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Wall Street is Chasing Ghosts

February 19, 2019

Wall Street’s absolute obsession with the soon to be announced most wonderful trade deal with China is mind-boggling. The cheerleaders that haunt mainstream financial media don’t even care what kind of deal gets done. They don’t care if it hurts the already faltering condition of China’s economy or even if it does little to improve the chronically massive US trade deficits—just as long as both sides can spin it as a victory and return to the status quo all will be fine.

But let’s look at some facts that contradict this assumption. The problems with China are structural and have very little if anything to do with a trade war. To prove this let’s first look at the main stock market in China called the Shanghai Composite Index. This index peaked at over 5,100 in the summer of 2015. It began last year at 3,550. But today is trading at just 2,720. From its peak in 2015 to the day the trade war began on July 6th of 2018, the index fell by 47%. Therefore, it is silly to blame China’s issues on trade alone. The real issue with China is debt. In 2007 its debt was $7 trillion, and it has skyrocketed to $40 trillion today. It is the most unbalanced and unproductive pile of debt dung the world has ever seen, and it was built in record time by an edict from the communist state.

Next, while it is true that in the long run, tariffs are bad for growth – and history proves this beyond a doubt — in the short term, this trade war between the US and China has actually helped boost global trade and GDP. A prolonged period of tariffs is bad for global growth because it stunts global trade—that is what’s bad about a trade war. But that is not what happened in this case; trade has actually increased. This is probably because president Trump first put on a relatively small level of tariffs in July of last year and then threatened to significantly increase the import duties at the start of 2019. This caused a surge in trade from both countries in an attempt to front run the deadline. Hence, China actually had a record trade surplus with the US in 2018 of $323.3 billion. US imports from China surged by 11.3% year over year to $478.4 billion. And, exports from the US to China actually increased as well—however, by a much smaller 0.7%. This trend continued in January, as China’s January dollar-denominated exports rose 9.1% from the year-ago period—most likely due to Trump’s can kick with raising tariffs until March 1st.

The point here is that global trade actually increased in the year the trade war began. So, if China’s exports actually increased strongly during the trade war and China doesn’t pay US tariffs, it is paid by US importers, how is it reasonable to contend that China’s growth will surge once a trade war truce is declared? Of course, if tariffs increased to 25% on all of China’s exports to the US it would stunt global growth. But that has not happened yet and investors are pricing almost no chance of it ever occurring.

Again, China is a debt disabled economy—much like Europe—that has been responsible for one-third of global growth coming out of the Great Recession of 2007-2009. However, it just can’t re-stimulate growth yet again by building another empty, unproductive city or port. Stimulating growth now by issuing more debt may be enough to levitate the economy from crashing, but it just can’t produce robust growth any longer. In fact, bond defaults have begun to surge, quadrupling from last year, as the communist nation struggles to handle its mountain of obligations.

Wall Street will soon have a day of reckoning when it realizes the trade war was not at all the primary driver behind the dramatic slowdown in global growth. And global growth is slowing dramatically—with a conveyor belt of bad news to continue well after the announcement of a deal.  US Retail Sales in December crashing by the most in nearly a decade is just one example.

In the developed world we have the Italian economy, which is in an official recession and it is the third largest bond market on earth. Putting global banks that own this debt in high danger. Eurozone Industrial Production plunged -4.2% year-over-year in December after falling 3.3% in November. The headline German (IFO), business climate index, slid to a two-year low of 99.1 in January, from 101.0 in December, dragged down by a crash in the expectations index to 94.2. And Q4 German GDP was exactly 0.0%. Japan’s economy is a perpetual state of malaise, as growth for the full year 2018 was a sad 0.7%. And on an annual basis, its industrial output declined 1.9% in December.

Of course, the world is full of emerging market economic basket cases like; Argentina, Venezuela, Turkey, and South Africa as well. This condition is the opposite of the recently enjoyed globally synchronized recovery, and it is putting extreme downward pressure on US multinational earnings.

Which brings us to the other ghost Wall Street is chasing…the Fed. Along with a handshake between Trump and XI, those Carnival Barkers are also cheering on the Fed’s move towards a dovish stance on monetary policy. But it is ignoring with alacrity the reasons why the Fed has paused with its rate hikes. The Fed inverted the yield curve on the 2-5 year spread late last year and, at least for now, it is still destroying $40 billion worth of assets each month. How is it that investors are so sure the Fed hasn’t already gone too far; just like it always has done in the past?

US GDP growth has dropped from 4.2% in Q2 last year to display a 1% handle in Q4 2018, according to the Atlanta Fed. Earnings growth has plunged from 20% in 2018 to a negative number at the start of this year. Real estate is in a recession, and equity prices lost 7% last year. It is highly likely the Fed turned dovish too late. Remember, the Fed stopped raising rates in 2006 and began to cut rates aggressively in 2007. But that didn’t stop the global economy from imploding a year later. The Fed also began cutting rates in January 2001. But the S&P 500 still fell another 37% by March 2003. And keep in mind, the Fed is still tightening rates by selling off its balance sheet.

As the global economy waxes towards recession investors are jumping into the relative safety of sovereign bonds. The Japan, 10-year bond, went negative once again and pushed the number of global bonds with a negative yield back up to $9 trillion. Yields are falling here in the US too, despite the fact that the National debt just hit $22 trillion and total global debt hit $250 trillion.

