Pentonomics

Money Printing Can’t Trump a Depression

May 26, 2020

The Atlanta Fed’s GDP Now Estimate for Q2 Economic growth is minus 41.9%.

Thirty-nine million people filed Initial Jobless Claims in the past nine weeks. Continuing Jobless Claims (including Pandemic Unemployment Assistance) surged to over 31 million individuals.

US home construction fell by 30.2% in April.

The fiscal deficit in April (which is always a surplus month) was minus $738 billion!

Yes, unfortunately, we are in a depression. But that fact is not at all reflected in stocks.

The total market capitalization of equities is now back to 140% of GDP. That level is at the ceiling of the ratio’s history, and it is purely due to unprecedented central bank actions. However, even that eye-popping level is understating things by a great deal because the ratio is calculated using a denominator based on previously reported GDP data, which has since crashed. But it is critical to note that money printing has its limitations even when governments are buying stocks.

Look at a chart comparing the S&P 500 vs. Japanese stocks (EWJ) and China’s shares (CNYA).

As you can see, the S&P 500 is up 34% in the past 5 years, even though the Fed hasn’t yet resorted to buying stocks. For now, it has instead bought everything else, including junk bonds. In contrast, the PBOC and BOJ have purchased everything, including stocks. In the case of Japan, its central bank has been buying equities since 2013, and the Communist/Dictatorship that controls China has commanded the PBOC to support the market since at least 2015. And yet, China’s shares are up a paltry 13%, while Japanese stocks have actually made zero progress throughout the past five years. Meanwhile, both of those country’s indexes are still 50% off of their all-time highs.

The truth is that central bank equity purchases do not at all guarantee there will be a roaring bull market, but they can support stocks even when an economy has become zombified.

Indeed, Mr. Powell is breaking records in his attempt to reflate the market. The balance sheet of the Federal Reserve, which is a proxy for the amount of debt monetization undertaken by the central bank, has skyrocketed by $3.2 trillion (from September 2019 through today) –that is a grand total of only eight months. This compares to a $3.7 trillion increase in Fed money printing from the start of the great recession (in December 2007), through 2018–which is a total of over ten years.

Nevertheless, the bluffing game is over for central banks, as they can no longer pretend there is a pathway to normalcy. Perhaps this is what the gold market has been sniffing out over the past 20 years. The precious metal has soared by over 500% since 2000, while the S&P 500 has merely doubled in the past two decades. The fact that gold has trounced the S&P proves that the faith in fiat currencies is collapsing, and the Wuhan virus has expedited this process.

The current illusion of stock market prosperity has three predicates. The first is that there will be a robust reopening of the economy as the virus dissipates in the context of imminent therapies and vaccines. The second is that inflation is far off in the future, which will enable the Fed to control the level of long-term interest rates much more easily. And, the third is that central banks will have no interest in letting up on the monetary throttle for a very long time. The second and third conditions are indeed far off in the future. However, whether or not we have a successful reopening of the economy depends entirely on the progression of the virus; and that verdict will be known in the very near future.

This begs the question: even though the predicted economic depression has arrived, where do markets go from here? We should all understand that in the longer term, a viable economy cannot be engendered through the process of diluting the purchasing power of a currency and falsifying asset prices. But what will happen to stocks while we wait for stagflation to run intractable? To help answer that question, we must monitor the number of new Wuhan virus infections and deaths.

The hope is for a viable treatment and/or a vaccine by the fall. On the subject of vaccines, it should be noted that Moderna Pharmaceutical made positive comments about finding an effective and safe vaccine on May 18, which sent the Dow up 900 points. However, it is very disturbing that Moderna only partially released results of an interim Phase 1 trial without any specific data on neutralizing antibody counts; and then conveniently announced a $1.34 billion stock offering the following day. If the company’s confidence in the vaccine was robust, then why not wait a few more weeks until the Phase 1 trial data could be fully released, with peer-reviewed status, and then make the secondary offering at a much higher price?

It also should be noted that the Wuhan virus is a coronavirus. The common cold is also a type of coronavirus, and so is SARS and MERS. These differ from the influenza virus, and there has never been a vaccine approved for any coronavirus…ever. In addition, vaccines normally take years to develop in order to ensure both their safety and efficacy. Nevertheless, President Trump wants one ready to disseminate in just a few months’ timeframe. The President’s “operation warp speed” is seeking 100 million vaccine doses by November. But a vaccine not only must not harm people, it also cannot give them a false sense of protection. Despite all this, Moderna has amazingly created its mRNA-1273 vaccine within just two months from the first breakout of this novel virus.

In any event, the economy is now in the reopening phase, and it is imperative to analyze the capacity levels within the leisure and hospitality sector to determine how consumers are responding to being let out of lockdown. For example, airlines breakeven at 75% capacity but are currently flying at just around 28%, with bookings plunging by 95%. According to the WSJ, after the 9/11 terrorist attacks, it took three years before airline capacity recovered; eight years before the average fare got back to what it was in 2000, and it was six years before airlines turned profitable once again. Looking at hotels, occupancy on the island of Oahu, for example, during the week ending April 6 was down 90%. Turning to the foodservice industry, regulators are requiring restaurants to open at between 25%-50% capacity; but they need around an 80% capacity level to breakeven.

Analyzing the rate of change with this data will be critical to determine how to correctly allocate the portfolio according to the appropriate economic cycle. Our IDEC Model currently has the portfolio positioned in 25% stocks, 15% gold, and 10% TIPs. Our 50% cash hoard is being used to generate income right now until we can determine the quality of the reopening. Much more will be known during June, and I will analyze how the 20 components of the IDEC Model react to it and then take the appropriate action.

 

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.”

 

 

Fed Now Owns All Markets

May 11, 2020

 Since the Great Recession hit in 2008, central banks have been in the business of keeping insolvent governments from defaulting through the process of pegging borrowing costs near zero. These money printers are now in the practice of propping up corporations–even those of the junk and zombie variety–by ensuring their cost of funds bears absolutely zero relationship to the credit quality of the issuer. To be clear, central banks have been falsifying public and now private bond prices to historic and monumental degrees just as the intensity of issuances and insolvency deepens.

And now, the Fed is bailing out bankrupt consumers with helicopter money in the form of enhanced and extended unemployment, grants through the Payroll Protection Plan and direct UBI to consumers through the CARES Act Recovery Rebates clause. All together there has been about $2.8 trillion worth of deficit spending so far.

