By Victor Sperandeo with the Curmudgeon
The U.S. equity markets, and economy have been disconnected for quite some time and that disconnect is accelerating. As weve said many times, its due to the Federal Reserve Boards policy of feeding their masters (who are the material owners of stocks) free fiat currency via seemingly endless rounds of Quantitative Easing (QE). Instead of the newly created Fed bond buying money going into the real economy, its been injected into financial markets.
The Fed has also maintained short term interest rates at 0 to 25 bps (ZIRP or zero interest rate policy) for most of the last 12 years and says that will continue into the near future without concern for inflation. ZIRP encourages risk taking and has turned many savers into speculators or even Reddit inspired day traders.
The orchestrated decline/crash in money velocity has muted inflation. Thats because banks would rather keep their reserves on deposit with the Fed rather than loan money. The Fed paying banks interest on required and excess reserves encouraged them to not loan money, which in turn caused the steep decline in money velocity.
Over the last 12+ years, monetary policy and deficits have had no negative consequences for the markets (or seemingly for the economy). However, that will surely change as per our Sustainability and Debt to GDP sections below.
Like the end of the USSR, change will happen suddenly. As Herbert Stein, the well-known economist of the 1970s and 1980s said: If something cannot go on forever, it will stop! When it will stop is impossible to know in advance, i.e., the timing is uncertain.
A Calvin Coolidge History Lesson:
The U.S. economy boomed under President Calvin Coolidge. The rapid U.S. economic growth was known as the "Roaring Twenties." Unemployment remained low while the country's gross domestic product rose from $85.2 billion in 1924 to $101.4 in 1929. Yet U.S. federal government spending declined and there was a budget surplus each year! Total federal government spending in 1923 was $3.14 billion and in 1928 it was $2.96 billion.
Moreover, Coolidge worked tirelessly to reduce the burden of taxation on the American people. From his 1925 Presidential Inaugural Address:
The collection of any taxes which are not absolutely required, which do not beyond reasonable doubt contribute to the public welfare, is only a species of legalized larceny. Under this republic the rewards of industry belong to those who earn them. The only constitutional tax is the tax which ministers to public necessity. The property of the country belongs to the people of the country. Their title is absolute.
The Revenue Act of 1924 reduced rates retroactively for 1923, and by 1924 the top rate had come down to 46% of income over $500,000. Coolidges Revenue Act of 1926 again lowered the top rate to 25%, retroactively for incomes over $100,000.
The U.S. economy flourished as a result of these enlightened tax policies. Economic productivity increased, as did employment and income levels. Also, the federal government collected more tax revenue in many years after the Coolidge tax cuts were enacted than before, as a result of a growing economy and many high-income earners deciding to invest their money in the real economy rather than using tax shelters.
Heres something to think about: U.S. federal government spending went from $2.96 billion in 1928 to $ 8.025 trillion ($22 billion a day) in 2020. Thats a mind-boggling increase of 267,400%!
Over 92 years, its a compounded annual increase in spending of 8.96%. During the same time, there was an increase in revenues (taxes) of 7.62% yearly, according to the U.S. debt clock. Last year taxes were $3.458 trillion.
Do you think U.S. government debt and spending increases are sustainable?
CBO Report on the U.S. Economic Outlook:
Each January, the Congressional Budget Office (CBO) usually puts out a 60-to-120-page report of their projections/overview for the next 10 years. But this year the CBO put out an eight-page mini report titled, An Overview of the Economic Outlook: 2021 to 2031. Their forecast incorporates economic and other information available as of January 12, 2021, as well as estimates of the economic effects of all legislation (including pandemic-related legislation) enacted up to that date.
The CBO projects Real GDP of +4.6% for 2021 (Year over Year), with an inflation rate using the PCE (personal consumption expenditures) price index of 1.6%. The budget office expects the unemployment rate to fall to 5.3% at the end of the year, down from an 8.4% projection in July 2020.