This begs the question: if global economic growth was about to turn around sharply to the upside based upon dovish central banks and an end to the trade war, then why do global bond yields continue to fall?

No, things are not normal, and the world has gone insane. And that is why heading to the safety of the gold market at this juncture is becoming more crucial by the day.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

Powell’s Rate Pause Won’t Save Stocks

February 11, 2019

Jerome Powell threw Wall Street a lifeline recently when he decided to temporarily take a pause with the Fed’s rate hiking campaign. The Fed Head also indicated that the process of credit destruction, known as Quantitative Tightening, may soon be brought to an end.  This move towards donning a dovish plume caused the total value of equities to soar back to a level that is now 137% of GDP. For some context, that valuation is over 30 percentage points higher than it was at the start of Great Recession and over 90 percentage points greater than 1985. So, the salient question for investors is: will a slightly dovish FOMC be enough to support the massively overvalued market?

The S&P 500 is now trading at over 16x forward earnings. But the growth rate of that earnings will plunge from over 20% last year to a minus 0.8% in Q1 of this year, according to FACTSET. It might have made sense to pay 19x earnings back in 2018 because it was justified by a commensurate rate of earnings growth. But only a fool would pay 16x or 17x earnings if growth is actually negative?

The only reason why that would make sense is if investors were convinced EPS growth was about to soar back towards the unusually-strong rate of growth enjoyed last year. And for that to be the case several stars have to align perfectly.

The structural problems that are leading to sharp slowdowns in Europe, China and Japan all have to be resolved favorably and in a very short period of time. And, of course, global central banks begin another round of massive and coordinated of QE.

In addition, the trade war must also be resolved quickly and in a way that does not inflict any further damage to the ailing economy in China. Not only does China have to agree on a myriad of concessions; including eliminating its trade surplus with the U.S. and renouncing its practice of intellectual property theft. But the communist nation must also agree to subject itself to rigorous monitoring and enforcement mechanisms. Not only this, but any eventual deal must be constructed in a way that ensures increasing China’s dependence on imports does not negatively affect domestic production.

Additionally, China’s government must be able to re-stimulate its growth by forcing yet more debt upon its economy, which is already so overleveraged that it has begun to crash.

In addition, the chaos that surrounds Washington must abate quickly. This means future government shutdowns must be averted and that there will not be Presidential indictments from the soon to be released Mueller probe. Also, the upcoming conflagrations and brinksmanship over funding the government and increasing the debt ceiling must not adversely affect consumer sentiment.

But by far the most important of all these factors is the Fed. It must turn out to be the case that the previous 9 rate hikes and $500 billion worth of currency destruction through QT haven’t already been enough to push the economy and stock market over the edge–especially in view of the fact that the balance sheet reduction process is still ongoing.

It is prudent to point out that the Fed last stopped raising rates in the summer of 2006. But that certainly didn’t turn out to be the all-clear sign for the economy. A mere twelve months later the stock market began to crash, and 18 months after the Fed’s last hike the real estate crisis and Great Recession began.

Back in 2006, the global economy was booming with growth of over 4%. In sharp contrast, today we have parts of Europe in a recession, while Japan’s GDP is contracting. There is now a sharp slowdown in China from well over 10% growth in 2006, to the 6% range today.  Also, the U.S. economy has slowed from 4.2% in Q2 of last year to around 1% at the start of this year. The point here, is the world isn’t growing like it was 13 years ago, or even where it was a year ago–it is now teetering on recession.

This means there is a huge difference between the point in which the Fed is going dovish this time around–if you can indeed categorize a dovish Fed as one that is still in the process of destroying 10’s of billions of dollars each month through its reverse QE program.

It is true that the Fed stopped hiking the Funds Rate at 5.25% back in 2006; while today it is just below 2.5%. Therefore, Wall Street shills take solace in the fact that rates are at a lower point now than they were in the last hiking cycle. So, they conclude with an alacrity that today’s level of interest rates will turn out to be innocuous.

However, as already mentioned, stock prices are much higher relative to GDP today than in 2006. And, debt levels today dwarf what was evident at the start of The Great Recession. The fact is that total non-financial debt in the U.S. has surged from $33.3T (231% of GDP) at the start of the Great Recession in December of 2007, to $51.3T (249% of GDP) as of Q3 2018. The bottom line is the economy is lugging around an extra $18 trillion of debt that it has to service on top of what it could not bear a decade ago.

Therefore, it is logical to conclude after raising the Fed Funds Rate 9 times since December 2015 and also for the first time in history destroying $500 billion from its Quantitative Tightening program, that the Fed has already tightened enough to send earnings and GDP into a recession.

Despite the sharp slowdown in the global economy, the perma-bulls dismiss the idea of an earnings recession that lasts more than one quarter. This is primarily because the Fed has gone on hold with its monetary policy. However, this ignores the earnings recession that occurred only a few years back.

The S&P 500 EPS for the calendar year 2014 was $119.06, for 2015 it was $118.76, and for 2016 it was $119.31. It should be noted that the earnings recession of 2014-2016 occurred in a much more favorable macroeconomic environment. The ECB was still in the throes of its QE program, the Fed Funds Rate was 200 basis points lower, the trade war had not yet begun, the Fed’s reverse QE program was still another year off, and the Fed’s balance sheet was a half-trillion dollars larger. Yet, the earnings recession still happened; and the stock market went absolutely nowhere for two full years with a couple of steep double-digit percentage point drops mixed in.

