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#MacroView: The Threats To The Bullish Thesis Have Grown

#MacroView: The Threats To The Bullish Thesis Have Grown

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Since the March lows, the markets have rallied on optimism of a “V-shaped” economic recovery and constant stimulus from the Fed. So far, that has been the right call. However, in recent weeks, the threats to the bullish thesis have grown.

We recently discussed the Fed’s inflation of an asset bubble. The crux of the analysis was the unprecedented amount of monetary stimulus to counter the “pandemic.”

The Fed was able to inflate another asset bubble to restore consumer confidence and stabilize the credit markets. The problem is that since the Fed never unwound their previous policies, current policies will have a more muted long-term effect.

However, this time there are 50+ million unemployed, wage growth is declining, and bankruptcies are on the rise. The Fed’s attempt to inflate another bubble to offset the damage from the deflation of the last bubble, will likely not work.”

In the short-term, the Fed’s actions had the intended outcome by providing “stability” to the financial markets.

The Paradox

What is most imperative for the Fed is those market participants, and consumers “believe” in their actions. With the financial ecosystem more heavily levered than ever, the “instability of stability” remains the most significant risk.

“The ‘stability/instability paradox’ assumes that all players are rational. That assumption implies participants will avoid complete destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’”

The problem the Fed, and Global Central banks, currently face is an inability to extract themselves from ongoing monetary policy measures. After the “Financial Crisis,” the Fed had hoped they would be able to reduce their accommodation as economic growth and inflation returned.

Neither ever happened.

A Diminishing Rate Of Return

Instead, as each year passed, more monetary policy was required just to sustain economic growth. Whenever the Fed tightened policy, economic growth weakened, and financial markets declined. The table shows it takes increasingly larger amounts of QE to create an equivalent increase in asset prices.

As with everything, there is a “diminishing rate of return” on QE over time. Since QE requires more debt to be issued, the consequence is slower economic growth over time.

“The relevance of debt growth versus economic growth is all too evident. Debt issuance initially exploded during the Obama administration. It further accelerated under President Trump, and has taken ever-increasing amounts of debt to generate $1 of economic growth.”

In other words, without debt, there has been no organic economic growth.

Importantly, after a decade of unprecedented monetary policy programs in U.S., the risks in the system have been expanded. It is now imperative that everyone continues to “act rationally.”

By not letting the system correct, letting weak companies fail, and allowing valuations to mean revert, the Fed has trapped itself. Such was a point we discussed previously:

“One way to view this problem is by looking at the Nasdaq 100 versus the S&P 500 index. That ratio is now at the highest level ever.”

These levels of extremes rarely exist for extended periods. It currently seems as if “nothing can stop the bullish market.” However, it is always an unexpected, exogenous event, which pops the bubble. 

The Bear Case

My colleague Doug Kass recently penned an interesting post on this issue:

“In aggregate terms, COVID -19 will likely have a sustained impact on the domestic economy. Such will be seen in reduced production and profitability for several years and forever in some industries.

At the core of my concerns:

  • Important Industries Gutted: Several key labor-intensive industries, such as education, lodging, entertainment, restaurant, travel, retail, and non-residential real estate, all face an existential threat. For these industries, they simply cannot survive the conditions they face. For these gutted industries, we face, at best, an 80% to 85% recovery in the years to come. In the case of some of these sectors like retail, Covid-19 only sped up what was already a secular decline. 
  • A Negative Knock-On Effect: Tangential industries, like food and other services surrounding less utilized offices, malls, and other spaces, will also get hit. They, too, face at best, an 80% recovery.
  • Widening Income and Wealth Inequality: The combined unemployment impact will run deep and cause adverse economic ramifications and intensified social imbalances.
  • A Battered Public Sector: With a lower revenue base, the Federal government and municipalities will cut services (and employment).
  • Rising Tax Rates and Redistribution: To fund the revenue shortfall tax rates will steadily increase. Such will exacerbate the disruption described above, and create a less than virtuous cycle.

Negative Impact To Stocks

As Doug also notes, there are substantial impacts to companies individually, which will eventually manifest in lower asset prices.

  • Weak Capital Spending: With a large output gap and higher debt loads ($2.5 trillion of Federal Debt and $16 trillion of non-financial debt), the outlook for capital spending is weak over the next several years.
  • Higher Costs And Lower Profit Margins: The surviving companies in a post-virus world will face higher costs of doing business. 
  • The Competitive Influence of Zombie Companies Exacerbate Lower Profitability: Corporations will face further pressure on profit margins from “zombie companies.” These companies compete aggressively on cost, and take longer to die due to low interest rates and weak loan covenants. 
  • Small Businesses Gutted: The greatest brunt from the pandemic is faced by small businesses that historically account for the largest job creators.
  • The Specter of a Secular Erosion in Unemployment: Permanent job losses will be surprisingly large, ultimately killing consumption. 
  • More Cautious Business Confidence and Spending: The surviving companies were ill-prepared operationally and financially, in early 2020 for the disruptive impact of COVID- 19. Such will force companies to maintain a “buffer” of additional capital (and cash) in the event of another unforeseen event or tragedy. In all likelihood, this will make for less ambitious capital spending and expansion plans relative to the past. 
  • Financial Repression Holds Multiple Risks: A sustained period of low-interest rates, necessary (by some) to offset reduced economic growth, could backfire. Repressing interest rates runs the risk of a pension fund crisis, and intransigence on the part of businesses to expand and may impair the U.S. banking system.
  • A Political Stasis: Political divisiveness and partisanship could intensify – dimming the probability of effective, pro-growth fiscal policy necessary in a low growth economy.

