic recovery" is not one of the main drivers behind the stock market's meteoric rise to record highs, although the 'green shoots' story did start the rally ball rolling in March 2009.
Similarly, earnings, expansions in PE multiples, the recovery in housing, rising wages and the falling unemployment rates have also all been offered up as reasons to explain the stock market's rise at one time or another over the last few years. While all of these measures have seen increases or improvements, none have been consistently strong enough to be thought of as the main underlying support system in the market since the end of the Great Financial Crisis.
One theory that I will expand upon in this post relates to my view that the Federal Reserve is actively using the US stock market as a policy tool to impact and influence consumer sentiment. By increasing consumer sentiment (through a rising stock market), the Fed believes there will be an increase in consumption expenditures that would be more significant than leaving sentiment to run on its own merits.
First - we need to take a close look at the historical and recent correlations that exist between Consumer sentiment and the S&P 500. In this example I've used both the University of Michigan Consumer Survey as well as the Conference Board's Consumer Sentiment Index.

As you can see from the charts below, while there is a marginal correlation between consumer sentiment and the markets over the entire history of these measures, the correlation in BOTH surveys from March 2009 to today (2017) is almost perfect.

The Conference Board's Consumer index shows a similar pattern:

Given the work above - there should be absolutely no debate that from March 2009 to today, consumer sentiment is greatly influenced by the rises and falls of the S&P 500.
Now that we've established that this close relationship exists, let's review research written by the Federal Reserve on the subject of consumer sentiment to gain insight into how they feel sentiment relates to future consumption:
Research Review -
1993 - "What Role Does Consumer Sentiment Play in the U.S. Economy?" 
By Federal Reserve Bank of Boston Economist Jeffrey C. Fuhrer

Key quotes:

"The economy is mired in recession. Consumer spending is weak, investment in plant and equipment is lethargic, and firms are hesitant to hire unemployed workers, given bleak forecasts of demand for final products. Monetary policy has lowered short-term interest rates and long rates have followed suit, but consumers and businesses resist borrowing. The conditions seem ripe for a recovery, but still the economy has not taken off as expected. What is the missing ingredient? Consumer confidence.

Once the mood of consumers shifts toward the optimistic, shoppers will buy, firms will hire and the engine of growth will rev up again".
"In its most recent publication (1992), the Survey research Center (SRC) at the University of Michigan is careful to point out that the important of the Michigan Surveys derives from the

"important influence of consumer spending and saving decisions in determining whether the national economy slips into recession or is propelled toward recovery and growth". They argue that consumer's optimism or pessimism primarily affects the timing of decisions to purchase homes, vehicles and other durables".

June 1998
"Does Consumer Confidence Forecast Household Expenditure? A Sentiment Index Horse Race" 
by Jason Bram & Sydney Ludvigson

Key quotes:
"Household sentiment has been cited as one of the leading causes of the 1990-91 recession"

"In response to the widespread belief that consumer's opinions and expectations influence the direction of the economy, a growing number of studies have set out to analyze the relationship between consumer attitudes and economic variables"
"Our empirical analysis suggests that consumer sentiment can help predict future movements in consumer spending"
.."our results suggest that consumer confidence can help predict consumption, and that consumer attitudes may also act as a catalyst for economic fluctuations".

September 2006
"Stock Prices, News and Economic Fluctuations"
by Paul Beaudry and Franck Portier

Key quotes:

"There is huge literature suggesting that stock price movements reflect the market's expectation of future developments in the economy"

"There is also a huge literature, and a long tradition in Macroeconomics (from Arthur C. Pigou, 1927, John Maynard Keynes, 1936, to the survey of Jess Benhabib and Roger E. A. Farmer, 1999) suggesting that changes in expectation may be an important element driving economic fluctuations."

"In particular, our evidence suggests that business cycles may be driven to a large extent by TFP (total factor productivity) growth that is heavily anticipated by economic agents, thereby leading to what might be called expectation driven booms.

May 2009
"Trends in Consumer Sentiment and Spending"
by Maude Toussaint-Comeau and Daniel DiFranco

Key quotes:

"Consumer sentiment is one of the many macroeconomic indicators tracked by policymakers. It is seen as an important barometer of economic activities - an indicator of the way people plan to spend their income."