The earnings recession was only bailed out by Trump’s massive corporate tax cut, an unprecedented stimulus package from China, and global QE that was spitting out around $100 billion of monetary confetti each month. But those conditions are not likely to be repeated, and that means that the global economy must stand on its own debt-disabled legs for the first time in over a decade.

Sadly, it should end up taking much more than an abeyance with rate hikes to levitate stock prices. After this next plunge in asset prices, the Fed will be quickly cutting interest rates back to zero percent and all global central banks will be forced to re-engage with a massive, protracted and record-breaking round of QE. This will also be combined with a humongous global fiscal stimulus package that will serve to push bankrupt nations further into insolvency.

It may be possible to rescue the stock market in nominal terms using this type of fiscal and monetary madness. However, it also means the already endangered middle class will take a giant step towards extinction. And this is why the timing of precious metals ownership will be more crucial than ever.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

Has the Fed Already Gone Too Far?

January 14, 2019

It is crucial for investors to understand that the Federal Reserve has not yet turned dovish and the Fed “Put” it not yet in place. Wall Street sometimes hears what it desperately needs, but that does not make it fact. While Jerome Powell has moved incrementally towards the dovish side of the ledger in the past few weeks, the Fed is still firmly in hawkish territory. If, however, Mr. Powell was actively reducing the Fed Funds Rate (FFR) and expanding the balance sheet, then we would have a dovish Fed. However, by just indicating that the FOMC might be close to finishing its rate hiking campaign, while still selling nearly $50 billion of bonds every month from its balance sheet, the Fed is still tightening monetary policy–and in a big way.

However, “The Fed is now dovish, so it’s a good time to buy stocks” mantra from Wall Street is a dangerous one indeed. This argument is false on two fronts. First, as already mentioned, Jerome Powell is still tightening monetary policy through its reverse QE process. Second, the fact that the Fed may be cutting rates soon doesn’t mean the stock market automatically goes up. The Fed began cutting rates in September of 2007 and reached 0% by December of 2008. Was it a good time to buy stocks during that time? No, it was a very dumb idea that cost you half of your investable assets. The market actually peaked around the same time the Fed began cutting rates and didn’t bottom until March 2009, three months after interest rates hit 0%.

Wall Street is gladly overlooking the current global economic crash—not slow down—and that means EPS for the S&P 500 going forward will be well short of the 7% currently predicted. In fact, we are most likely undergoing an earnings recession worse than what occurred during 2014-2016; especially when you factor in the fall in oil prices that will hurt the earnings of energy companies. Only, this time around there won’t be another once-in-a-generation tax cut to bail out stocks and the economy. Just the end of QE on a global basis pushing the financial world over a cliff.

Here’s another salient point. The Fed pushed the economy over the edge in 2008 when it raised rates 17 times from 2004-2006, taking the FFR from 1%-5.25%. In this current rate hiking cycle, the Fed has raised rates 9 times but also has already sold off about a half trillion dollars from its balance sheet. A reduction of this size in the balance sheet, which is a gigantic destruction of liquidity from the financial system, is something never before done or even attempted. And, the Fed continues to burn cash even though the business cycle has clearly rolled over. Add to this the fact that total non-financial debt in the US has surged from $33.3T (231% of GDP) at the start of the Great Recession in December of 2007, to $51.3T (249% of GDP) as of Q3 2018 and you can understand why this economy cannot handle higher rates…not with an extra $18 trillion it has to service on top of what it could not bear a decade ago.

The GDP level of today is the most unstable and fragile ever. This is because today’s GDP is more reliant on asset bubbles and free money than at any other time in history. Now that rates have risen, liquidity has been removed, and the stock market is rolling over, GDP should begin to fall.

My 20-point Inflation/Deflation and Economic Cycle model predicts the Fed has already tightened enough to bring on a recession, and history has proven that is where stocks can lose 50% or more of their value. Eventually, Jerome Powell will come to grips that these massive and unprecedented debt levels cannot sustain higher rates and QT at the same time. He will then start cutting rates and return to QE, but that is when most of the damage to the market occurs.

My model will monitor the incoming data to see if I’m correct in the preceding assumptions. And if so, there will be perhaps the best shorting opportunity yet coming up very soon. This is because the perma-bulls and shills on financial TV have caused the majority of investors to already price in a favorable conclusion to the trade war.  And, have also convinced them that the Fed put is back in place. But the trade war has become a red herring, and the Fed’s damage to the economy has most likely already been done. In reality, the destruction caused by central banks occurred a long time ago when they eviscerated markets in favor of perpetual bubbles. Yes, central banks have indeed already gone way too far!

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

 

Some Predictions for 2019

January 7, 2019

Bond Yields Continue to Fall in First Half of Year

The epoch bond bubble continues to build and become a dagger over the worldwide economy and markets. Wall Street Shills are fond of claiming that global bond yields remain at historically low levels due to central bank manipulations, but this argument is no longer tenable. It was once true, but QE on a net global basis has now gone negative. And the data shows the amount of U.S. publicly traded debt relative to GDP is much greater today than it was prior to the start of the Great Recession—even after adjusted for the size of the Fed’s balance sheet–in other words, taking into account all the debt the Fed has purchased and is still rolling over.