But the bailouts won’t end there. Nancy Pelosi is now seeking an additional $1 trillion for states and cities in the next round of government “stimulus.” The Wuhan virus is now causing a Pension fund crisis. States’ revenues are plunging from an income and sales tax vacuum at the same time spending is surging. This is from Moody’s:

Moody’s investors service estimated that state and local pension funds had lost $1 trillion in the market sell-off that began in February. The exact damage is hard to determine, though, because pension funds do not issue quarterly reports. “You’re not going to see real data on the market crash until Christmas,” said Girard Miller, a former chief investment officer of the Orange County, Calif., pension fund and a former member of the Governmental Accounting Standards Board.

According to the NY Times, as of 2018 state pension funds had on average invested 74 percent of their money in risky assets; including stocks, private equities, hedge funds and commodities. That was up from 69 percent in 2010, after the 2008 crash, and from 61 percent in 2001. Of course, going out on the risk curve to overweight stocks in a portfolio–which are in a bubble–simply because bonds are in an even bigger bubble, carries huge consequences.

This is what Yahoo Finance has to say on the subject of bankrupt pension funds:  Declines in the financial markets may have cost the funds as much as $1 trillion in assets, or about 25% of their total, according to Moody’s Investors Service. That would bring the aggregate funding ratio—the value of assets divided by actuarial value of liabilities—from 52% based on the last report by the Census Bureau down to perhaps 37%. But it’s not aggregate numbers or official reports that will trigger a crisis. It’s the big {state} funds in the worst shape. Connecticut could be looking at a 28% funded percentage, Kentucky 25%, New Jersey 24% and Illinois 20%.

This is what my friend John Rubino of Dollar Collapse.com has to say about the Pension crisis:

“Letting Illinois go bankrupt would send the muni bond market into a “who’s next?” seizure, which would quickly spread to corporate bonds, equities, and real estate, cratering the U.S. and then the global economy. At least that’s the worst-case scenario economists will present to policymakers.”

“With no stomach for presiding over the end of the world during an election year, Washington will cave, agreeing to whatever governors demand. And so the grossest mismanagement in the history of U.S. state and city government will be swept under the rug – or more accurately will be swept onto taxpayer balance sheets along with that of all the other sectors that are – surprise! – too big to fail.”

Meanwhile, the resulting multi-trillion-dollar addition to the national debt will hasten the fiery end of the fiat currency/fractional reserve banking/unlimited-government-debt world. One can only hope that future historians will get the story right while the perps are still alive to answer for their sins.

The Fed is trying to once again re-inflate asset bubbles by offering free money and buying all kinds of debt. Hence, new borrowings are surging as Mr. Powell provides a toxic dump site for banks to unload their waste, just as he is providing a lifeline for consumers and businesses to take on more liabilities. Commercial bank lending in the U.S. increased by 17.0% year-over-year as of April 15th, according to the Federal Reserve. And, Household debt rose to $14.3 trillion through the first three months of 2020, which is $1.6 trillion greater than its peak at the height of the Great Recession.

In other words, government is once again bailing out an overleveraged economy by encouraging it to take on even more debt. Only this go around lending standards have totally evaporated, and there is no pretense of vetting the loans. Lenders are completely cognizant that most of the borrowers are either currently unemployed or have no revenue. Most of them can’t and won’t pay back the money, and the bill will end up on the taxpayers’ balance sheets. But since the tax base has been destroyed, it will all need to be monetized by the Fed. The amount of new money printing has to also cover the run rate of a 25% increase in corporate debt. Then there is the $3 trillion of new Treasury borrowings in the second quarter alone, which will accreditive at a record pace to the $25 trillion National Debt! Indeed, that Q2 borrowing will be more than 2x greater than entire deficit for all of 2009.

This is the only explanation behind the existence of one Narayana Kocherlakota. Here is what the former President of the Minneapolis Fed said while he was pontificating about negative interest rates in a recent interview on the MSFM: the presence of physical cash in society is restraining the Fed’s hands from seeking higher inflation much like a gold standard tied its hands prior to 1971. In other words, the Fed couldn’t easily expand the money supply when dollars were linked to gold; and neither can it now easily impose negative interest rates on consumers while physical money is in existence.

Adding to this stagflation crisis will soon be the Fed’s ability to purchase stocks. This is what Former Fed Chair Janet Yellen has to say on the subject: “It would be a substantial change to give the Federal Reserve the ability to buy stocks,” Yellen told CNBC. “I frankly don’t think it’s necessary at this point…but longer term it wouldn’t be a bad thing for Congress to reconsider the powers that the Fed has with respect to assets it can own.”

For now, the primary concern is disinflation and depression. But that should morph into stagflation later this year as debt levels surge alongside massive and unprecedented global central bank monetization. As far as the stock market is concerned, in the immediate term there is a lot of hope about a V-shaped recovery with the global economy opening up the virus dissipating. However, come June and July, the risks to the economy and markets increase significantly concomitant with a failed reopening:

  • Businesses experience only 25%-50% of the revenue received prior to closing the economy and cannot rehire their furloughed workers
  • The Wuhan virus partially rebounds as consumers let down their guard and become more socially interactive
  • The 2-month requirement to keep employees under the PPP expires resulting in a second round of mass layoffs
  • Enhanced Unemployment keeps potential re-hires safely on the sidelines and making more money doing so until the program expires in August

We will continue to monitor the 20-components of the Inflation/Deflation and Economic Cycle Model S.M. to understand if the above scenario is becoming manifest and take the necessary steps in our portfolio to protect from any such mid-summer decline.

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.”

 

Money Printing is the New Mother’s Milk of Stocks

May 4, 2020

My friend Larry Kudlow always says that Profits are the mother’s milk of stocks. That used to be true when we had a real economy. But sadly, that is no longer factual because we now have a global equity market that is totally controlled by central banks.  To prove this point, let’s look at the last few years of earnings. During the year 2018, the EPS growth for the S&P 500 was 20%; yet the S&P 500 Index was down 7% over that same time-frame.

Conversely, during 2019, the S&P 500 EPS growth was a dismal 1%; yet the Index surged by nearly 30%. What could possibly account for such a huge divergence between EPS growth and market performance? We need only to view Fed actions for the simple answer: it was the degree to which our central bank was willing to falsify asset prices.

During 2018, the Fed raised the overnight bank lending rate 4x and by a total of 100bps, and at the same time, it increased the amount of its Quantitative Tightening Program from $10 billion per month to $60 billion per month. In sharp contrast, Mr. Powell indicated one month before 2019 began that the Fed would stop raising interest rates; and by early ’19 he indicated that the pace of balance sheet runoff was flexible and its termination was in sight. The Fed then announced in July of ’19 that it would cease the selling of its assets come August. Most importantly, by the end of the summer, the Fed did a complete 180-degree pivot–it was once gain cutting interest rates and re-engaged with Quantitative Easing. The Fed ended up cutting interest rates by 75bps during 2019.