Some budget hawks worry that too much aid would risk wasting money and stoking inflation. Its probably better to overshoot than undershoot, but there can be too much of a good thing, said Maya MacGuineas, the president of the Committee for a Responsible Federal Budget, a nonprofit in Washington. Sending money to people who dont need it, overstimulating the economy or unnecessary debt all set us up for more things to clean up later.
Perhaps the best statistics in the CBO mini report are the forecasts of GDP growth... Annual real GDP is projected to increase 4.6% in 2021, 2.9% in 2022, 2.2% in 2023, 2.3% average from 2024-2025, and 1.7% from 2026-2031 (without any recessions)?
Nonetheless, I take this CBO report to be worthless, as without the specifics of spending and policy decisions, GDP and inflation can change materially.
GDP Forecasts vs Reality:
My original forecast was that U.S. GDP would be +/- 1% from last June, without fiscal stimulus starting after September 2020. In the 4th quarter of 2020, real GDP was +0.99% (+4.0% annualized), while current dollar GDP was +1.48% (+6.0% annualized).
Congress passed a $900 billion stimulus last December, which the CBO says will add about 1.5% to the level of GDP this year and next. The Dems are now pushing hard for another $1.9 trillion aid package, but the GOP hasnt agreed yet. The potential $2.8 trillion federal government stimulus is about equal to 13% of nominal GDP and will certainly boost U.S. economic growth. But what else will short of a return to normal via the end of government shutdowns and restrictions?
Goldman Sachs recently raised its U.S. GDP forecasts. Economists at the bank now expect GDP to be 6.6% in 2021 from 6.4%. Goldman expects a 4.3% GDP growth in 2022 and 1.6% growth in 2023.
If you spend and print enough dollars you can get GDP up in 2021, which is possible, but no way can I understand CBO projected growth at 4.6% (or higher) with large sections of the U.S. economy still shut down.
Ill update my U.S. GDP view if and when Congress passes another stimulus package.
ShadowStats View of U.S. Economy:
4th Quarter 2020 GDP came in as expected, with continuing record deterioration in the Trade Balance, some retrenchment in Durable Goods Orders and New-Home Sales. The consumer remains constrained by liquidity, employment and related Pandemic issues.
Suffering from a Pandemic-driven systemic and economic collapse, the 2020 annual decline in real GDP was the deepest since 1946, when U.S. economic activity dropped by -11.16% in its post-World War II reset.
The Pandemic already has inflicted lingering, massive structural damage on the United States economy and on the lives and psyche of its people. Renewed, intensifying economic damage from pandemic appears likely in at least the next quarter or two. Although one can hope that circumstances will begin to stabilize, as vaccines and treatments begin to tame the pandemic, continuing major, expansive Federal Reserve Monetary Policies already are in place, and further, expansive new Federal Government Fiscal Policies already are promised, and likely will be needed and will continue well into 2022 and beyond.
The Feds Balance Sheet:
To understand U.S. economic growth and financial market performance, one must examine the Feds balance sheet:
On 6/11/08 it was $890 billion. In 12.58 years (through 1/27/21) it is now $7,404 trillion. Thats an increase of 18.3% compounded annually over 12.58 years.
Moreover, in the last year (from 10/2/19 to 9/30/20) the Feds balance sheet went from $3.945 trillion to $7.056 trillion. Thats a hyperbolic increase of 78.9%. Heres a six-month view of the Feds total assets:
Did all that Fed bond buying help the U.S. economy? You be the judge: GDP declined -3.5% for the full year of 2020, the most since the 1929-32 depression. Furthermore, U.S. GDP has been way below trend [1.] since the Fed announced QE1 on November 25, 2008.
Note 1. U.S. GDP Trend Growth Rate:
GDP Annual Growth Rate in the U.S. averaged 3.17% from 1947 until 2020, reaching an all-time high of 13.4% in the 4th quarter of 1950 and a record low of -9% (-31.4% annualized) in the 2nd quarter of 2020. It has decreased over the past 12 years due to the weakest U.S. economic recovery on record (from June 2009 through February 2020).
U.S. Debt to GDP Ratio:
An under discussed and often ignored Risk Metric for the U.S. is the Debt to GDP ratio. Lets take a closer look.
