Now It Gets Interesting

Now It Gets Interesting

2nd Quarter 2014 Review

The stock market ended the first half of 2014 on an uptick but has backed up in July.  In the first half the Dow Jones Industrial Average was up 2.68%, the S&P 500 was up 7.14% and the NASDAQ Composite was up 6.18%.  The interest rate on the 10-year US Treasury was around 2.5%.   Things were looking good in the first half.  Through August 1, 2014 the markets corrected.  The Dow Jones Industrial Average was at -0.5% year-to-date, the S&P 500 was at 4.2% and the NASDAQ Composite was at 4.2%.  The reasons the markets have corrected are that the Federal Reserve delivered a modestly more upbeat assessment of inflation, jobs and the economy after its two-day meeting in late July.  Its assessment, combined with a stronger-than-expected report on gross domestic product and news of 209,000 jobs gained in July, cemented the belief that the central bank will conclude its Treasury purchase in October and start raising rates in 2015 if the economy continues to improve.  If this thinking continues we could see a 10%-12% correction in the stock market.  Corrections of this sort are common in market cycles and are not a reason to do anything as far as asset allocation changes.  As you know Monroe Vos does not “market time” in normal market conditions.  We have made asset allocation changes in extreme circumstances like the 2001-2002 Tech Bubble and the 2008 Financial Crisis to the benefit of our clients.

As our good friend Robert Davis, CFA, the former head of Davis Hamilton Jackson & Associates, author of the “Caney Creek Report”, and an experienced market veteran, said in his newsletter on August 2, 2014:

Since March of 2009 when the Standard & Poor’s 500 bottomed below 700, it has essentially been a one way market, straight up.  Any attempts to take profits and wait for a pullback has cost you money.  And, the riskier the investment sector, the better was the return.  So called Junk bonds have outperformed all other fixed income.  Small capitalization stocks have outperformed large company shares, etc.  It has been one of the longest straight up bull runs on record.  As we said last month, it is going to get harder.

That is not because of Ukraine, Gaza, Ebola, or whatever.  It is because the economy of the US is reaching the point in the cycle that wage gains are going to start to catch up with profits.  Productivity will decline.  Profit margins will contract.  Inflation will accelerate.  And, most importantly, short term interest rates will rise.

Recent comments from the Federal Reserve make it clear that increasing short term rates from essentially zero, where they have been for the last five years, is only a matter of time.  The Federal Funds target rate today is 0-.25%.  Futures contracts project overnight money rates to be .75% by the end of next year, and 1.75% by the end of 2016.  These are not high levels in absolute terms or relative to historic norms.  But, the markets have been pricing as if zero interest rates would be the norm forever. 

That is the main reason that sentiment in the stock market remains at such a bullish extreme.  The difference between the bulls and the bears in the Investor Intelligence survey of professional letter writers has been 40-50% more bulls for close to a year.  Everyone has learned that it doesn’t pay to lose your position.  Everyone argues that stocks are the only alternative to zero rates, etc.  Mr. Market, on the other hand, always strives to fool the most people he can.  This time is no different.  The selloff this week that brought the Dow Jones Industrials to a loss for the year, is the beginning of the market adjustment to the reality of a monetary policy that might not be restrictive compared to history, but certainly is when compared to recent times and market expectations.

So, we must learn once again that markets don’t go straight up forever.  We are back to a more “normal” situation having weathered the financial crisis.  Some caution is in order in the short run for stocks and other risky assets.  Junk bonds, so called high yield bonds, had a worse week than stock this week as we expected.

I don’t mean to imply that the bull market for US stocks is over.  With the Standard & Poor’s 500 at 1925 today, stocks are “fairly” valued at 16X earnings forecasts for 2015.  They are not overvalued.  A pullback toward the 200 day moving average for the Index at 1860, which we expect, would leave enough room in valuation for a 10-15% return by midyear next year.  Bull markets end with an overvalued market and a flattening yield curve (short term rates about the same as long rates).  We are a long way from both.  A little market timing and risk management are in order, but US common stocks should remain the core of investor’s portfolios. We still have a lot of catching up to do from the poor returns of the first part of the new century.

Hoisington Investment Management Company Quarterly Review and Outlook Second Quarter 2014

Our other good friends at Hoisington think the economy will continue to be slow and interest rates will fall:

Treasury Bonds Undervalued

Thirty-year treasury bonds appear to be undervalued based on the tepid growth rate of the U.S. economy. The past four quarters have recorded a nominal “top-line” GDP expansion of only 2.9%, while the 30-year Treasury bond yield remains close to 3.4%. Knut Wicksell (1851-1926) noted that the natural rate of interest, a level that does not tend to slow or accelerate economic activity, should approximate the growth rate of nominal GDP. Interest rates higher than the top-line growth rate of the economy, which is the case today, would mean that resources from the income stream of the economy would be required to pay for the higher rate of interest, thus slowing the economy. Wicksell preferred to use, not a risk free rate of interest such as thirty-year treasury bonds, but a business rate of interest such as BAA corporates.