Hence, 2018 was a terrible year for equities despite surging EPS growth. However, 2019 turned out great for stock investors despite having virtually zero earnings expansion.

Turning to 2020, the S&P 500 EPS growth rate is projected by FactSet to decline a whopping 15.8% during Q2, and GDP is tracking to shrink by around 25-30% at a seasonally adjusted annualized rate. Adding to the misery, the unemployment rate is projected to reach a depressionary 17%. Nevertheless, the S&P 500 is down a very ordinary and pedestrian 10% YTD. How did the Fed pull off this magic trick yet again? Take a look at what its balance sheet has done so far this year.

Mr. Powell has committed to buying everything at this point except stocks. This includes junk bonds, issuing primary loans to businesses, and purchasing corporate bond ETFs. It has so far printed nearly $2.5 trillion in less than two months just to boost equities back to the thermosphere.

Because of these actions, the stock market is far more expensive today than it was prior to the start of the Wuhan virus crisis. This is because the ratio of total market cap to GDP has increased. Simply stated, the numerator is down just slightly while the denominator has crashed. Equity market capitalization is reported to be 138% of GDP as of this writing. This is down from the record high of 150% reached at the start of this year. Nevertheless, the current ratio is still extremely high, historically speaking. However, that figure is based on antiquated GDP data. As the new data is reported for Q2, expect the ratio to soar.

There are now over 30 million newly unemployed Americans who have lost their jobs in the past six weeks. We have now completely wiped out the 22.7 million new jobs created since the Great Recession ended in June 2009 plus another near 8 million. The damage to US balance sheets is immense, and that debt is accretive to the $71 trillion already oppressing growth. Tremendous psychological injuries have occurred to consumers and corporations, as they are forced to take on new debt due to a dearth of liquidity. For example, listed US companies took on an additional over $300 billion in new debt since March alone. At that pace of corporate debt accumulation—which was already at an all-time high both nominally and in terms of GDP pre-virus–will surge by nearly 25% in just one single year. But what else would you expect when the Fed is promoting more borrowing by providing a huge fat bid for businesses to sell all the debt they need…and more.

The stock market has already priced in a “V” shaped recovery in the economy, but the rebound will most likely be of the insipid variety. The question is will stocks care even if economic growth doesn’t rebound? It is my view that the economy and EPS will certainly not return to pre-Wuhan virus levels for a very long time.

Therefore, the answer to how stocks react to a sluggish economy even after the lockdowns are lifted can be found within the confines of D.C. Will the continued panoply of negative earnings news and economic data cause the Federal government to announce even more fiscal stimulus programs to bail out states and municipalities? And, will the Fed continue to monetize all that debt? I believe the answer to those questions is a resounding yes, but only after we see another crash in asset prices that results from a negative reaction to a failed reopening of the global economy. This is the salient risk during the mid-May through July time-frame. A failed opening can be defined as one in which consumers don’t return to normal activities because of balance sheet, unemployment, and wealth effect issues. And, the virus makes a comeback in the context where there is no effective treatment or vaccine yet available.

One sentence from the Fed’s meeting of April 29, which produced an unusually-horrific statement even for the FOMC, “The Committee expects to maintain this target range (of zero percent interest rates) until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”.  In other words, the Fed will be offering free money until the 30 million displaced workers find a job, and inflation runs well above its 2% target on its core PCE favorite metric, which removes all prices that go up—interpretation; expect ZIRP for another decade.

We continue to hold 20% gold-related investments, 15% invested in defense, healthcare, and clean energy, and 10% TIPS. Passive Index investing has become a sure way to lower your standard of living, and therefore, we will continue to actively trade the portfolio with a continued vigilance on the cyclical dynamics of growth/recession & inflation/deflation. Is your wealth manager monitoring these changes? Or are they just telling you to hang on to their brand of an index fund that is blindly and passively heading towards the slaughterhouse yet again?

 

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.”

Inflationary and Insolvency Implosion of the Bond Market

April 13, 2020

We are all praying for the Wuhan virus to die. But there is something the virus can actually “cure” itself: deflation. I put the word cure in quotes because it’s not an actual issue in reality. Low inflation and disinflation are actually great conditions to enjoy and help an economy thrive. Increasing the purchasing power of consumers is something that should be cherished and targeted goal. Increases in productivity, along with a strong currency, raises your standard of living. In sharp contrast, Central Banks think any rate of inflation that is less than 2% is a deadly economic disease that must be vanquished faster than the Wuhan virus.

Many Austrian economists believed the money printing that occurred during the Great Recession of 2008 would engender massive inflation. That indeed turned out to be the case; but only with asset price inflation. The Fed’s balance sheet expansion left Consumer Price Inflation (CPI) far behind. This is because the Fed bailed out banks, not consumers. Mr. Bernanke printed trillions of new dollars to purchase bad assets from banks’ balance sheets. Thus, it gave banks credit in exchange for those assets; and that base money was primarily parked back at the Federal Reserve. In other words, there was a huge increase in Fed credit but not in loans that would have led to an increase in the broader monetary aggregates—the kind of money supply increase that leads to rising CPI. What money that was lent out arrived directly to Wall Street by the process of banks selling MBS, ABS and other troubles assets and then using that credit to buy more bonds and stocks. The rich got richer and the lower classes were, for the most part, left out in a big way.

However, this current virus-induced depression is being fought by central banks using some different tactics. Of course, the Fed—along with every other central bank in the developed world and beyond—is buying all the same bad assets from banks that existed during the Great Recession. But, this time around it is also purchasing corporate debt issued in the primary market, purchasing corporate bond ETFs, and making new loans directly to corporations and businesses. Most importantly, the Fed is also working directly hand and hand with the Treasury to send 100’s of billions in cash payments directly to consumers–A.KA. Helicopter Money. Therefore, Central banks aren’t just bailing out Wall Street like they did back in 2008; but are now directly increasing the broader monetary aggregates of M1, M2 and M3.

Hence, the Wuhan virus is going to solve the Fed’s inflation deficiencies by paving the way towards its ultimate destiny, which is where all central banks have wanted to end up for a long time, using Helicopter money to send both asset prices and CPI much higher.

Of course, pushing prices higher in the context of a failing economy is no panacea to say the least. The Depression of 2020 will cause an even larger chasm between stock prices and the economy than what existed prior to the outbreak.

Abetting this stagflation will be the loss of confidence in global central banks to maintain the purchasing power of their paper currencies.