The amount of publicly traded debt in the U.S. has soared to 58% of GDP. This is up from 29% in 2007 when the U.S. 10-year Note was yielding 5%. The Fed is now selling $50b of bonds each month, with an extra $7.8T in publicly traded debt that it doesn’t own; and that equates to nearly 2x the amount of debt compared to GDP than what existed just prior to the Great Recession. This debt must now be absorbed by the private market and at a fair market price, instead of just purchased mindlessly by the Fed…and yet yields are still falling. This means investors are piling into sovereign debt for safety ahead of the global economic crisis even though they understand that debt is, for the most part, insolvent.

Recession Begins Prior to Year’s End

The yield curve continues to invert and presages a recession that begins in late 2019. Meanwhile, the nucleus of the next credit crisis (the leveraged loan and junk bond markets) implode; as corporations need to roll over more than $800 billion of debt at much higher interest rates this year.

My Inflation/Deflation and Economic Cycle Model has 20 components. 19 out of 20 indicators are indicating we are about to enter into a recession. Only initial unemployment claims remain at a positive level. I believe GDP growth in Q1 2019 will have a one handle in front of it because the 2nd derivatives of growth and inflation are slowing significantly. Therefore, we are headed into sector 1 of my Inflation/Deflation and Growth Spectrum; where assets are falling sharply as the economy is deflating.

Trade War Truce

The Main Stream Financial Media will continue to obsess over Trump’s twitter account to find out if some U.S. trade delegation met with someone in China and had a nice conversation. And, if President Trump announces that General Tso’s chicken is his favorite meal.

Trump will end the trade war soon and claim that it was the biggest and greatest deal in human history. Hence, my prediction: the tariffs against China are lifted in Q1 2019. This is what all the perma-bulls are waiting for. But that isn’t going to bail out the market. A trade deal with Mexico was reached back on August 27th, but that didn’t stop its stock market from crashing 20%.

Debt and Deficits Soar Globally

Sovereign debt skyrockets at an even faster pace than the breakneck speed witnessed since the Great Recession. In this same vein, in the U.S. the federal budget deficit surged to a record for the month of November to reach a negative $204.9 billion. The Treasury Department says that the deficit for November was $66.4 billion higher than November of ’17. For the first 2 months of this fiscal year, the deficit totaled $305.4 billion, up 51.4% from the same period last year. Deficits this high outside of a recession are both highly unusual and dangerous.

My Prediction: the U.S. deficit for fiscal 2019 breaches far above $1 trillion; and this type of fiscal profligacy is replete throughout Asia, Europe and in emerging markets. Indeed, there isn’t a shred of prudence found pretty much anywhere in the world.

This massive increase of $70 trillion in debt since 2007, which adds up to $250 trillion globally, must now rely on the support of investors instead of the mindless and price insensitive purchases of central banks. Therefore, the potential for a 2012 European-style debt crisis occurring on a global basis is likely in 2019.

Equity Markets Go into Freefall

The U.S. stock market takes its most significant leg down since 2008 in the first half of the year. The economic data and earnings reports will be extremely negative in comparison to the first half of 2018. For instance, Q2 of last year reported GDP growth of 4.2%. However, it is very likely that Q1 of this year will have GDP growth of just around 1% and Q2 could come in negative.

The total value of the market could drop by 25% and still be at a valuation level that is equal to 100% of GDP. And that assumes GDP doesn’t drop. But at 100% of GDP the market would still be, historically speaking, about twice as overvalued as it was from 1974-1990. Hence, I predict the worst of the stock market is still very much in front of us. The Fed will continue its $50 billion per month of reverse QE—at least until the stock market drops another 20% from here. And, the ECB is now out of its massive €80 billion per month QE program. Therefore, despite the fact that the Fed goes on hold with further rate hikes, asset prices remain in peril–at least until the Fed is actually cutting interest rates and ends Quantitative Tightening.

D.C. Chaos

And finally, 2019 will be marked by a conflagration in our government. The year will be marred by budget showdowns and shutdowns, debt ceiling brinksmanship and indictments from Special Prosecutor Robert Mueller. Those hoping for cooperation between Democrats and Republicans on things such as a massive debt-funding infrastructure spending package to save the economy will be greatly disappointed. The cacophony between Democrats and Trump adds to the dysfunction in D.C. and puts added pressure on the market.

Concluding Prediction

The global bond bubble continues to slam into the reality of the end of central bank support. That is the salient issue concerning economies and markets worldwide. Household net worth (think real estate and equity portfolios) as a percent of GDP reached over 525% at the start of Q3 last year. According to Forbes, the average for that figure is 380% going back to 1951. The sad fact is that the “health” of the global economy (however uneven and biased against the lower and middle classes) has become completely reliant upon the perpetual state of these unprecedented asset bubbles. Therefore, as they implode they are taking the global economy down with it.

This process will only intensify throughout 20109. As former Fed Chair Alan Greenspan said recently, “run for cover”…he’s finally got it right.

