Each year, there has been only one possible candidate for Chart of the Year. Last year it was the collapse of China’s shadow banking bubble; 2017 was Bitcoin’s stratospheric rise; 2016 the near-doubling in US 10-year interest rates; and 2015 the oil price fall.
This year, the ‘Chart of the Decade’ is in a league of its own. Produced by Goldman Sachs, it shows that the S&P 500 is in its longest-ever run without a 20% downturn.
The reason for this amazing performance is not hard to find. It has been caused by the US Federal Reserve’s adoption of Ben Bernanke’s concept that:
“Higher stock prices will boost consumer wealth and help increase confidence“.
Set out in 2010, it replaced the previous policy set out by William McChesney Martin that their job was:
“To take away the punchbowl as the party gets going”.
“Don’t fight the Fed” is one of the best short-term investment principles, but the Fed’s success is quite extraordinary when one looks back over the past decade. Each time the market has threatened to slide, they have rushed in with yet more support:
- In QE1, the Fed pumped out $1.3tn of support for financial markets, in addition to reducing interest rates to near-zero
- This free money mostly went straight into asset markets such as stocks, which weakened when the stimulus stopped
- QE2 came to the rescue with another $600bn of support – but again, stocks then weakened
- QE3 provided longer-term support, with $40bn/month then increasing to $85bn/month
President Trump’s tax cuts provided even further support when the Fed finally paused, as the Financial Times chart confirms, by encouraging a massive wave of share buybacks.
Remarkably, these buybacks came at a time when profits were actually falling as a percentage of GDP, as the third chart shows. Investors should really have been pulling out of shares, rather than buying more. But after so many years of Fed support, most asset managers had either forgotten how to read a Profit & Loss account and Balance Sheet – or had decided these were irrelevant to stock valuation.
Since September, we have been in a new Fed stimulus cycle. As I noted then, a $50bn hole had appeared in New York financial markets. Regulators and consensus commentators combined to explain this was only due to temporary factors. But since then, the support has reached $376bn, and the Fed has announced it will happily supply another $500bn of support to cover possible year-end problems, probably taking the total close to $1tn since September.
Behind this panic is the IMF’s warning that the $8.1tn of Treasury bonds available as collateral for the repo market, are in fact “owned” by an average of 2.2 different banks at the same time. Understandably, bank CFOs are pulling back, and trying to establish if “their” Treasury bonds in fact belong to someone else.
Regulators should never have allowed this to happen. They should also have focused long ago – as I suggested this time last year – on the implications of the decline in China’s shadow banking sector. Just as I expected, China is now exporting deflation around the world, with its PPI falling since June.
China’s slowdown also means an end to the flow of Chinese cash that flooded into New York financial markets, which hedge funds have then leveraged into outsize profits in financial markets.
The Fed turned a blind eye to this, just as it allowed BBB corporate debt to expand at a record rate, as the chart from S&P confirms. As we noted in June’s pH Report:
“US BBB grade debt, the lowest grade in which most funds are allowed to invest, is now more than $3tn, with 19% of this total ($579bn) in the very lowest BBB– grade. And this BBB– total jumps to $1tn if one includes financial sector debt. S&P also report that global BBB debt is now $7tn, with US companies accounting for 54% of the total.
“The problem is that BBB- debt becomes speculative debt if it is downgraded by just one notch to BB grade. And most investors are then forced by their mandate to sell their holding in a hurry, creating the potential for a vicious circle, as the most liquid bonds will inevitably be sold first. In turn, this creates the potential for a “waterfall effect” in the overall bond market – and to contagion in the stock market itself.”
The Fed’s focus on boosting the stock market is clearly going to end in a debt crisis. But when warning of this, the consensus responds as in 2006-8, when I was warning of a global financial crash, “That’s impossible”. And no doubt, once the debt crisis has occurred, it will again claim “nobody could have seen this coming”.
This is why the S&P 500 chart is my ‘chart of the decade’.
Did your company or investment manager use $50/bbl as a forecast Scenario price for oil this year? If not, why not? And has this question even been asked, as you finalise forecasts for 2016?
In recent months, many readers have told me despairingly of their efforts to suggest alternative Scenarios to last year’s “consensus” view that prices would always be $100/bbl. They are even more despairing today, when they see the forecast for the next few years – which almost always suggests prices will now rise steadily.
My suggestion is that you ask your company to evaluate the success of its forecasts over the past 5 – 10 years:
- Did it simply adopt the consensus view of $70/bbl in 2007, when budgeting for 2008?
- Did it include a Scenario based on the potential for a major financial crisis in 2008 and a price collapse?
- More recently, did it forecast last year’s collapse from $100/bbl?
- And did it foresee the potential for a major slowdown in China to impact the global economy?
If not, why not? And, even more importantly, what is it doing to improve the track record for the future?
The problem is that very few companies do this type of routine evaluation. Yet engineers routinely monitor whether projects are “on time, on budget”; manufacturing teams monitor product quality and safety records; customer services monitor whether deliveries are “on time, in full”. They know there can be no improvement without measurement.
Obviously, I do have a stake in this debate. As readers will know, I routinely post a review of the previous year’s Budget Outlook before issuing the new one. I also routinely publish the full record of Budget Outlooks since 2007, and the full record of my New Year Outlooks since 2008.
This should be basic practice for everyone. Past performance may not ensure success in the future, but it is the best guide that we have. This discipline was certainly one reason why I was able to successfully forecast here, in the blog:
- 2007-8′s final upward rush and subsequent collapse in oil prices, as well as the potential for a major financial crisis – as highlighted in ICIS Chemical Business in November 2008
- Plus, of course, I have argued since August 2014 that a Great Unwinding of policymaker stimulus is underway due to China’s adoption of its New Normal policies, and that oil prices would collapse to $50/bbl
My point is simply that it is nonsense for others to say “nobody could have forecast these developments”. And the world cannot progress unless we apply the basic principles of measurement to such important areas.
One particular piece of current nonsense is summarised in the above chart. This is the myth that the decline in the number of drilling rigs will have a major impact on US oil production. As we reported in last month’s pH Report:
“The story has everything that is required in the era of Twitter and sound-bites: it sounds logical, is easy to grasp, and needs no follow-up.
“The only problem is that it ignores the fact that oil rig productivity, like that of gas rigs, doesn’t stand still, as we discussed back in May. The number of gas rigs has fallen from 1600 in 2008 to 200 today according to Baker Hughes (BH) data, yet US Energy Information Administration’s (EIA) data shows total US gas output has risen by a third from 1.8Tcf to 2.5Tcf over the period. Gas rig productivity has thus risen 11-fold, and still seems to be on an upward path. Oil rig productivity appears to be following the same pattern.
“As the chart shows (using BH oil rig count data and EIA oil output data), oil rig productivity has already risen 4-fold over the past 4 years, with no doubt more to come.
“The key is the adoption of new drilling techniques, imported from deep water operations. It would be horrendously expensive to keep drilling new wells in 1000 metres of water. Instead, companies developed the new technique of horizontal drilling which can increase production by up to 20x compared to traditional horizontal drilling. Three quarters of US rigs now drill horizontally, compared to only one quarter in 2007.”
This type of analysis is not rocket science. It only needs access to the internet and a calculator. Yet last Wednesday, a leading hedge fund told Reuters they were mystified by the rise in oil rig production:
“The part of the report that continues to amaze is the domestic production number, which showed a small rise, despite the ever-plunging rig count” .
Please, send a copy of this post to your CEO and senior management, and ask them to review its argument. It is, after all, your salary and career prospects that are affected when myths and opinion are mistaken for analysis.