 

Much More Fiat Paper Will Be Needed and For a Very Long Time

Once central banks abrogate markets, and indeed become the market, they can never fully step away. The ECB and BOJ never were able to lift off zero percent interest rates once arriving at that level in the aftermath of the Great Recession; and the BOJ could never even exit QE. The ECB did briefly end QE at the end of 2018 but then had to quickly re-enter that dirty business in September of 2019. The Fed ended QE in October of 2014 and was able to reach 2.5% on FFR. However, by August and Sept of 2019 it had to begin cutting rates and went back into QE because of the soaring borrowing costs found in the REPO market. Please note that this trip back into QE and towards ZIRP was before the COVID-19 virus existed. What makes anyone think central banks can ever exit the capital and money markets? They cannot.

Shortly before the outbreak, the WSJ reported that 40% of all listed companies had not made any money in the prior 12 months. And, the Bank of International Settlements stated that 12% of corporations in the developed world needed to tap the junk bond market just to pay interest on existing obligations in order to stay afloat. According to the BLS, During the Great Recession the lasted from 12/07-06/09, a total of 19 months in duration, the economy lost 7.3 million jobs. The Wuhan virus that pricked the everything bubble has caused a total of 16.8 million jobs to be lost in just the last 3 weeks. What condition do you think these same Zombie corporation are in now that the global economy has been shut down and borrowing costs for many businesses have spiked some 10 percentage points above where they were pre-crisis?

The truth is Central bank balance sheets can never be unwound and will only grow inexorably from here. Investors need to ignore central bank bluster about returning to normalcy. For example, Jerome Powell predicted that the Fed’s balance sheet would retreat to around $2 trillion by this time. In sharp contrast, the value of Fed assets has skyrocketed to $6 trillion already and is on its way to $10 trillion by year’s end—and then far beyond from there. These money printers can no longer pretend this is only a temporary expansion of the money supply that can be quickly and permanently reversed. That game is over and with it should terminate the confidence in fiat paper currencies to hold value.

Hence, double digit CPI and intractable stagflation is on the way. This will lead to the real crash; an inflationary and insolvency implosion of the bond market where there is nothing governments can do to mitigate the crisis. For, if they stop printing money the record amount of debt outstanding crashes in price from the thermosphere due to the exit of its primary buyer. Or, central banks can continue to print yet more money in an attempt to keep soaring interest rates under control. But, creating more inflation will only cause the private market to push the sell button faster as short sellers pile on top of plunging fixed income prices and skyrocketing yields. The Wuhan virus has simply hit the FF button on when this pernicious crisis appears; but is was surely on its way regardless. Prepare now while you still have some time left before the real crash begins.

“V” Shaped Recovery Will Need Viagra

My clients have known for a long time that the nucleus of the next crisis will be in the over-leveraged corporate bond market.

This notion was confirmed recently in an article from the WSJ: companies that borrow in the junk loan market are now in a far weaker condition financially than they were prior to the Great Recession. Borrowers with loans Moody’s Investors Service rated with the worst rating in the junk-debt category—B3 or lower—made up 38% of the market in July compared with 22% in 2008. Bank of America calculates that about 29% of outstanding leveraged loans will likely default in the next credit recession.

Again, from the WSJ: CLOs are highly susceptible because they use borrowed money to buy leveraged loans, boosting the yield, and the risk, of the investments. CLO managers issue bonds to buy bundles of leveraged loans, then use cash flow from the loans to pay interest and principal on the CLO bonds, pocketing the difference. When downgrades and defaults mount, CLO managers stop making payments on their most junior bonds, prices plummet and the market for new CLOs shuts down.

The soaring amount of distressed debt is simply reflecting the economic plunge taking place right now during. For examples, the Empire State Manufacturing Survey saw a record decline to minus 21.5, the Philly Fed survey saw new orders plummet to a record low as the overall index fell to minus 12.8, Initial Jobless Claims are a record high of 3.3 million, and the Markit Services PMI registering a dismal 39.1, whereas 49.9 would be recessionary. These data points all indicate the depression has begun. How long this lasts depends on the Wuhan-virus curve.

But the primary cause of this economic crisis was not the Virus. The virus was merely a catalyst that revealed the economic rot underneath. Namely, the global manipulation of interest rates to 0% that engendered a record pile of debt held by corporations, sovereign nations and households. This in turn sent asset bubbles to the thermosphere and set in position corporate bonds to implode once the economy contracted or inflation began to run intractable.

I’ve said many times before that the ersatz economic growth and bull market would meet an ill-fated reality once the bond bubble imploded—this is now a fact. The virus has caused the destruction of corporate bonds and it is now infecting mortgage bonds, municipal debt, CLOs and a myriad of other asset backed securities.

Therefore, we are not simply dealing with a self-induced and temporary recession from which the government can extricate at will. Rather, it has now fully become an economic crisis based on insolvency of public and private sectors and the death of zombie businesses that had been living off the specter of free money forever.

CNBS has also become infected by the overcrowding of the V shaped recovery clowns. These shills have now fully wiped out your retirement for the 3rd time since 2000; and they fail to realize the real crash is still ahead because its genesis is being concocted in D.C. once again at this very moment. Washington’s reflex action is to bailout an insolvent economy by borrowing and printing more money, while suppressing interest rates further into record-low territory and for an even greater duration. Therefore, the set-up now is for an inflationary collapse of the bond market from which government will be impotent to stop.

Governments should have been saving for a rainy day instead of starting out over-indebted. However, we entered into this crisis with trillion-dollar deficits, which are 5% of GDP. Now, we are facing deficits that are $4 trillion (20% of GDP)

The last Treasury bailout was “only” $700 billion and this one is $2.2 trillion to start. And, of course, the Fed is back in unlimited QE. But this time it has extended its asset buying scheme to include corporate bond ETFs and is even making primary loans to corporations! Mr. Powell is trying to keep BBB debt, which is barely investment grade, from falling into the junk category. Our central bank is taking on extreme default risk that will be backed by the Treasury. Hence, the total bailout package is at least $6 trillion to start and will probably grow from there.

On the other end of this bailout we will find that nations, corporations and individuals will be even more saturated in debt and at the same time will have experienced many months of diminished income. In other words, the private and public sector balance sheets will be in need a massive repair. On top of this we will have an extremely negative wealth effect in place coming from plunging stock prices.

Therefore, once the lock-down ends those businesses that survived may not be able to re-hire all of its former employees and certainly will not be in a position to go on a capex spending spree. Nor will they be in a position to buy back their stock. That is because D.C. won’t allow it to happen again and neither will the borrowing lines of credit by open to resume a record-breaking corporate buy-back scheme that just finished destroying corporate balance sheets.