Investors Still too Bullish

It’s been a wild ride on Wall Street lately. Major averages had hit their highs in late September. But if this sell-off continues, it will be Wall Street’s worst year since the financial crisis and the worst December since the Great Depression! This should have been enough to shake investor confidence. But judging from the data in the chart below, compiled by my friend Kevin Duffy of Bearing Asset Management and using data from Charles Schwab, we see that investors on both the retail and institutional level have a near-record low level of cash. They are anything but scared of this market.

This data was compiled on November 30, 2018, when cash levels registered just 11.2%. That was not up much from the low reading of 10.3% held on September 30th. The retail investors is, relatively speaking, all in.

And, analysts aren’t pulling in their horns either.

According to FactSet: Overall, there are 11,136 ratings on stocks in the S&P 500. Of these ratings from Wall Street analysts, 53.9% are Buy ratings, 40.8% are Hold, and just 5.3% are Sell ratings. Yet, with the mounting weight of evidence in favor of a sharp slowdown in global growth, it has not dissuaded analysts from still having ebullient forecast for earnings growth next year. Analysts are projecting S&P 500 EPS estimates for the Calendar year 2019, according to FactSet, to grow at 8.3% with revenue growth of 5.5%.

The global economy is showing signs of cracking now that QE has gone from $180 billion per month in 2017, to a negative number in 2019. That has sent the Emerging Markets into chaos and help lead European and Japanese economies into contraction.

And now China, which has been responsible for 1/3rd of global growth coming out of the Great Recession, is entering into a recession. Of course, having the government force an increase of debt to the tune of 2,000 percent since the year 2000 guarantees a crash of historic proportions. In fact, the government in Beijing is so concerned about the current debacle that it has banned the gathering of private economic data.

According to the South China Morning Post, China’s central government has ordered authorities in the Guangdong province – China’s main manufacturing hub–to stop producing a regional purchasing managers’ index. This means the province will not release the purchasing managers’ index (PMI) data for both October or November. Instead, all future purchasing managers’ indexes will be produced in-house by the National Bureau of Statistics.

It is evident that Beijing is trying to suppress the dissemination of economic data because its economy is growing at a much slower rate than what the communist party will admit to…that is, if it is growing at all. This is hindering its position in negotiations with the United States in the trade war. And it also reiterates the complete lack of transparency in the Chinese markets and the desire on the part of the Chinese government to keep the world in the dark about the true state of its economy.

Perhaps December’s continued debacle in global markets and economies was enough to begin pushing U.S. investors toward the exit–we will monitor this dynamic closely. However, history shows that it is a multi-month process to move investors’ psyche from euphoria to panic. This dynamic is still in its infancy.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

Stock Buy-Backs Go Bust

The perfect storm of zero percent interest rates that existed concurrently with a debt-disabled economy lured executives at major corporations into a decade-long stock buyback program. The Fed pumped money into the economy thru its various Quantitative Easing programs to force interest rates near zero percent, with the expectation corporations would borrow money at the lowest rates in history and then invest in their businesses in the form of Property Plant and Equipment (capital goods). This in turn would expand productivity and help foster a low-inflation and strong growth environment.

But many corporate executives found a much more enticing path to take in the form of EPS manipulation. That is, they boosted both their companies share price and, consequently, their own compensation, by simply buying back shares of their own stock.

For the most part, companies have used debt to finance these earnings-boosting share purchases. Stock buybacks have been at a record pace this year.

This is a short-term positive for shareholders because it bids up the stock price in the market; just as it also reduces the shares outstanding. This process boosts the EPS calculation and increases cash flows as fewer dividends are paid to outside shareholders. As an added bonus, it also provides for a nice tax write-off.

Wall Street is easily fooled into thinking valuations are in line using the traditional PE ratio calculation. But this metric becomes hugely distorted by share repurchases that boost that EPS number. Other metrics that are not as easily manipulated, such as the price-to-sales ratio and the total market cap-to-GDP ratio, have been screaming the overvaluation of this market in record capacity.

Traditionally speaking, a company decides to buy back shares when they believe their stock is undervalued. But from 2008-2010–a time when stocks were trading at fire-sale prices, companies bought back very few shares. However, it was only after Wall Street became confident that the Fed’s printing presses were going to stay on for years that share purchases went into overdrive—even though the underlying economic growth was anemic.

The truth is the volume of debt-sponsored share buybacks over the past few years is putting many companies at an extreme level of risk.  According to Bianco Research, 14% of S&P 500 companies must now issue new debt just to pay the interest on existing debt. In other words, these Zombie companies are actually Ponzi schemes that can only continue operations in a near zero-percent interest rate environment; and if the credit markets remain liquid. But, both of those conditions are rapidly moving in the wrong direction.

Share buybacks have a metric known as the Return on Investment or “ROI,” which tracks post-buyback stock prices to measure the effectiveness of corporate repurchases. The fact is that corporate executives have a miserable track record when it comes to their ROI on share repurchase programs.

One such example of this is Chi­potle. According to Fortune Magazine, the company spent heavily on share repurchases in the first quarter of 2016, at the height of their E Coli scare. Subsequently, these shares have crashed, giving the company an ROI of minus 23%.

Then there is General Electric. Between 2015 and 2017, GE repurchased $40 billion of shares at prices between $20 and $32—its share price sits around $6 today. The company has destroyed about $30 billion of shareholders’ money. It lost more on its share repurchase programs during those three years than it made in operations—and by a substantial margin. But GE is just one of several hundred big companies who have thrown good money away on bad share buybacks.

