Secular Bear Market Baked into the Future

Executive Summary: I cover 2 topics in todays blog. The first revolves around the concept that we are in a secular bear market for stocks, and that even if corporate profits hold up, in a secular bear market, the Price/Earnings ratios can go down significantly, and this by itself could feed a stock market which drops in price by over 50% from current levels. The second part of the blog revolves around the game of what foreign countries, who holding US treasury debt and dollars, will do when faced with additional Fed money printing activities. I conclude, with the help of a readers comments, that the trade surplus countries who hold most of our debt will do nothing to destabilize the value of the dollar, despite the fact that the Fed’s QE strategy should push the value of the dollar lower. Alternatively, this is likely to play itself out withcommodity price inflation and a continuation in the rally for precious metals.


* Equity Prices – in previous blogs, I raised the concept that in bear markets, the Price to Earnings ratio of the S&P can sink to single digit levels, and even if companies are making the same profits, it is possible that their stock price can drop by 50%. The last time the P/E ratio was in the single digits was in 1981, before the 1982-2000 bull market kicked in. Of course, at that time, interest rates were sky high, inflation was high, and a low P/E ratio made sense. In the 1930s depression, the market had a single digit P/E ratio as well, but this occurred with low interest rates and deflation. If you have S&P earnings of $70 to $90, and a P/E ratio of 8, then that implies that the S&P 500 index can go to 560 to 720, which is considerably below today’s 1080 level, and around, or below the lows seen in March of 2009.


I am not a stock market guy, but rather a bond guy, so I do not purport to be an expert on the subject of P/E ratios, and forecasting the earnings for the S&P. So today I want to reference a link to John Mauldin’s market letter at this link:


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You might have to subscribe to his letter, to read this piece, but the letter is usually a compilation of selected works of others, and comes out twice a week. Usually there is something noteworthy once a month. Nonetheless, the article at this link spends more time examining the concept of secular bear markets, and is consistent with my thoughts about the bear market which started in 2007. 


More specifically, a change of psychology is underway which is going to take stock prices significantly lower over the next few years. At the low of the unfolding bear market, it is possible that S&P earnings might not be down that much, but it is possible for stock prices to get chopped in half. In fact, given how resilient corporate America is about cutting expenses and firing staff, it is quite likely that corporate America will do OK while the equity wealth of our country gets cut down by at least 50%. In turn, the negative feedback loop from the negative wealth effect, will result in a drop of real (inflation adjusted) economic activity, which on some level, will serve to reduce the ‘E’ in the P/E ratio, and will likely push stock prices dramatically lower than the lows seen in March of 2009. In this article, Mauldin comes to a similar conclusion that stock prices and P/E ratios have not seen their secular low.


One last comment I will add to the bearish view on equities has to do with the advancing age of the Baby Boomer generation. The oldest members of the baby boomer population bulge are starting to enter retirement age, and the rest will be contemplating retirement retirement over the next 10 years. This group, which controls many investable assets, will be getting more conservative, especially in light of how much their wealth took a hit over the last 3 years, when the value of their homes and equities are collectively considered. This augers for a shift away from equities.


* Weimar America: In response to my piece about the Fed’s money printing activities, a reader writes in with the following comment:


“Rick- This was a great piece! You are spot on about Weimar America.” (end of reader’s comment)


Yes, I know I am tooting my horn, but I do want to draw your attention to the piece from Tuesday if you missed it. The Fed’s printing press will be the way in which the US plays the currency devaluation game. I am not saying that they intend to print money for this purpose, but the influence on currency markets is something which will be a welcome side-effect. It is how the other countries respond to our money printing activities which will require monitoring.


Along these lines, and in response to yesterday’s blog, another reader writes in with this comment:


“Rick, another interesting blog. You write:                                                                                                                     ’Eventually our money will become funny money, if we print enough of it.

Part of the reason why it might take so long for our currency to become

bankrupt is because our trading partners with US dollar surpluses, continue to

stockpile dollars, and in the case of China, uses their dollar hoard to issue

more of their own currency. It is when they run into problems with their

currency, and have to sell dollars to make good on their bank losses, and other

bad, Yuan denominated investments, is when the fun (or trouble) will begin for

the US. So who knows when the day of reckoning will come, but when it does, it

spells trouble for the US treasury market, and the dollar. Although I will add

that if the Fed buys up all the treasuries it needs to, then it is possible

that we will just have a dollar problem and not a treasury securities crisis.’