In addition, don’t look for another global bailout from China, which was responsible for a third of global growth after the Great Recession ended in 2009. Beijing was in the vanguard of leading the world out of that economic malaise by taking on massive leverage to build the largest fixed asset bubble the world has ever seen. That cannot happen again.

Servicing all this debt will also remove a tremendous amount of capital away from the free market. And, it should force the Fed and other central banks to become permanent participants in the buying of all sorts of public and private debt.

At the onset of the 2008 Great Recession, government broke the mold on how much money it could create and what it could spend it on. Now, the Wuhan Virus has paved the way to helicopter money, which has now arrived. After all, the Fed knows there won’t be a solvent pension plan in America if it doesn’t massively inflate asset prices…and fast.

Therefore, another prediction of mine is about to come true: stagflation the likes of which we have never seen before is on the way. Expect a very slow grind higher in the global economy once the virus is under control. However, there should be a steeper incline in asset prices as the world’s central banks work overtime on printing money in order to finance the massive increase in government expenditures and to put in place Universal Basic Income. Also, expect the gap between asset prices and the underlying economy to grow even greater than ever before.

Enormous volatility between inflation and deflation cycles have become the norm—just as predicted. And that condition will only grow more intense over time. Passive management is indeed a death sentence for your retirement and something you will never find here at PPS.

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.”

 

 

Debt be Damned

The U.S. National Debt is about to surge like never before, along with the rest of the entire planet’s gigantic pile of sovereign IOUs. America started with a $23.5 trillion debt before the Wuhan virus outbreak, with annual deficits running over a $1 trillion; and projected to be at least that amount for the next dozen years. But then, the stock market and economy crashed due to the catalyst of the COVID-19 pandemic, which pricked the massive bubble in junk bonds and equities that I have been warning about for years.

In addition to the automatic stabilizers that kick in during a recession, like unemployment insurance and food stamps, the Treasury is now buying commercial paper, suspending interest payments on student loans, and writing checks to small businesses. There are also various other bailouts and stimulus packages in the works; the IRS is allowing taxpayers a deferment for three months of up to $300 billion. Also, the government will soon be sending checks to nearly every American, the proposal is for at least $1,000 for each adult and $500 per child, per month—around $500 billion in total. Helicopter money is now coming, and both parties embrace it with alacrity. The total amount of stimulus proposed so far was reported by Bloomberg to be $1.3 trillion this year alone.

A global depression is now here, but the question is for how long. A small taste of the miserable data that is to come came from the Empire State Manufacturing Survey for the month of March. The index plummeted by the most in history to an incredible minus 21.5. Since the survey was taken, we have seen entire counties shut down, U.S. schools and corporations shuttered, and at least 50 major retailers are shutting their doors, and that number is growing daily. The retail sector employs a total of 15.7 million people. There will be about 3.5 million jobs that are predicted to be lost if this economic slowdown turns out to be like the average since WWII. However, it is clear this economic contraction will be nothing like the typical recession. Indeed, when was the last time a great portion of the world’s population was told to shelter in place. Around 67 million Americans think they will have trouble paying their credit card bills due to the coronavirus, according to WalletHub. And, nearly 80% of Americans are living paycheck to paycheck—we really need this virus to dissipate quickly, but the probability of that outcome is impossible to know.

To give you further insight as to how bad the unemployment numbers could get, let’s look at where the jobs are now. In the U.S., most of the jobs created since the Great Recession ended back in 2009 have been in the Leisure and Hospitality sectors. According to the BLS, there are nearly 17 million people employed in those two sectors alone. But now, a great deal of those doors have been closed. Many of these people are 1099 employees and have no access to unemployment insurance. Those that are W-2 employees will see a huge reduction of their income and may not see an immediate request to be rehired once the economy begins to recover.

This is because there will be a serious degradation of consumer and business’ balance sheets. Coming into this crisis, there was a record amount of household debt and a record amount of corporate debt both in nominal terms and as a percentage of GDP. There is now a significant shock to the incomes of the public and private sectors, while all the existing debt remains and new debt is being accumulated. Government assistance can help, but it will not make people 100% whole.

But now the major averages have crashed by over 30%, and the Russell 2000 is down just shy of 40% in one month. Not only are all of the gains made last year now gone but the market has given back all the gains made since January 2017. As an aside, I was wondering how all those C-suite geniuses feel that levered up their corporations in record proportions to buy back stocks at record highs? I also wonder what public or private pension fund will be solvent since there has been no money made in the last three years, and the Benchmark Treasury yield is 1%? These retirement funds need to make at least 7-8% each year to come close to satisfying their obligations.

To combat these issues, global governments are reacting with massive fiscal and monetary stimulus. We already mentioned what the U.S. Treasury is doing. Also, the Fed cut rates back to zero, is buying commercial paper, openly admitted to launching Q.E. 5, and massively expanded its REPO facility—which it was supposed to draw down to zero beginning in April. In sharp contrast, Mr. Powell’s balance sheet has now exploded to an all-time high of $4.7 trillion. The Fed may also start buying corporate debt very soon and announced unlimited Q.E. on Monday, March 23rd.

Wall Street now needs a 50% increase in stocks just to get back to where it was a month ago. That’s how the math works when you are down about 35%.

At the end of this crisis, we will have an even bigger mountain of debt, interest rates than are even further into the twilight zone and the seeds of runaway inflation that have been fertilized with a gigantic pile of poop from a massive herd of government-fattened brontosauruses.  That is the real crash still coming, which will occur after the market soars back to record highs on unprecedented money printing, interest rate manipulation, and debt-fueled stimuli. To be clear, the inflationary/insolvency crash of the bond market is dead ahead.

In the interim, we should continue to see wild swings in asset prices as the market struggles to reconcile with a temporary, yet brutal, depression that is being offset by Helicopter money. PPS models these cycles of inflation/deflation and growth/recession. That is your best chance to increase your standard of living, even during the increasing occasions when Wall Street burns.

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.”

Fed’s 3rd Mandate: Expanding Asset Bubbles

March 9, 2020

Wall Street hit a new all-time high on February 20th. It was supposed to be smooth sailing from there, riding along the global liquidity wave. But then, that wave crashed into what turned out to be the fastest correction from a new high in the history of the US stock market. Even though the fall was mild in comparison to the record-breaking bull run of the past few years, it was enough to frighten central planners to the core. Hence, we had further confirmation on Tuesday, March 3rd of what we already knew: our central bank has been fully corrupted and co-opted by Wall Street.