Big Tech icons Apple, Alphabet, Cisco, Microsoft, and Oracle, have bought back $115 billion of stock in the first three quarters of 2018. But now these share prices are headed down. In fact, IBM has lost 20% of its value this year alone. The company bought back $50 billion of its stock between 2011 and 2016 and ended the second quarter with $11.9 billion of cash on hand; but its debt totaled $45.5 billion. In other words, these companies are destroying their balance sheets for a short-term boost in stock prices that has now gone into reverse.

When overleveraged companies are faced with soaring debt service payments, the results are never good. Indeed, as the global economy continues to deteriorate, look for the rate of bankruptcies and unemployment claims to skyrocket.

Corporate America has leveraged itself to the hilt to buy back shares. Once again, with impeccably bad timing. These companies will now have to raise capital to strengthen their balance sheets just as interest rates are rising and the recession of 2019 unfolds.

Then, these same companies who bought back their shares at the highs will soon have to pull those same shares out of retirement and sell them back to the public at much lower prices. Thus, diluting the shares outstanding and lowering EPS counts yet again…Wall Street never learns.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

 

Does Wall Street Now Have a Powell Put

December 10, 2018

First, let’s explain exactly what a “Fed Put” is. A Fed put is defined as The confidence of Wall Street that the Fed will lower interest rates and print money to support the market until economic strength will be strong enough to carry stocks higher. The term “Put” is ascribed to this because a put option is basically a contract that offers a buyer protection from falling asset prices. It was first coined under the Chairmanship of Alan Greenspan when he lowered interest rates and printed money to rescue Wall Street from its 22% Black Monday crash back in 1987. The practice of bailing out stocks was institutionalized by Ben Bernanke, and then became a bonafide tradition perpetuated by Janet Yellen.

During the tenure of Ben Bernanke, the Fed Put took on new dimensions never before conceived. Such as a zero interest rate policy and the massive monetization of long-term Treasuries and Mortgage-backed Securities. The purpose of this strategy was to put a floor under asset prices and encourage the private sector to stop deleveraging. It was a total success. Wall Street’s mantra under Janet Yellen went something like this: The economy will soon improve and thus boost share prices. Or, if it does not, the Fed will keep interest rates at zero percent and force money down the throat of banks in the form of QE. With this, they will feel compelled to push a flood of new capital towards real estate, equities, and bonds, regardless of the underlying economic conditions.

And now, Wall Street believes that investors have received the latest iteration of a central-bank Put following Fed Chair Jerome Powell’s recent comments. Mr. Powell gave a speech on November 28th at the Economic Club of New York, in which the Main Stream Financial Media was quick to assess that the central bank is now on hold with its tightening of monetary policy.

That conclusion could not be more in error. It is what Wall Street wanted to hear, but that is not at all what came out of Jerome Powell’s mouth. The following was his direct quote: “Interest rates are still low by historical standards and they remain just below the range of estimates of that level that would be neutral for the economy.”

Powell’s statement was indeed meant to moderate his pronouncement on October 3rd that the Fed Funds Rate (FFR) was very far from neutral and that it could actually go above neutral for a period of time. But, by now stating that the FFR is just below a “the range of estimates” does not mean the Fed is near neutral. Rather, that there is a low, middle and high-end in the spectrum of estimates; and that the current rate is just below that range. That’s it.

However, Wall Street misinterpreted his statement as the Fed having achieved its neutral interest rate and is about to go on hold with further rate hikes. Nevertheless, the Jerome Powell Fed faces a much different dynamic than what both Bernanke and Yellen faced. Inflation targets have now been reached; whereas inflation was struggling to stay positive for much of tenure of the two previous Chairs. Not only this, but the FFR is not even half the level of where nominal GDP is currently—meaning it is extremely low by historical measures. And, asset prices are firmly back in bubble territory. Due to those asset bubbles and inflation rates, the Fed really has no choice but to raise the overnight lending rate for the 9th time during this cycle on December 19th. Otherwise, it risks long-term bonds spiking uncontrollably. The Fed also promises to hike 2-4 times next year.

Therefore, a more realistic Wall Street mantra at this time should be: the Fed will continue to slowly raise interest rates and burn $50 billion per month of bank credit, and will continue to do so unless or until the stock market or economy undergoes a significant decline. Hence, the Fed will only end its reverse QE process and stop raising rates ex-post; i.e., after the economy enters a recession, or in the wake of a stock market crash.

The truth is that the Fed is 180 degrees away from offering investors a genuine “Put” at this time, which would comprise the lowering of interest rates back to 0 percent and begin increasing its balance sheet through another iteration of QE. Therefore, the stock market is going to struggle due to a faltering economy, which will depress earnings and place further downward pressure on prices. Or, stocks will sink further into bear market territory because the Fed will continue to raise interest rates and make cash more competitive with equities—which still display extremely rich valuations historically.

