The world has changed a great deal in the last 85 years in terms of how the markets and the economy functions as well as how we see them operating. Slowly over time we have added and implemented more and more policies, regulations, controls, mechanisms and various forms of stimulus in an attempt to smooth out business cycles booms and busts. Central Banks (CB's) and Governments have tried very hard to shorten the busts / recession cycle by lowering interest rates and extend the boom cycles in each and every business cycle over the last 85 years.
Now we fast forward to 2016 and the chief aim is to never experience a bust / recession / depression or deflation ever again. Central Banks (CB's) have taught us that they are all bad things and that we must avoid them at all costs.
These CB's have tried multiple policies and even some new experiments like negative interest rates in attempt to keep the global economy from experiencing a slow down or any amount of deflation. How bad is it really if the price of everyday items like food, rent and fuel becomes 1 or 2% cheaper each year. For the average income earner around the world their money will be allowed to go further if prices fall.
The more we have tried to control every aspect of the market, capitalism and the economy, the harder its becoming to not lose total control of these very things. However I believe we are already in the process of losing control of one of the most important things, the real economy. Presently all the Central Banks have done an excellent job at keeping the Financial assets Ie Stocks and Bonds markets up at or near record highs , while the actual economy has been unable to improve in real inflation adjusted terms over the last 10 years.
Real Assets At All Time Lows
If we take a look at the chart below, it illustrates perfectly the complete distortion of over 85+ years of controlling mechanisms, policies and Central Bank experiments have done to the relative value of real assets compared to financial assets.
This chart goes all the way back to 1925 and currently we are at an all time low, for real assets (Houses, commodities, fine art, jewellery etc) relative to financial assets of stocks and bonds. All the stimulus and attempts at controlling the markets and economy have only influenced the price of financial assets. Financial assets are more easily influenced and controlled through electronic exchanges, rather than real tangible assets which are much harder to manipulate on a global scale.
In the video below, Ray Dalio and company deliver a frank assessment on how we have reached the physically limits of the system. As we have artificially pushed markets and demand higher through debt accumulation, lowering interest rates to zero and by ballooning the derivatives market.
Increasing Volatility And Valuation Divergence
The chart below provides a good understanding on the ever increasing huge swings in volatility the financial markets have experienced. Central Banks began to introduce and try new stimulus and policy ideas in the early 2000's to reduce the busts / recessionary periods, causing large swings in the prices of the financial market as well as the valuations.
The most recent round of stimulus that began in 2009 with Zero Interest Rate Policy (ZIRP), followed by QE 1, 2, 3 and negative interest rates have stretched out the valuation of the S&P 500 relative to US productivity. Up to 1995 / 96 US productivity moved in sync with the S&P 500 stock market. This is clearly no longer the case as the chart indicates a strong divergence in valuation.
This week we received the latest monthly industrial production number in the US and showed that the year on year figure remains negative.
Since mid 2014 you will notice that industrial production data used to coincide with the value of the S&P 500 index very well. Now industrial production has been falling for 2 years and the stock market is near nominal all time record highs.
One of the policies that the Central Banks have utilized to try and control the economy, markets and financial assets values is to physically adjust interest rates up and down. Since the 1980's when Paul Volcker raised interest rate to around 18% to combat high inflation, we have been steadily lowering them all the way to zero.
Why Lower Interest Rates No Longer Work?
Presently the federal funds rate is at 0.25% as you can see from the chart, however lower interest rates are no longer having the desired effects to stimulate the real economy anymore. One of the reasons for this is the fact we have reached the limits of our debt bubble cycle. We can no longer leverage ourselves any higher despite having interest rates at close to zero .
Leveraging Corporate America
One of the many side effects of lowering the federal funds rate to close to zero, has been the leveraging of US companies to levels higher than the 2007 and 2008 peak before the GFC crisis. Debt to equity is approaching 60% for non-financial companies, as the incentive to load up on debt has never been so high. But is it really helping corporate America?
What Is The Debt Being Utilized For?
The accumulation of more debt relative to assets would be ideal in the short term if companies were utilizing the debt to fund new innovation, capital expenditure and additional capacity for future growth.
The reality is that a large majority of the debt accumulation has been utilized to fund buybacks of company stocks to artificially boost earnings per share (EPS) which in turn helps stock prices rise despite the company profit not actually growing from this strategy.
The chart below shows that share buybacks have more than doubled since 2012 to $161 Billion in the 1st quarter of 2016, as more companies engaged in artificial growth strategies rather than invest in their own business models.
IBM a large technology company that has been an consistent innovator issuing several thousand new patents each year. However even though IBM still continues to issue several thousand patents, the company has been steadily increasing its debt levels (See chart below) to allow it to participate in stock buybacks.
IBM Increasing Debt & No Growth
These higher debt levels has allowed IBM to engaged in stock buybacks with the additional funds at their disposal. Unfortunately for IBM the stock buybacks have not helped the actual company as it has struggled to grow over the last few years.