                                                                                (The reader continues:) One view that I have that seems to always hold, is that countries act in their own best interest, much like individuals. Allowing the dollar to fall exports the cost of default to foreign surplus nations. Allowing rates to rise places the cost on the domestic economy. I think that answers your question, The US has the QE option, the US will exercise it. Note I say the US not the Fed. The Fed is given its powers by an act of Congress. If they pursue an inflation fighting mandate at the wrong time, thier powers can change.  (We are a democracy where the average citizen is in debt – they will vote for inflation not deflation)                                                                                                                               The bigger question that I have spent some time thinking about is, can an engineered inflation be created? I think the answer to this lies in who is the “price taker” of a Treasury security the US Treasury or foreign central bank investor. Everyone’s Econ 201 text book explains that as a currency goes down in value import prices should rise. But this assumes a floating exchange rate.  Just in the past week, There is rumor that China is moving into Yen based assets and the Yen moves aggressively  – The BoJ then openly discusses intervention – which means buying dollars.                                                                                                                    Any attempt to move FX reserves out of dollar will cause alternative investment to increase in value versus the dollar. If the alternative investment is a currency then host central bank will be under pressure to intervene. The intervention just shifts the dollar purchaser. Look what the Swiss Cental Bank had to do during the Euro crisis.                                                                                                                                        I think these dynamics are completely missed by most financial market participants. We talk of the disaster scenario of foreign CBs not buying our Treasuries, but what does that mean? One central bank would allow its currency to rapidly rise versus the dollar. (Remember US consumption represents roughly 17% of global of GDP). When you look at bilateral trade statistics, this would be economic suicide for any large surplus nation. When you consider the amount leverage within the surplus nations banking/financial systems, could they tolerate the 7-10% reduction in GDP that would accompany a substantial decline in the value of the dollar on a bilateral basis (15% to 30%). This assumes about a 50% pass-thru to consumers.                                                                                                                     

With all of this, it seems that it may be possible for the US to have contained inflation and extremely low rates for quite some time. It may take even more QE to get the inflation rate to remain positive – and thus this game can go on longer than anyone thinks is possible. A growing Fed balance sheet supports the deficit in two ways  – lower rates and thus lowerinterest expense plus the Fed rebates the Treasury its interest income net of expense  – if I remember correctly this is called Seigniorage.” (end of readers comment)


This comment is a great introduction into the FX topics I want to cover, as it relates to the Fed’s money printing operations. Let me tackle the readers comments in order:


1> The Fed is a creation of Congress, and the Fed Chairman has to testify before Congress at least twice a year. While the Fed is supposedly independent, they still derive their power from Congress, so they need to be mindful of our national interests, inflation fighting notwithstanding. To that end, QE will support the government’s deficit running ways, without forcing a debt crisis


2> The reader points out that the governments which consistently earn trade surpluses with the US, seem to hold the most treasuries. And yes, it is true that China has started to add Yen to the foreign currency reserves. The interesting thing about China is that they cannot spend their surplus as fast as they are accumulating it. Instead, they are stockpiling the sovereign debt of the US and the Euro-zone, and now Japan. These FX reserves sits on the balance sheet of their central bank, and acts as collateral for the $3.3 trillion of currency and bank credit the Central bank has issued. (By the way the PBOC balance sheet ifs 50% higher than the Fed’s balance sheet, despite the fact that the US economy is three times the size of China’s. There is talk that there are many bad loans being made by the Chinese banks which the government owns, so, eventually, if there is a China bubble blow-up, as the press seems to be indicating, then the local bank takes the loss, and I would imagine, then defaults to the Central Bank, who I figure, can just create more Yuan. Alternatively, the PBOC (People’s Bank of China) can sell dollars and buy Yuan to cover their losses, but all that would do is make the Yuan more expensive, which is something which will hurt their exports, and not something they will do to any large degree, in my opinion.


Net-Net, the dollars and treasury securities which our surplus trading partners hold, pretty much sit there. If they sell dollars for Yen, or Swiss Francs for instance, the reader is correct that this will shift the burden of holding dollars to the country whose currency the surplus countries acquire. In effect, the trade surplus countries have built a $ prison around their banking system, and there is no way these countries can sell enough dollars to make a difference without pushing the value of their own currency higher, and sinking their export driven economies.


Meanwhile, the amount of dollars in the world will surely be increasing, and non-central bank investors are being forced to figure out where to invest their assets. With interest rates being low, and the stock market being an uncertain place to put your money, it is clear as daylight to me that more dollars in circulation means inflation. The primary asset which serves as a currency alternative is gold, and more recently, the price of Silver has started to play a bit of catchup. How else can you explain that gold has the best performance of any internationally traded investment vehicle over the past few years. The returns do not lie.


How else can this game end, except in wild inflation, despite the fact that we are in a depression? And if the Fed decides they want to tame inflation, or are forced to by Congress, then we have a deflationary depression, not an inflationary one. I do agree with the reader, that when given a choice between the two alternatives, that the Fed (government) will choose inflation.


* Blog humor from Jay Leno last night: 


“Things are so rough in the economy that the best place to put your money is in Nigerian email scams.”