Of course, there is no doubt that a Powell Put is coming. The Fed’s unbroken tradition since 1987 has been firmly inculcated into the current Keynesian regime. Nevertheless, the safety net below the equity market still remains a great distance below current valuations.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

 

A Trade War Truce Won’t Fix China

December 3, 2018

The Main Stream Financial Media would love to have investors believe that the recent problems in the global equity market are all about a trade war with China. Therefore, everything can be made right just because Trump shook hands with Xi Jinping at the G-20 meeting in Argentina. But the truth is, China’s problems are structural in nature–resulting from a centrally-planned economy that goads its citizenry into pre-fabricated urban areas in order to manufacture a pre-determined rate of growth. Nevertheless, what the Chinese government has actually accomplished is to produce a dystopia; one that was erected upon the largest percentage increase in debt the world has ever witnessed.

China is home to 18.5% of the world’s population. In order to micro-manage all these people, the Communist government has engineered a mass migration from rural areas into urban pre-planned cities. The government claimed this would allow them to better distribute resources. But the government’s biggest fear is a peasant’s revolt. By moving people into highly populated urban areas where they can be placed under constant surveillance by over 170 million cameras, helps Xi Jinping sleep much better.  It also helps him implement China’s “Social Credit System,” where people gain and lose points by conducting their lives in allegiance with government policies. This is not a monetary reward system, but one where freedoms must be earned from autocrats instead of ordained by God.

Since 1995, the amount of Chinese living in urban areas has doubled from 30% to 60%. Yet, even with this huge relocation, over 22% of these dwellings remain vacant. This is because relocation plans went into overdrive during the worldwide financial crisis. What started as an exercise in state control, morphed into a Keynesian style unproductive jobs initiative. With this, China’s debt has risen from $2 trillion in 2000 to $40 trillion today.

Mortgage loans have grown 8-fold in the past decade. Loans on empty homes in China grew to 4.2 trillion yuan, on what is estimated to be 50 million vacant apartments. There were 22.4% vacant homes in 2013. That number is up from 20.6% in 2011, according to the Research Center for China Household Finance.

This centrally planned rural exodus has created an enormous real estate bubble. Therefore, home prices are trying to be stabilized by the government, which purchases the surplus inventory. But, this is becoming increasingly difficult to manage because the value of the yuan is coming under extreme downward pressure. The government now has a balancing act dilemma: print more yuan to support the real estate market and the economy or allow the housing Ponzi scheme to collapse. In some areas, home prices are already declining, forcing sellers to cut prices by 30%.

The Chinese government must maintain the illusion of economic stability to preserve social order. However, should the housing slowdown pick up steam and tens of millions of empty units suddenly hit the market, we may see a resurgence of the Tiananmen Square revolts; the kind that turned the nation upside down back in 1989 and engendered the condemnation from the worldwide community.

The Chinese economic smoke screen is also showing signs of fading in the automobile industry, which was once viewed as a bottomless pit of opportunity and growth. October auto sales numbers, according to the Wall Street Journal, were down 12% year over year.

China’s slowdown in consumption is partially the result of a persistent bear market in their stock market, which is down 25% year to date and has crashed over 50% since its 2015 high. This equity-market carnage has had a huge negative effect on disposable income. Also, adding to investor uncertainty is the record wave of onshore bond defaults by Chinese companies. These defaults have shaken the faith of the country’s bondholders and created doubt among international investors, who have only recently gained access to the Chinese bond market. Chinese banks have as much as 2 trillion yuan ($287 billion) of nonperforming loans on their books—at least that is the amount that they are admitting to.

China’s economic problems are taking a toll on the global economy. For example, the European Union’s biggest customer is China. Also, the Asian-block nations rely on a rising Sino GDP growth rate for their economic health. A wounded China is a significant cause of contracting Japanese and German Q3 GDP growth. The other salient factor is the major shift of global central banks to a hawkish monetary policy stance.

Hence, the state of global growth lies within China’s ability to juggle its currency and debt-disabled economy. The nation has accounted for about 1/3 of global growth since the Great Recession. However, its Potemkin economy is now heading for a crash commensurate with the debacle currently witnessed in the Shanghai Stock Exchange.  A handshake agreement between Trump and Jinping to work towards resolving the trade war isn’t going to ameliorate the primary issues behind anemic global growth.

Rather, look for this to provide just a relief rally across financial markets. But that should prove short-lived, as the Fed continues to slowly raise interest rates and burn $600 billion worth of cash during fiscal 2019. And, as the ECB shuts down QE entirely in December and prepares to raise rates later in ‘19.

This is because the immutable and baneful reason behind the weakening global economy consists of record global debt that was issued to push asset prices to record highs. The dagger to those bubbles is rising interest rates. Now that central bankers have achieved their inflation goals, especially in asset prices, they really have no other choice but to continue on a hawkish path; or risk asset prices, debt ratios, and long-term rates rise out of control.

In Q1 2018, it took a record $8 trillion of new debt to create all of $1.3 trillion of global GDP, according to the Institute of international finance. Therefore, don’t expect more debt-based stimulus measures to automatically rescue the economy. Instead, look for a deflationary recession/depression to finally reconcile the massive imbalances of debt and asset prices that have been built up over the past two decades.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

Earnings Recession of 2019

November 19, 2018

 President Trump’s plan to stimulate the economy, known as The Tax Cut and Jobs Act, was signed into law at the end of 2017. It ushered in a massive and permanent tax cut for corporations, along with a temporary reduction in rates for individuals. Consequently, earnings growth has soared this year when compared to the same period in the prior year. Companies in the S&P 500 grew their earnings by 25.6% in the third quarter of 2018 compared to the same period in 2017, according to FACTSET. And earnings growth is set to rise by 19% in the fourth quarter of 2018 y/y.