The chart below is a perfect example how a large company has tried to control its EPS through artificial boosting its profits with stock purchases funded through debt. However the actual result is that IBM's revenue (which can't be artificially adjusted through stock buybacks) has been falling since 2012 as the company continues to struggle to grow its top line and bottom line numbers.
Netflix, which is relatively young technology company that provide online streaming of TV content, is a company that has been investing large amounts of money into the companyto deliver new and original TV content, as it differentiates itself and reduces its reliance on licensing content from other media companies.
On the 18th October Netflix announced its latest quarterly result, which was above estimates for EPS and subscriber growth. However the interesting thing that investors didn't seem care about is that Netflix free cash flow is going the wrong way and accelerating. It burned through $506 million in a single quarter and just over $1 billion over 3 quarters. (See chart below) The stock ended up jumping around 19% after reporting its results.
Because of the huge drain of cash despite reporting a profit, Netflix did mention it will be tapping the markets for an increase in debt soon. Because interest rates are so low the market does not care that Netflix is essentially, borrowing more money to make new TV shows to attract more members. The current business model is simply not sustainable, especially when the company spends $142 to add one new subscriber.
If Interest rates were set by the market and were not manipulated by Central Banks the actual interest rate would be significantly higher to encourage savers to part with the capital. In this scenario Netflix business model would not survive in its current form.
The last chart summaries very simply, how "we have lost control of the real economy by trying to control everything". Global GDP estimates continues to decline as global stocks continue to increase, as Central Bank balance sheets fund global stocks higher.
Lastly this MUST WATCH video Rick Santelli makes a simple request to Central Banks.
With all the recent volatility in global stock markets, commodities and currencies due to fears of interest rates rising in the US soon. I take a look at the bull market in global stock markets to see if its coming to an end.
After falling around 55% in value during the GFC back in 2008 and 2009, the MSCI world index has been in a stellar 7 year bull market rally. The MSCI World Equity Index is a global stock market index that represents the majority of major stock indices.
The MSCI index has risen back to the 2007 pre GFC levels, as Central Banks around the world have conducted unprecedented stimulus actions by lowering interest rates and initiating Quantitative Easing or QE (printing money) to purchase Government bonds and lowering the cost of borrowing money.
The Bull Market In Stocks Is Stalling
Since the MSCI index reached the previous peak of 2007 forming a double top early last year, it has struggled to make new highs and has been heading lower.
Currently the MSCI world index is still within its 7 year bull market uptrend, however the index will find it difficult to stay at these elevated levels, as Government Bond interest rates have started to rise again despite massive amounts of QE being conducted globally by the Central Banks.
Looking at the US 10 Year Government Bond Yield chart below, you can see the downtrend for interest rates has been in place since the start of the year and has recently completed a reversal of its downtrend. If the US 10 year Government bond is to climb above the current 1.705% level the next level of resistance is around 1.98% or 0.275% high from current levels.
A similar situation is evident with the German 10 Year Government Bond yield chart below, as the downtrend has ended with a reversal that occurred in the last few weeks.
The 10 year German Government bond is sitting today at merely 0.05% interest rate, with the levels of resistance at 0.125% and 0.28% that it would need to cross before heading higher.
Will The Global Stock Market Bull Market Continue?
So while the MSCI World Equity Index is safe for now and is still within a bull market, the current reversal of trend for Government bond interest rates going higher is a big problem for global stock markets to handle right now. If the trend continues for interest rates heading higher, the 7 year bull market uptrend will most likely reverse and begin to fall.
Disclaimer: This post was for educational purposes only, and all the information contained within this post is not to be considered as advice or a recommendation of any kind. If you require advice or assistance please seek a licensed professional who can provide these services.
If you were told 5 years ago that at some point in the near future that investors would be happy to part with their capital to invest in companies and lend them money and be charged interest for handing over their capital, you would probably say 'that's impossible' and 'that would never happen'.
Well today that idea has become a reality in Europe, where 2 non-financial companies borrowed money from investors and will be receiving interest instead of paying interest to investors.
A German multinational company Henkel AG as well as French company Sanofi SA have both issued debt that carry a negative yield.
Henkel AG has borrowed €500 million for two years issuing bonds that yield negative -0.05%, and Sanofi SA has issued €1 billion in 3 year bonds also yielding -0.05%.
Up until recently investors had only been buying negative yielding Government bonds as Central Banks around the globe had increased their Quantitative Easing (QE) purchases buying back from investors AAA + AA Government bonds.
However the EU Central Bank ran into a problem with their QE purchases of highly rated Government bonds, the pool of available bonds to purchase was quickly shrinking so the EU Central Bank decided to modify the QE buying of acceptable bonds to include A rated EU corporate bonds to increase the available pool of bonds to purchase.
Because of the expanded EU QE program that has been running since last year, yields on European corporate bonds have been steadily falling where by A + BBB rated bonds are now negative yielding with riskier BB rated corporate bonds about to go negative as well.
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I am a private trader and equities investor that loves the trading and investing world, following the markets and everything in between.