"Research has shown that consumer expectations align more closely with spending during periods of weakness in the economy, and the forecasting contributions (or predictive power) of consumer sentiment appear to be wrong when the economy is weaker. During times of greater economic uncertainty, as consumers perceive greater risk, they tend to accumulate precautionary savings to insure against a sudden loss in income. For example, even if a consumer's financial position remains unchanged, the precautionary motive for saving will affect his discretionary consumption, i.e. spending on nonessential goods and services, in the present."

"We find that the condition of the macroeconomy has a strong influence on consumption spending. Consistent with the implications of precautionary motives, the impact of consumer sentiment on spending decisions is stronger among those with greater constraints in income and liquidity."

"The stock market index may affect consumer confidence in two ways: An increase in stock market prices may increase wealth and directly boost confidence, or rising stock markets may act as an indicator of higher expect labor income, which would also increase confidence and hence consumption spending."

November 2010
"Confidence and the Business Cycle"
by Sylvain Leduc

Key Quotes:

"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 risk that pessimism can become entrenched and self-reinforcing, further dampening the nascent recovery".

"The boom-and-bust cycles in the United States and other parts of the world over the past two decades and the stock market collapses in 2000 and 2008 have prompted macroeconomists to take another look at the extent to which confidence, optimism, and changes in expectations may drive and amplify business cycle fluctuations. Recent empirical work indicates that these sentiments contribute significantly to economic ups and downs. Typically that means monetary policy remains accommodative when weakness in confidence becomes entrenched".


So, based on research produced by the Federal Reserve over the last 25 years, we know that consumer sentiment is thought to have a very large and measurable impact (positively and negatively) on the underlying economy. One report in particular attempts to calculate exactly how much consumer confidence can add or take away from economic activity.

April 1995
"Consumer Confidence and Economic Fluctuations"
by John G. Matsusaka & Argia M. Sbordone

Key Quotes:
"The pattern is striking; all recessions were preceded by a fall in confidence, and all major falls in consumer sentiment were followed by a recession (except in 1965 which, while not in recession, was the so-called "growth recession")."

"In a multiple-equlibria model, output responds to fundamentals, but in addition there can be fluctuations as the economy shifts between equilibria. Perhaps the most intriguing feature of these models is that output can fluctuate simple because everyone expects it to. Put differently, expectations can be self-fulfilling in that if people expect bad times they get them."

"... the evidence that movements in consumer confidence precede movements in output can be interpreted in two ways. Either consumer sentiment causes GNP or it simply anticipates GNP." [emphasis theirs]

".. changes in consumer sentiment have a statistically significant effect on output fluctuations. In other words, we find evidence of Granger-causality running from consumer sentiment to GNP".

[Granger-Causality definition from Wikipedia: The Granger causality test is a statistical hypothesis test for determining whether one time series is useful in forecasting another, first proposed in 1969.[1] Ordinarily, regressions reflect "mere" correlations, but Clive Granger argued that causality in economics could be tested for by measuring the ability to predict the future values of a time series using prior values of another time series. Since the question of "true causality" is deeply philosophical, and because of the post hoc ergo propter hoc fallacy of assuming that one thing preceding another can be used as a proof of causation, econometricians assert that the Granger test finds only "predictive causality".[2]]

"Our second finding is that while sentiment is not the most important factor in GNP fluctuations, it plays a quantitatively significant role: between 13 percent and 26 percent of GNP innovation variance can be attributed to innovations in consumer sentiment."

[referencing Oh and Waldman research (1990, 1993)] "Their key insight is that if there is an announcement that the economy is about to boom and everyone believes it then future output should be high, even if the announcement is based on false information".

"This paper explores the possibility that the economy's total output occasionally varies not in response to a shift in fundamentals but in response to a shift in consumer sentiment. Specifically the paper asks whether and to what extent exogenous declines in consumer confidence cause recessions, and conversely whether and to what extent bullish consumers drive economic growth."

"There are two inspirations for this research. The first is the fact that something called "consumer confidence" plays an important role in popular explanations of the business cycle and in the public statement of business and political leaders. The second purpose of the paper is to provide some evidence on the rich collection of macroeconomic models with strategic complementaries that have been developed in recent years. All these multiple-equilibria models have in common that expectations are self-fulfilling - because agents must expect to be in a particular equilibrium before the economy can move to it, either expectations in a sense cause the movement to the equilibrium.