But things aren’t looking nearly as good for next year’s comparisons. EPS growth for the S&P 500 in the first quarter of 2019 compared to 2018 is estimated–by the, it’s always sunny outside crowd on Wall Street–to be 9.5%. But this guestimate might very well turn out to be extremely optimistic.

During the second quarter of this year, the economy grew at a 4.2% Q/Q SAAR. The third quarter growth in the U.S. saw the economy decelerate to 3.5%. And, according to Bloomberg, the estimate for fourth-quarter growth of this year will be 2.7%. Keeping with this trend in slowing growth, Q1 2019 is projected to post growth of just 2.4%–there is no doubt that the U.S. economy is in the process of decelerating.

Given the strong headwinds hitting the global economy right now, and the fact that no economy exists on an island, it seems very likely that U.S. corporate profit growth could struggle just to remain in positive territory during 2019. Those headwinds include: The Fed continuing along its interest rate hiking path, while it also removes $600 billion from the financial system. Global central banks that have turned hawkish, causing the amount of QE to crash from $180 billion per month in recent years, to zero. Corporation are seeing profit margins shrinking from rising wages, much higher interest rates expenses and a stronger dollar. The end of trade war front-running, which caused a huge inventory build and a temporary boost to growth. Emerging Markets turmoil is worsening. The U.S. is posting trillion dollar deficits and that amount of red ink is only getting bigger, and finally, the debt-disabled global economy is rolling over hard, causing stock market collapses and putting downward pressure on consumers worldwide.

In addition to all those factors, corporate profits face extremely difficult comparisons due to the lapping of the repatriation of foreign earnings, along with the tax stimulus package.

This year started off with an extreme level of investor optimism. Equity markets were supported by the outlook for a continuation of synchronized global growth. Nevertheless, the global economy is now weakening, as global monetary policies are tightening into record levels of debt.

This is causing turmoil in currency, bond and equity markets across the globe. In this environment, it seems highly likely that S&P 500 earnings will struggle to grow at all. Indeed, the level of earnings for the S&P could find it difficult to remain at the $162.48 level that is projected by FactSet for calendar 2018. Therefore, investors need to reprice the rosy forecast of $177.90 for TTM 2019 that is currently hoped for by Wall Street.

Not only is it the case that EPS growth will be far less than the 25% seen earlier this year; it is very likely that there will be an earnings recession next year. If this is indeed the case, the market will be forced to place a much lower multiple on that plunging growth rate of earnings.

The current forward multiple on the S&P 500 EPS is 15.6. But this considers a robust growth rate that is near double digits. If the EPS number next year comes in closer to the same low $160’s EPS level seen in the trailing twelve months of this year, the multiple on those earnings should be closer to 14x…at best. Hence, if this assessment is anywhere near correct, the S&P 500 should trade around 2,240 at the end of next year. That would equate to a drop of nearly 20% from the current level.

It is of paramount importance to note that those EPS figures are grossly overstated due to a decade’s worth of debt-fueled stock buybacks that have been prompted by near zero percent borrowing costs. Therefore, the fair value of the S&P 500 would only be achieved from a plunge much greater than 20%.

The last earnings recession occurred during calendar year 2015; where EPS for the S&P 500 dropped by 0.3% over the year prior. During this timeframe, the return on stocks was essentially flat. However, if earnings undergo another year over year decline next year, the market may not fare nearly as well. This is because global central banks were busy printing nearly a trillion dollars’ worth of QE during the last earnings recession in order to pump up asset prices. In sharp contrast, during 2019 the amount of money printing, on a net global basis, is projected to become negative.

Such a dramatic plunge in asset prices should come as no surprise. What other possible outcome could be expected given that global central banks printed $14 trillion ex-nihilo in order to manipulate every major asset class into an unprecedented bubble. But, now inflation has forced them to reverse course on monetary policy or risk having long-term interest rates spike out of control. Investors should already have their portfolios prepared for the third collapse of equity prices since the year 2000.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check”, is Host of The Pentonomics Program and Author of the book “The Coming Bond Market Collapse.”

 

Bond Bubble Conundrum

October 22, 2018

Wall Street shills are in near perfect agreement that the bond market is not in a bubble. And, even if there are a few on the fringes who will admit that one does exist, they claim it will burst harmlessly because the Fed is merely gradually letting the air out from inside. However, the fact that we are in a bond bubble is beyond a doubt—and given the magnitude of the yield distortions that exist today, the effects of its unwinding will be epoch.

Due to the risks associated with inflation and solvency concerns, it should be a prima facie case that sovereign bond yields should never venture anywhere near zero percent—and in some cases, shockingly, below zero percent. Even if a nation were to have an annual budget surplus with no inflation, it should still provide investors with a real, after-tax return on government debt. But in the context of today’s inflation-seeking and debt-disabled governments, negative nominal interest rates are equivalent to investment heresy.

At its peak in 2016, there was a total of over $14 trillion worth of global sovereign bonds with a negative yield—mostly in European and Japanese debt. And even though that total has decreased recently, it is still above $8 trillion.

black and white graph from Bloomberg

 

And although the U.S. Ten-year Treasury note yield has never been negative in nominal terms, it is still clearly in the sub-basement of history.