Taking Stock: Go with the Flow!

I recently received an investment newsletter from a friend. In it, the perma-bear writer, (think of a poor man's Jim Rogers, except no bowtie), predicts the imminent demise of the market due to the elevated level of debt to GDP. The chart looked frightening and dire consequences are obvious just by looking - it's has no fewer than four crashes and a depression depicted! He has even named the current "crisis" with a cutesy title - "A World of Pure Imagination" from Willy Wonka (RIP Gene Wilder).

The knee-jerk, yet unsubstantiated advice from this fear monger, was to buy gold and lots of it. The gold bug crowd is getting older by the day and there are still no signs of the financial doomsday they seem to crave. The one news item I found on this guy was a Bloomberg article referencing his firm's involvement in a murky dividend rental scheme. I was not impressed with his "street cred".

Nevertheless, this piece went to great lengths, (at least I take less than 53 pages to spout off!), to juxtapose debt to various other measures, including U.S. GDP. I have always been a stickler for properly labeled axes and terms, (these were not), so I had to infer from the presentation which aggregates were being depicted. But two very obvious mistakes were repeated throughout.

First, the data often compared apples to oranges. "Total Credit Market Debt" was compared to U.S. GDP. We know the effects of globalisation is often lost on many, but I thought the author would be more informed on these matters than to make such a simple error. The U.S. credit markets are used by a various domestic and global entities, including giant multinational corporations, because of their sheer depth. They may raise debt in the U.S. capital markets but many issuers receive revenues and profits from foreign operations. As well, many issuers are completely non-domestic. It's hardly fair to place all the burden to service all this credit on US GDP alone!

But that's not the biggest mistake of this type of analysis.

In economic analysis, variables are divided generally into two types: 'stock' and 'flow'.

Stock variables, like total credit, are a finite one time measurements. Flow variables, like revenue, income and GDP, will fluctuate with time. They are continuous not discrete. For a given credit aggregate, the relevant flow variable would actually be debt service costs. Comparing the two flow variables, the more commonly used debt service ratio, reveals the true level of risk inherent in this economic relationship.

Lets look at current US Household Debt to see what happens when you adjust for the proper flow vs flow comparison.

First using stock vs flow:

Scary debt levels?

Now the relevant flow vs flow of the same data:

Whew, not so scary. A forty year low.

So we can see 'fun with figures' is still alive and well in newsletter land. Figures lie and liars figure, I guess. We think can rest a bit easier now that we see how much room the US consumer has to absorb interest cost increases relative to prior cycles.

This not to say rising rates won't choke off a recovery in the future. In fact, the increase in debt servicing costs inherent in current low interest rate environment is quite elastic. This is one reason the Fed has been more dovish than in prior cycles. It is a real problem for the Fed as it attempts interest rate normalisation and they know it.

But I think Gold has to wait a bit longer to be relevant.

Valuation Watch

I suggest you all read Jeremy Grantham's latest GMO Quarterly letter (search Yahoo Finance) in which he helps shed light on the current situation of higher than normal valuations from a behavioural perspective. He argues that current low inflation, the lack of dramatic swings in GDP, combined with accommodative central banks have caused a "double counting" effect on stock valuation. High and sustained profit margins are promoting high PEs - effectively double counting the good times.

The phenomenon of expanding valuation at economic peaks and contracting ones at troughs is the strongest argument against market efficiency I have ever seen. A truly profit maximizing investor should lower valuations at cycle peaks to allow for the inevitable mean reversion of high profits. Similarly, shouldn't investors bid up cheap stocks when, like March of 2009, they are pricing in an imminent Martian landing complete with ray guns? But they don't.

So I guess it's a simple matter of getting a few more hikes and we're there... a bear market! Right? ... Except it's not that simple.

The next few months will be critical to the state of investor expectations. Should growth and/or inflation expectations pick up, watch for the Fed to respond quickly. If the economy remains 'Goldilocks', the correction will be pushed off yet again.

This is the ultimate "Good news is bad news" environment. If animal spirits revive, and the Fed is forced to respond, I suggest we all start trading closer to the exit door. But we need to get the bull/bear reading higher first. For now, I'm rotating into financials again. The Goldman chart looks great!

Risk Model: 5/5

The model has kicked it up a notch with all indicators in 'risk on' mode. The copper/gold indicator is still rising sharply indicating an economic upswing that has yet to be appreciated by the talking heads. It's being mirrored by an upturn in the Citi Economic Surprise index from its recently oversold level.

Momentum is turning up in the Financials and a stealth rotation into this 'value' group is needed to sustain the rally. The driver for this group will be tax reform and a upswing loan demand.

The Vix is in a coma with the most recent single digit print. The 10 day realized volatility of the S&P 500 just hit 2.75%, its lowest level this cycle. Never short a quiet tape!