"An implication of these models, then, is that after controlling for movements in economic fundamentals, changes in consumer sentiment lead to changes in GNP".

Based on the examples and statements above, it is clear that the Federal Reserve views consumer confidence as a very important and influential component that impacts the broader economy (either positively or negatively). Now to be thorough, let's look at two simple examples where consumer confidence has had a measurable impact on an economy.

Example one -

The U.S. recession of 1990-91 -
"A Better Economic Mood; Many Say the Gulf Crisis Shook Confidence and Foresee a Recovery as Hope Revives" by Sylvia Nasar, The New York Times (April 3, 1991)

Key Quotes:

"The current recession may be the first in memory that can be attributed to a case of nerves. And now that confidence has come roaring back, signs are that an economic recovery is not far behind."

"Pinning hopes of an economic revival on the recovery of nerve makes sense for the great many who believe that when the economy stumbled, psychology was the main culprit".

"Confidence Indexes Show Brighter Consumer Outlook" by Sylvia Nasar, The New York Times (March 21st, 1992)

Key Quotes:
"To economists, improvement in the confidence indexes is critical evidence that the recent jump in retail sales was not a fluke and that the economic recovery is not necessarily doomed to fizzle."

"Economists had worried that consumer's pessimism could turn into a self-fulfilling prophecy. A DRI/McGraw Hill calculation showed that if consumers remained deeply worried, retail sales would be $20 billion lower, and 100,000 fewer cars and 40,000 fewer houses would be sold this year".

Example two:

The economic impact of the D.C. Sniper attacks of 2002

"DC economy suffers in wake of Sniper attacks" By Jeremy Raelin, The Heights, Volume LXXXIII, Number 25, 5 November 2002

Key quotes:

"While the sniper was at large, the Washington Post reported that retailers in Montgomery County MD, were suffering a 50 percent drop in sales. People were afraid to leave their homes, fearing assassination while doing even the most trivial tasks such as pumping gas, playing at recess and walking to a car".

"Retailers have lost money in one of the biggest shopping months of the year. Anirban Basu, chief economist at Towson University's Regional Economic Studies Institute, which tracks the Washington area's economy, said in an interview with the Washington Post. "It's never a good time for a sniper, but this is really not a good time. If it persists, if people do not come out of their houses to shop, the effects are going to be more permanent".

While there are many more examples where consumer confidence has impacted an economy, for the sake of keeping this post at a reasonable length, I will move on.

Thus far we have established two incontrovertible facts:

1. After a tremendous amount of research, the Federal Reserve is convinced that high or rising consumer confidence will help boost & support the economy and keep it out of recession.
2. The correlation between the S&P 500 and consumer confidence has increased substantially since the bottom of the Great Financial Crisis (March 2009).

Correlations between the stock market and consumer sentiment are now running at 88% to 97% (depending on which survey is measured). Given the Federal Reserve has not admitted to explicitly supporting the stock market in an effort to help the economy recover, we must therefore use our research and the information available to draw inferences that suggest this is exactly their strategy.

The first hint came during an unprecedented interview with then Fed chairman Ben Bernanke on 60 minutes on March 15th, 2009 - right at the bottom of the crisis.

The first few minutes of this interview have Ben Bernanke suggesting that the crisis will only stop when the financial system is stabilized. Then, at the 12:05 mark, Bernanke makes a pledge that the Fed will backstop ANY problems that arise in the banking system.

Scott Pelley: "Are you committing in this interview that you are not going to let any of these banks fail? That no matter what their balance sheets actually look like, they are not going to fail?"

Ben Bernanke: They are not going to fail. But, what we can do should it be necessary, is try to wind it down in a safe way".

Part Two also contains provides us with some excellent insight into Fed thinking:

9:50 in to the second half of the interview -

Scott Pelley: "There's an argument made today that that's not what the problem is. The problem isn't that there's too little money in the system, the problem is that there's too much fear in the system. That with these companies being propped up by the government, no one on Wall Street can tell who's solvent and who's not, and therefore business does not move."