Currently the higher interest rates are retarding economic growth, suggesting the next move in interest rates is lower.

To put the 2.9% change in nominal GDP over the past four quarters in perspective, it is below the entry point of any post-war recession. Even adjusting for inflation the average four-quarter growth rate in real GDP for this recovery is 1.8%, well below the 4.2% average in all of the previous post-war expansions.

An Alternative View of Debt

The perplexing fact is that the growth rate of the economy continues to erode despite six years of cumulative deficits totaling $6.27 trillion and the Federal Reserve’s quantitative easing policy which added net $3.63 trillion of treasury and agency securities to their portfolio. Many would assume that such stimulus would be associated with a booming economic environment, not a slowing one.

Readers of our letters are familiar with our long-standing assessment that the cause of slower growth is the overly indebted economy with too much non-productive debt. Rather than repairing its balance sheet by reducing debt, the U.S. economy is starting to increase its leverage. Total debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.

It is possible to cast an increase in debt in positive terms since it suggests that banks and other financial intermediaries are now confident and are lowering credit standards for automobiles, home equity, credit cards and other types of loans. Indeed, the economy gets a temporary boost when participants become more indebted. This conclusion was the essence of the pioneering work by Eugen von Böhm-Bawerk (1851-1914) and Irving Fisher which stated that debt is an increase in current spending (economic expansion) followed by a decline in future spending (economic contraction).

The Personal Saving Rate (PSR) and the Private Debt Linkage

The PSR and the private debt to GDP ratio should be negatively correlated over time. When the PSR rises, consumer income exceeds outlays and taxes. This means that the consumer has the funds to either acquire assets or pay down debt, thus closely linking the balance sheet and income statement.

Historical Record

The most recently available PSR is at low levels relative to the past 114 years and well below the long-term historical average of 8.5%. The PSR averaged 9.4% during the first year of all 22 recessions from 1900 to the present. However this latest reading of 4.8% is about the same as in the first year of the Great Depression and slightly below the 5% reading in the first year of the Great Recession.

In Dr. Martha Olney’s (University of California, Berkeley and author of Buy Now, Pay Later) terminology, when the PSR falls households are buying now but will need to pay later. Contrarily, if the PSR rises households are improving their future purchasing power. A review of the historical record leads to two additional empirical conclusions. First, the trend in the PSR matters. A decline in the PSR when it has been falling for a prolonged period of time is more significant than a decline after it has risen. Second, the significance of any quarterly or annual PSR should be judged in terms of its long-term average.

For example, multi-year declines occurred as the economy approached both the Great Recession of 2008 and the Great Depression of 1929. In 1925 the PSR was 9.2%, but by 1929 it had declined by almost half to 4.7%. The PSR offered an equal, and possibly even better, signal as to the excesses of the 1920s than did the private debt to GDP ratio. Both the level of PSR and the trend of its direction are significant meaningful inputs.

John Maynard Keynes (1883-1946) correctly argued that the severity of the Great Depression was due to under-consumption or over-saving. What Keynes failed to note was that the under-consumption of the 1930s was due to over-spending in the second half of the 1920s. In other words, once circumstances have allowed the under-saving event to occur, the net result will be a long period of economic under-performance.

Keynes, along with his most famous American supporter, Alvin Hansen (1887-1975), argued that the U.S. economy would face something he termed “an under-employment equilibrium.” They believed the U.S. economy would return to the Great Depression after World War II ended unless the federal government ran large budget deficits to offset weakness in consumer spending. The PSR averaged 23% from 1942 through 1946, and the excessive indebtedness of the 1920s was reversed. Consumers had accumulated savings and were in a position to fuel the post WWII boom. The economy enjoyed great prosperity even though the budget deficit was virtually eliminated. The concerns about the under-employment equilibrium were entirely wrong. In Keynes’ defense, the PSR statistics cited above were not known at the time but have been painstakingly created by archival scholars since then.

In previous letters we have shown that the largest economies in the world have a higher total debt to GDP today than at the time of the Great Recession in 2008. PSRs also indicate that foreign households are living further above their means than six years ago.


We believe that we may see a short term 10%-12% correction in the stock market and a continuing slowdown in the economy due to excessive debt to GDP and a lower PSR resulting in lower interest rates.  After the market corrects we may see a 10%-15% increase in stock prices by the middle of next year.

Please visit our website at

Jamison Monroe
Chairman & CEO

Released: August 05th, 2014 09:30 AM

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