The Fed lowered rates by 50bps in an emergency meeting, even though its regularly scheduled meeting was just two weeks away–maybe Trump will now give Powell the Presidential Medal of Freedom. But someone should have informed the White House and the Fed that the 4th rate cut in a rate-cutting cycle has nearly always led to market panics. But to be clear, the only reason the Fed cut rates is that the stock market suffered a brief correction. It wasn’t a bear market or a recession. It wasn’t even runaway deflation or an outright recession scare, …but just an 8% fall in stock prices from an all-time bubble high at the time of its decision.

There can no longer be any doubt that the Fed has become a slave to markets. After years of manipulating interest rates lower, it now must do everything in its power to make sure borrowing costs never rise, asset prices never go down, and the massive pile of US debt (330% of GDP) never sees a recession. Otherwise, the default tsunami will engender the greater depression. However, central banks can’t hold off a recession forever, and they have ensured its inevitable arrival will lead to nothing short of perdition.

The global junk bond market started to freeze in late February, just like it did back in December 2018, which caused the major averages to plunge by 20-30% at that time–this is what Powell was pooping his pants about.

Nevertheless, the Fed now only has four rate cuts left before running out of ammo. Lowering borrowing costs isn’t a vaccine, but the Fed is simply panicked to keep stock prices from crashing any further.

The Coronavirus, it is an exogenous market event, not an endogenous market event. In other words, the selloff in stocks was not generated from a deteriorating macroeconomic function, such as spiking inflation, recession, or a full-blown liquidity crisis. Yet, it is now becoming one. Rate cuts do not ameliorate much of the effects of the disease. But investors should expect further rate cuts and additional QE in an effort to prop up markets.

So, where is all this artificial manipulation of interest rates, money supply, and asset prices leading us? I believe the penultimate liquidity wave is now upon us. Investors can expect Central Banks to print money like never before and fiscal policies to expand deficits in record proportions to combat the effects of the virus. But it won’t work. Just like every other attempt to provide a viable economy has failed since the Great Recession. This is because the equity and bond markets have become addicted to each artificial stimulus program. Government remedies of lowering rates and money printing are merely palliative in nature. That is, alleviating the symptoms while exacerbating the underlying economic rot, which consists of excessive debt and intractable asset bubbles. But now this second-to-last impulse from the Fed should land us back to a 0% Fed Funds Rate and in permanent QE just like the rest of the world.

Then, after another relatively brief period of ersatz market and economic growth, another cyclical plunge in economic growth and asset prices should ensue. The big difference this time around will be that global central banks will already be offering money for free and in great quantities—but primarily for banks; not for you and I.

Therefore, in response to the next crisis, central banks (in full cooperation with fiscal authorities) will be forced to pull the pin on the ultimate inflation grenade: UBI, MMT, and Helicopter money directly to the people, which should produce a period of intense stagflation globally such as never before seen. If you ever had any doubt about the stagflationary disaster that awaits this world, check out what the Bank Of Japan did on Monday. It purchased over a billion dollars’ worth of ETFs on that one day alone!

The key point here is that during a bond market crisis caused by inflation, global central banks will be completely impotent to do anything about it.

The liberal maniac central planners that run the world have concurrently embraced the vapid and specious philosophy of usurping markets in favor of price-fixing. Sadly, they no longer have much of a choice because bubbles have been forced up to the thermosphere and, therefore, a mild and truncated recession has become impossible. Instead, a protracted depression has become inevitable.

The economic data has already become rancid in China—the epicenter of COVID-19. China’s official Purchasing Managers’ Index fell to 35.7 in February from 50.0 in January. This was the greatest plunge on record. China’s services sector saw its worst month on record in February as well, the Caixin/Markit services Purchasing Managers’ Index plunged to 26.5 in February, from 51.8 in January. And passenger car sales fell 80%.

Investors should expect the global economic news flow in the next few months—at least—to head towards what we are seeing now in China. And S&P 500 earnings growth, which was already zero coming into the virus, to be sharply negative in Q2. Indeed, passive management has become a death sentence for your standard of living.

Permanently Addicted to Zero

February 25th 2020

In Fed Chair Jerome Powell’s appearance before Congress on February 11th, formerly known as The Humphrey-Hawkins testimony, he asserted that the U.S. economy was, “In a very good place” and “There’s nothing about this expansion that is unstable or unsustainable.” But compare Powell’s sophomoric declaration to what Charlie Munger, Vice-Chairman of Berkshire Hathaway and Warren Buffett’s longtime right-hand-man, had to say about the market and the economy, “I think there are lots of troubles coming…there’s too much-wretched excess.”

Mr. Powell’s comments rival in ignorance with that of former Fed Chair Bernanke’s claim that the sub-prime mort crisis was contained. That is until the Great Recession wiped out 50% of stock valuations and over 30% of the real estate market. And of course, don’t forget about Fed Chairs Yellen and Powell’s contention that their Quantitative Tightening program would be like watching paint dry and run harmlessly in the background on autopilot. At least that was their belief until the junk bond market disintegrated and stocks went into freefall in the fall of 2018. Therefore, it should not be a surprise at all that the Fed doesn’t recognize the greatest financial bubble in history: the worldwide bond market mania. Perhaps this is because central banks created it in the first place and therefore didn’t want to take ownership of it.

Mr. Powell also averred this gem in his latest testimony, “Low rates are not really a choice anymore; they are a fact of reality.” Credit must be given here for finally admitting the truth—albeit what was probably a slip of the tongue. The Fed is tacitly stating that keeping money at a virtually-free rate is now a mandatory condition for perpetuating asset bubbles and preventing mass defaults on the record-breaking level of corporate debt.

So, how can hoping interest rates never rise back to normal be a condition that is either stable or sustainable? Jay Powell must understand this is an untenable position to take. And, how stable can interest really be when the budget deficit for the first four months of fiscal 2020 has jumped to $389.2 billion? That is an increase of 25% over last year. The National Debt is now an incredible $23.3 trillion; it was “just” $9.1 trillion at the end of 2007. Total household debt increased by $193 billion in Q4 2019 and is now $14.15 trillion. This marks 22 consecutive quarterly increases, with total household debt now $1.5 trillion higher than 2007. That’s the good news. Corporate debt has exploded by over 52% since the Great Recession and is at a record percentage of GDP. Total U.S. debt now stands at about 330% of GDP. This ratio was 150% of the economy prior to severing the dollar’s tether to gold in 1971.

And, the total market capitalization of stocks as a percentage of GDP has soared by 50 percentage points since June 2007–another all-time record high. But what else would you expect when returns on cash are losing value when subtracting inflation.

The only way these debt and asset bubbles are manageable is if interest rates are artificially held down close to zero percent by central banks. Otherwise, the economy will collapse and cause the GDP denominator in these ratios to plunge, just as all of the debt in the numerator remains. In other words, these debt ratios, which are already daunting, will become absolutely nightmarish.