Using the end of the 2020 calendar year Nominal GDP of $20.932 trillion and Real GDP of $18.422 trillion (official numbers as of Jan 28, 2021 from Current-Dollar and Real GDP), the Debt to GDP ratio is 1.41% and 1.62% for Nominal and Real GDP, respectively. Those ratios assume a $31 trillion stated U.S. debt and a 6% Gross GDP with 2.2% CPI inflation.
The unsustainable number is a jaw dropping 10-year debt projection of $73 trillion in 2031, based on the U.S. 50-year trend of increasing budget deficits of 9% a year.
Therefore, in 10 years at CBO projected growth rates (their GDP forecasts are historically high) and the 50-year trend in deficits of 9%, the U.S. Debt to GDP ratio will be 3.04% - the highest in the world! Compare that to todays world leader- Japan at 2.50%.
As anyone can see, the above numbers are not sustainable!
Impact on U.S. Stock Market:
According to the Wall Street Journal, the trailing P/E [2.] of the S&P 500 is 43.92 (vs 26.10 one year ago). The Schiller P/E is currently 35.39 (vs a median of 15.81). According to Investopedia, the average P/E for the S&P 500 has historically ranged from 13 to 15.
Note 2. Forward P/E Ratios Are Worthless:
We ignore forward P/E estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias. They seem to always overestimate earnings to suggest much lower forward P/E ratios one year out. A classic example of this was the Russell 2000 forward P/Es since the great recession ended in June 2009 till the present time.
With P/Es on U.S. stocks being this high, and CBO projected GDP growth for the next 10 years of ~ 2.1% per annum, there is no room for P/E expansion. Moreover, its operating earnings growth not P/E expansion- that drives equity valuations higher over the long run.
Where is future earnings growth to come from that would justify higher stock prices? Or will P/Es expansion continue indefinitely?
I have stated since March of last year that the U.S. is in deep decline. In April, I stated that pandemic induced shutdowns were equivalent to economic suicide as per our article that month titled, Perspective on U.S. Economy and the Coronavirus Suicide is NOT Painless! Sadly, my view for the long run is much worse today.
Based on the politics Ive observed, things in general will get worse with only brief pauses of relief happening with government spending and continued Fed money printing. The future of the U.S. is dire!
Furthermore, investing is not a viable concept anymore. Following the Fed and federal government stimulus packages have become the most popular mode of trading markets, in my view. Investing, based on earnings growth and valuations is largely a thing of the past.
Most people believe inflation, is coming. That might end the Feds one trick pony of printing MONEY TO SAVE THE DAY. Inflation sensitive commodities are finally in an uptrend and outperforming stocks since the end of 2020.
The U.S. economic decline is saddest for the children of today, who will in general never have the same standard of living as their parents.
My greatest wish is that Im dead wrong!
Closing Quotes and Key Takeaways:
Nothing in our material world, regardless of the form of government, can come from nowhere or go nowhere, nor can it be free: everything in our economic life was produced by taking risks, and has a source, a destination, and a cost that must be paid by someone (or everyone by inflation) somewhere.
From Dreams Come Due by John Galt.
This quote says it all in the historical cycles of mankind:
A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship. The average age of the world's greatest civilizations has been 200 years. These nations have progressed through this sequence: From bondage to spiritual faith; From spiritual faith to great courage; From courage to liberty; From liberty to abundance; From abundance to selfishness; From selfishness to apathy; From apathy to dependence; From dependence back into bondage.
by Alexander Fraser Tyler (1747-1813).
The key takeaway is the cause of abundance is Liberty, which is the basis of the Constitution and the Declaration of Independence.
Where do you see any current Congressman or leaders mention liberty? Without it, we trend to bondage! Can anyone deny our liberty is virtually gone?
Pop quiz: Within 5 minutes, I challenge the reader to name three things you can do without government permission or license?
Lets hope for a return to normal soon as more people are vaccinated. Till next time .
Follow the Curmudgeon on Twitter @ajwdct247
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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