Ben Bernanke: "Well I absolutely agree that confidence is key. People don't know what's happening and they're afraid and they're not sure whether or not the system is going to recover. Umm so how do you get confidence, that's the question. And I think the way that you get confidence is to show progress."

Bernanke then goes on to explain all of the various areas that he's seeing improvement - many of which are within the financial arena. As we know, the market started it's current rally a week prior (many, myself included think the bigger catalyst was the changing of FASB 157, but that is certainly open to debate). A few years later, Ben Bernanke made is first formal reference that associated the rise of the stock market to the US economy.

The date was January 13th, 2011 and Ben Bernanke was part of a panel hosted by the FDIC on the subject of "Overcoming Obstacles to Small Business Lending", the event was moderated by CNBC's Steve Liesman.

During the event, the following discussion took place:

Mr. Liesman: Chairman Bernanke, I have to ask you this question. Since you guys have launched QE2, rates have gone up. The stock market's gone up too. We did a poll of CNBC market participants and they said that QE2's responsible for a higher stock market, but also higher commodity prices. That does not seem to be something that in general is helping small business".

Chairman Bernanke: Well, how much time have you got to answer this question?

Mr. Liesman: As much time as you have sir.

Chairman Bernanke: First of all I do think that our policies have contributed to a stronger stock market, just as they did in March of '09 when we did the last iteration of this. The S&P 500 is up about 20 percent plus. The Russell 2000 which is about small cap stocks is up 30 percent. I think a stronger economy actually helps small business more than it helps even larger businesses. Yes, it is contributing to the stock market. Interest rates are higher, but I think that's mostly because the news is better. It's responded to a strong economy and better expectations.

The most interesting commentary about the Fed's attempt to push the stock market higher came from former Fed member Richard Fisher who in March 2016 said,

"I like to say that we injected cocaine and heroin into the system and now we are maintaining it on Ritalin"

So to summarize, given the volumes of research published by the Fed over the last 25 plus years, we can safely assume they were very concerned that, if left unchecked, consumer confidence could have become increasingly negative during the sub-prime crisis, making any form of future economic recovery impossible. To combat this potential danger, Fed Chair Ben Bernanke took the nprecedented step to address Americans directly via an interview with 60 minutes. In that interview he pledged that no other US bank would fail under his watch. He then suggested that the market would recover when progress was made and the financial system was stabilized.

A few years later, Bernanke cited the level of the S&P 500 and Russell 2000 as "proof" that the economy was positively responding to a stronger economy thanks to Fed policy. Further, whenever the US stock market experienced a significant correction (for example during the European debt crisis, the recession scare of 2011, the Brexit vote, etc), Fed members would make dovish statements suggesting that monetary policy would continue to be extremely accommodative (and therefore support stocks). These messages of assurance helped stocks rebound in kind, which in turn helped preserve positive consumer sentiment.

I personally do not think that the Fed is secretly "buying shares", although I am aware of theories to this effect. Instead I believe the Fed is simply sharing it's playbook with Wall Street and allowing them to act on this information.

Interestingly, it has come to light recently that in 2012 then Richmond Fed President Jeffrey Lacker leaked secret, market sensitive information to an analyst at Medley Global Advisors. But Lacker's leak is not the only example of a seemingly cozy relationship between Wall Street and policy markers. Some will recall then Treasury Secretary Hank Paulson setting up a meeting with some of Goldman Sachs' board members in Russia just as the crisis was unfolding in 2008, or Timothy Geithner's alleged leaking of policy to Ken Lewis, then CEO of Bank of America. 

So, by allowing Wall Street in on the strategy to boost the stock market, the Fed expects consumers to be relatively more optimistic than they would be on their own. As discussed in the research above, 

"if there is an announcement that the economy is about to boom and everyone believes it then future output should be high, even if the announcement is based on false information".

We can see that some of the foremost thinkers in the economics field are starting to be aware of the Fed's reliance on confidence and 'narratives' to generate optimism. Below are two very recent examples from some of the US's most influential economists: Mohamed El-Erian and Robert Shiller.