An economy that must lug along this tremendous debt burden encumbers its ability to grow. The Fed believes the only way to keep the credit markets open and keep the economy growing is by constantly lowering borrowing costs. However, it is now running out of room to lower interest rates—it only has 1.5% before it returns to zero. And, most of the major central banks around the world are already at zero. Therefore, without another round of massive fiscal stimulus, like we saw with Trump’s Tax Cuts and Jobs Act of 2017, the prospects of continuing to hold a recession in abeyance much longer are dwindling by the day. This is especially true given the appetite and ability to significantly cut taxes or increase spending–while annual deficits are already north of $1 trillion (5% of GDP)–is greatly attenuated.

Somehow Mr. Powell finds solace in these scary facts. He doesn’t understand that this bond bubble is international, and its bursting will wreak havoc across the globe. For example, the insolvent nation of Greece, which back in 2012 had its 10-year bond yielding a whopping 45%, has now seen its benchmark yield retreat to an all-time low of just 1% today. In fact, Greece is now issuing 13-week debt with a negative yield. This is especially concerning given that its Debt/GDP ratio has increased from 159% back in 2012, to 181% today. Mr. Powell should tremble while wondering what Greek bond yields would yield if the ECB ended Q.E. and stopped buying its debt. He’s unconcerned because the ECB, BOJ, and PBOC are all caught in the same trammel of ensuring money is free forever.

I’ll close with this piece of wisdom from Robert Kaplan, President of the Dallas Fed, in a paper he wrote about one year ago warning about the excesses in the corporate and government bond market:

“An elevated level of corporate debt, along with the high level of U.S. government debt, is likely to mean that the U.S. economy is much more interest-rate sensitive than it has been historically.”

I would have graded Mr. Kaplan’s paper with a “C” for using the word “likely” instead of “definitely” when referring to the economy’s addiction to low rates. However, ultimately, he gets an F- for not recognizing that it is, in fact, the fault of central bankers for getting caught in a trap of their own creation.

This is yet another admission by the Fed that interest rates can never be allowed to increase. Our central bank has now announced it is on hold forever. Therefore, it is not much longer before investors lose faith in fiat currencies, maintaining their value. And that is when the real crash will begin because a central can’t fix an inflation problem by promising to create more inflation.

In the meantime, each day that goes by, the madness grows larger, and the inevitable reconciliation process will become all the more severe.

 

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.”

 

Coronavirus Cure: Print More Money

February 10, 2020

A few days ago, the market was crashing on Coronavirus fears. But recently, the market has soared back based upon the hopes of a vaccine and some better than expected economic data in the US. The ADP January employment report showed that a net 291k jobs were created, and the ISM Services Index came in at a healthy 55.5. However, a couple of good data points doesn’t change the fact that US economic growth has contracted back to 2% trend growth and will absolutely become more anemic–at least in the short-term. This is because the measures needed to contain the virus are also GDP killers. I have no clue if the virus will become a pandemic or if it will fade away like the SARS and MERS viruses–without long-term economic damage. But, for the stock market to remain at record high valuations, nearly everything has to go perfectly. That is, the Fed has to keep pumping in money, and EPS growth must rebound sharply.

The government reported that real GDP increased by 2.1% in Q4 2018, and nominal GDP increased by 3.6%. Therefore, the BEA wants us to believe that inflation was running at an annual rate of just 1.5% in Q4 of last year. That sleight of hand caused the number to appear respectable. However, going forward, we see many corporations, some of the biggest in the world, warning about a big hit to earnings because of the ancillary effects of the virus-likee closing down many major cities in China. For example, the mighty Tesla stock dropped 21% intraday on February 5 on the announcement of Model 3 delivery delays in China. This is happening in the context of S&P 500 EPS growth that had already flatlined before the outbreak of the virus.

Looking forward to Q2, which is less than two months away, the market will have to deal with the reporting of some really bad economic data and earnings that will be much weaker than Q1. But not only this, it will also have to deal with the Fed’s withdrawal from the REPO market and QE 4. This means the most overvalued stock market in history is going to have to deal with anemic data and a crimp in the monetary hose at the same time.

The most important point is that stocks care much more about liquidity than economic data. With that said, the removal of the Fed’s latest monetary supports should, for a while at least, take a good chunk of air out of this equity bubble. Of course, another market crash will cause Fed Chair Powell to step back in to support stocks, but that will be in response to the chaos, and significant damage has been done. The sad truth is that central bank liquidity has become the paramount functioning mechanism for markets; 2018 proved this beyond a doubt.

In that year, both the ECB and Fed tried to exit—at least to a certain degree–their respective liquidity supports for the market and economy. ECB Chair Mario Draghi said in the summer of 2018:

“We anticipate that after September 2018…we will reduce the monthly pace of the net asset purchases to €15 billion until the end of December 2018. “his feeling at the time was that the QE program had succeeded in its aim of putting inflation on target and fixed Europe’s economy and markets.

In December of 2018, The European Central Bank decided to formally end its 2.6 trillion euro ($2.95 trillion) bond purchase scheme. And, as we all know, the Fed was raising rates and selling off its balance sheet throughout 2018. But, by the end of the year, the liquidity in the junk bond market completely evaporated, and the US equity markets went into freefall. The European SPDR ETF lost nearly 25% during 2018, which will go down in history as the year central banks attempted to normalize monetary policies but failed miserably.

By the time the calendar flipped to 2019, the Fed informed investors that rate hikes were over and, incredibly for most on Wall Street, the march back to free money was in store. By August, the Fed was again cutting rates and then launched QE4 ( $60b per month of bond purchase on October 11). And, at the September 12, 2019 meeting, the Governing Council of the ECB decreased interest rates by ten basis points to -0.5% and restarted an asset purchase program of €20 billion per month. Central banks’ sojourn with normalization didn’t get far off the ground at all. In fact, the Bank of Japan didn’t even attempt it; and they are all now trapped into the never-ending monetary manipulation of markets.

Of course, we recently had another growth scare coming from China’s Wuhan province. The Coronavirus caused Beijing to close down its markets for several days, and when they reopened, the plunge was over 7% in one day. This brought the maniac money printers back in full force. President Xi announced a huge stimulus package to stop the carnage. The People’s Bank of China injected a total of 1.7 trillion yuan ($242 billion) through reverse repos on February 3rd and 4th alone, as the central bank sought to stabilize financial markets. This was the biggest stimulus ever in China. It seems central banks have found a cure for every evil in the world, even a global pandemic: Print More Money!

It was not at all a trend towards more positive economic data that stopped the bleeding — only the promise of a tsunami of new money to be thrown at the market. The faith in governments to borrow and print their way out of every negative event has never been more prevalent—in fact, it is off the charts. The need to prevent a bear market has never been more salient because asset prices have risen to a record percentage of GDP. In other words, the pumping up of asset bubbles and GDP growth have become inextricably linked now that the US market cap of equities as a percentage of GDP is at a record high of 155%.

The truth is that liquidity trumps fundamentals. However, the rush to paper over each problem doesn’t always arrive on time and with enough force. Remember the NASDAQ and Real Estate debacles where equities plunged for many quarters before the Fed’s rate cuts had its desired effect. Central banks will continue to print money with each stock market hissy fit until they no longer are able to do so. The only things that can stop them are if the junk bond market craters at the time when major central banks are already in QE and ZIRP—we are perilously close to that point now. More stimulus at that point just won’t solve the problem.

Or, when inflation begins to run intractable, and the entire fixed-income spectrum begins to revolt—you can never solve an inflation problem by printing more money. If yields are spiking due to the market’s fear of currency debasement, then more QE at that point will cause investors fears of runaway inflation to become completely verified.

It will be at that point where those passively-managed, buy and hold, and indexed investors will be in for a shock. However, having a model that measures the cycles of Inflation/Deflation and Growth/Recession will give investors a fighting chance to maintain their purchasing power through the coming chaos.

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.”

Trillion-Dollar Market Cap Club

January 28th, 2020

There are a handful of stocks in which institutions and individual investors have recently piled into.  This behavior is emblematic of all bull markets once they begin to hit the manic phase. Wall Street falls in love with a few high-growth darlings and takes their valuations up to the thermosphere.

If you add up the market capitalizations of just four stocks, Google (Alphabet), Apple, Microsoft, and Amazon, their combined worth exceeds $5 trillion. If you throw in Facebook, you get the top 5 biggest firms by market capitalization, and they compose an amazing 18% of the S&P 500. Another way of looking at this is that the market cap of a full 282 companies in the S&P 500 now equals the same as the top 5 behemoths.

Again, this is not dissimilar to what has occurred in past blow-off tops. Recall the NASDAQ internet craze in the late ’90s and the Nifty Fifty bubble mania of the late ’60s and early ’70s. In the 694 days between January 11th, 1973, and December 6th, 1974, the Dow Jones Industrial Average lost over 45% of its value, but many stocks in the Nifty Fifty fared much worse. The Dot.com disaster was even more dramatic. It caused 5 trillion dollars of equity to vanish and wiped-out nearly 80% of market value.

The Nifty 50 stocks were the fastest-growing companies on the planet in the latter half of the 1960s and became known as “one-decision” stocks. These were viable companies with real business models but became extremely over-priced and over-owned. Investors were lulled into the belief they could buy and hold this group of stocks forever. By 1972, the overall S&P 500 Index’s P/E stood at 19. However, the Nifty Fifty’s average P/E at that time was more than twice that at 42. When the inevitable crash arrived, stocks that were part of the Nifty Fifty fell much more than the overall market. For example, by the end of ’74, Xerox fell 71 percent, while Avon and Polaroid plunged by 86 percent and 91 percent, respectively.

The years 1994 to 2000 marked a period of massive growth in the adoption of the internet, leading to a massive bubble in equities surrounding this technological revolution. This fostered an environment where investors overlooked traditional metrics, such as the price-earnings ratio. During this period, the Nasdaq Composite Index rose 400%, as its PE ratio soared to 200.

It’s always the same story: near the end of a massive bull market, a relatively small number of stocks get taken to incredible heights by a public that is thirsty for some story to justify such lofty valuations that are far above fundamentals. This can be clearly proved by viewing the Market capitalization of the Wilshire 5000 as a percentage of GDP. Stock valuations have now reached at an all-time high. In fact, they are nearly twice as high as the historical average and even higher than the NASDAQ bubble peak!

Not only this, but there are a record number of IPOs that don’t make any money, and a near-record number of U.S. listed companies that are spewing red ink—just like in past bubble tops.

This particular iteration of a massive equity bubble has seen a huge turn towards passive investments and a surge of money going into ETFs.

A paper done by the Federal Reserve explains that passive funds in 2018 now account for 39 percent of the combined U.S. Mutual Fund and ETF assets under management, up from just 3 percent in 1995 and 14 percent in 2005. According to the paper, passive investing is pushing up the prices of index constituents and there is a risk that rising prices can lead to more indexed investing, and the resulting “index bubble” eventually could burst.

The Potential Problem with ETFs

This brings us to a potentially huge problem with the overall market. A study done by Factset shows that in some instances of the largest market cap stocks that are held within ETFs, they represent more than 30 days of the average daily trading volume of the individual security that is traded on the exchanges. This means, for example, if only 10% of ETF holders decide to sell the security on any given day, it will represent three times the entire volume that is traded on the NYSE. Therefore, what we have is a condition where investors have become overcrowded in a few positions–just like what has occurred in previous market tops. However, this time around the situation is compounded by an influx of new money that has piled into ETFs. These same investments have doubled down on the doomed strategy of piling into a handful of winners.

In 2008 there was just $700 billion invested in ETFs; today, there is just under $5 trillion. ETFs have greatly exacerbated market directions in the past. Their existence tends to propel bull markets higher but, on the flip side, they also have led to flash crashes. To fully understand the dangers associated with buying and holding ETFs—and the overall market in general, especially in a bear market–you have to understand the process of creation and redemption units and how Authorized Participants (AP) function.

APs are the only entities that are allowed to directly interact with an ETF provider in order to create and redeem units. During a bull market, an ETF often trades at a premium to the underlying securities held by the index it tracks. In this case, an AP can buy the individual shares on the index at a discount and exchange them for a new ETF that is trading in the market at a higher price and then sells the ETF in the market for a profit. This process is known as creation, which adds to the supply of ETFs. And, it perpetuates the bull run.

Conversely, during market panics, an ETF will often sell at a steep discount to the shares trading on the index. In this case, an AP can buy the ETF in the market and exchange it for the individual shares on the index from the provider that is trading at a higher price. The AP can then sell the individual shares on the open market. This process is called redemption, and it reduces the number of ETF units. However, this process has also exacerbated crashes in the past by adding more selling pressure on to the individual shares of the index, which in turn leads to more panic selling for the less liquid ETF market.

Who are these very few lucky and privileged Authorized Participants? You may have guessed it, large banks such as; JP Morgan, Goldman Sachs, and Morgan Stanley.

This is just one more reason that validates the necessity of having a process that identifies when the epoch bear market begins before one occurs…because the next bear market should be one that makes the Great Recession of 2008 seem benign in comparison.

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.”