America's Confidence Economy - by Mohamed El-Erian

Key quote:

"The surge in business and consumer sentiment reflects an assumption that is deeply rooted in the American psyche: that deregulation and tax cuts always unleash transformative pro-growth entrepreneurship. (To some outside the US, it is an assumption that sometimes looks a lot like blind faith.)

Of course, sentiment can go in both directions. Just as a “pro-business” stance like Trump’s can boost
confidence, perhaps even excessively, the perception that a leader is “anti-business” can cause confidence to fall. Because sentiment can influence actual behavior, these shifts can have far-reaching impacts."

"Narrative Economics" - by Dr. Robert Shiller

Key quotes:

"This address considers the epidemiology of narratives relevant to economic fluctuations. the human brain has always been highly tuned towards narratives, whether factual or not, to justify ongoing actions, even such basic actions as spending and investing. Stories motivate and connect activities to deeply felt values and needs. Narratives 'go viral' and spread far, even worldwide, with economic impact. The 1920-21 depression, the Great Depression of the 1930's, the so called "Great Recession of 2007 and the contentious political-economic situation of today are considered as the results of popular narratives of their respective times".

"When in doubt as to how to behave in an ambiguous situation, people may think back to narratives and adopt a role as if acting in a play they've seen before. the narratives have the ability to produce social norms that partially govern out activities, including our economic actions.'


Considering all of the research and examples discussed above, it seems entirely reasonable to assume that a portion of the Federal Reserve's strategy to help stimulate the economy is to keep consumer confidence as high as possible. This would insure that pessimism would never have a chance to permeate the consumer's psyche, while also opening the door to a possible 13 to 26 percent bump in GNP than would not be forthcoming otherwise.

We can see these expectations for a jump in consumer expenditures by the Fed (given a rising stock market) contained in a few comments by Fed officials recently. First we have Janet Yellen responding to a question from Binyamin Appelbaum from the New York Times on the apparent lack of concern by the Fed to excessively elevated equity prices. 

(apologies but C-SPAN doesn't allow me to embed into Blogspot - so the picture will take you to the clip) - here is the link just in case:

Key Quote:

Chair Yellen: "the higher level of stock prices is one factor that looks like it’s likely to somewhat boost consumption spending"

Secondly we have this story in Bloomberg,
"How the Yellen Fed Got Religion Over the Stock Market and Policy" by Matthew Boesler

Key quotes: 

" In February 1998, Dudley and his team at Goldman took a cue from then-Fed Chairman Alan Greenspan, who had just testified before Congress that although inflation-adjusted interest rates had risen, “in virtually all other respects financial markets remained quite accommodative and, indeed, judging by the rise in equity prices, were providing additional impetus to domestic spending.” Two years later, the technology bubble burst."

 "Ultimately, the Fed’s response to easier financial conditions should hinge on whether or not that boost in business sentiment translates to an actual acceleration in consumption, said Freedman.

“Stock markets go up. That in itself is not relevant,” he said. “What is relevant is its effect on people’s willingness to spend.”


If we consider all of the material covered above, and put two and two together, I think it is very easy to come to the conclusion that the Fed has been attempting to use the stock market as a policy tool to help the US economy recover. By informing Wall Street of its intentions and going out of their way to keep the market stable and elevated, consumer sentiment remains high, which in turn could add several valuable percentage points to economic growth. This potential 13 to 26 percent swing in GNP could, for example, have been the difference between the 'near miss' recession in 2011, and another full blown recession.

While this is the third longest expansion in U.S. history, it is also the weakest in the post world war II era. For reasons I've laid out in my larger macro thesis (The View from 30,000 feet: the US economy was sick before the Great Financial Crisis), the consumer has been mortally wounded and as such should not be expected to bounce back in the same fashion that they have from previous recessions. It appears as though the Fed continues to be bewildered by the lack of increased consumer expenditures in the face of a rising stock market and high confidence.

It is my sense that the Fed is now backing away from trying to push the market higher as they realize the gap between stocks and the underlying economy is at a very critical and dangerous level. By raising interest rates at this point, the Fed is attempting to slowly deflate the asset bubble they've created, while simultaneously trying to preserve consumer confidence and the forward progress they've made in the economy. Given the Fed's track record at deflating bubbles, I am not optimistic that they will be successful in their attempts. Time will tell.

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!