Overly Bullish

When reading through Doug’s list, the immediate response from readers who have a “bullish bias,” is “yeah…but what about the Fed?”

In the short-term, the Fed’s monetary interventions can certainly lift asset prices. As noted in the table above, the biggest “bang for the buck” is when asset markets are profoundly depressed, and negative sentiment is exceptionally high.

Such is not the case currently with retail investors chasing momentum in the markets with reckless disregard of the underlying investment risk. The sharp rise in the Russell 2000 index, as noted by Sentiment Trader, supports this view:

“Below is the percentage of Russell 2000 firms that have negative operating earnings over the trailing-12 months. It just moved above 30%, the most in over a decade. Only twice before in 20 years have such a high proportion of these small companies lost money. Those two periods were in April 2002 and December 2009 through February 2010.”

Furthermore, you have a near-record number of small traders speculating on asset prices through the use of options.

As noted previously, investors are also using 24-month forward estimates to justify overpaying for assets.

But, by nearly any metric, stocks are extremely expensive. There is only so much “future growth” that can be pulled forward. Eventually, “the piper must be paid.” 

The Risks Of Being Bullish

At the moment, none of these risks seem to matter.

What is vital to understand none of these issues will “cause” the “bear market.”

They are just the “fuel” that will exacerbate an eventual decline when the right catalyst is applied. Much like a can of gasoline stored in your garage, gas is inert until introducing the proper catalyst (a match.)

Concerning the financial markets, it will most likely not be a resurgence of the virus, weak economic data, or even a dismal earnings season. Such has already been “priced in” by the market. However, as stated, it will require an unexpected, exogenous event to ignite the fuel. At the point, it will become hard to contain the flames.

From an investment standpoint, it is critical to understand the “risk” under which you deploy capital into overvalued and extended assets.

While it may seem like a “no-lose” scenario due to the Fed’s liquidity programs, mean reversions can, and have previously, occurred.

As Doug concluded:

“While the Federal Reserve can provide the necessary ammunition (and liquidity) to stabilize activity briefly – it is unlikely a longer-term solution.

As we pass another Independence Day, the downcast prospects will impact the markets in the coming weeks and months

These are not an ingredient for a “Bull Market” or rising valuations. Instead, the above factors may be an ingredient to:

  1. Increased market volatility.
  2. Increasing economic uncertainty and cautiousness in the C-suite.
  3. An irregular period of growth.
  4. Lower price-earnings ratios.
  5. More social unrest.

The U.S. economy and our financial markets now face a crossroad – they are once again decoupling. The test of economic aspiration and market optimism will come in the years ahead.”

Navigating The Risk

Whenever I write an article that discusses a “bearish view” on the financial markets, readers construe it to mean I am sitting in cash, or short the “bull market.”

Nothing could be further from the truth. As stated over the last few weeks, we are currently “uncomfortably long” the market on our portfolios’ equity side. While we continue to hedge our risks to some degree through our bond, gold, and cash holdings, we are still well exposed to potential downside risks.

Having a thorough understanding of the “risk” is to have better control over long-term outcomes. While it is essential to make money while markets are rising, it is even more critical to control the losses. Spending a bulk of your time getting “back to even” is not a long-term investment strategy.

In January and February of this year, we discussed taking profits in stocks like AAPL, MSFT, AMZN, and others. The reason was not some prediction about the impact of the virus, but rather the gross deviation and extension of these positions from long-term means.

That risk reduction benefited us much when the crash came in March.

On Wednesday, we took profits in AAPL, MSFT, NFLX, and AMZN. (Taking profits does not mean we sold the entire position.)

I don’t know what might cause the next correction, or if there will even be one. But what I do know is that when stocks are this extended, overbought, and deviated above long-term means, bad things tend to happen.

The post #MacroView: The Threats To The Bullish Thesis Have Grown appeared first on RIA.

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Royal Caribbean Keeps One Covid Change Passengers May Not Like

Royal Caribbean cruise line has decided that one policy change made during the pandemic era will stay in place.

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Royal Caribbean cruise line has decided that one policy change made during the pandemic era will stay in place.

The covid pandemic forced the cruise industry to make a lot of changes -- some superficial and others that altered long-term policies. 

Some of these changes, like making muster drills mostly virtual, delighted customers. Others, like improving air filtration, happened behind the scenes, benefiting cruise passengers even if they weren't aware that anything had happened.

Royal Caribbean International (RCL) - Get Royal Caribbean Group Report, Carnival Cruise Line (CCL) - Get Carnival Corporation Report, and Norwegian Cruise Line (NCLH) - Get Norwegian Cruise Line Holdings Ltd. Report all moved largely in lockstep during the pandemic. In July 2021, when all three cruise lines returned to service from U.S. ports, they had to deal with oversight from the Centers for Disease Control and Prevention.

Those rules mandated that all passengers age 12 and older had to be vaccinated, and all passengers had to provide negative covid tests. Mask rules varied a bit, but for much of the past year and a few months since the cruise lines were able to start sailing again, masks were required in a number of areas, including cruise terminals.

Now, the CDC has basically stopped regulating the cruise industry. It offers guidance but it no longer tracks covid on cruise ships, and most rules have gone away. 

And while Royal Caribbean, Carnival, and Norwegian have seen operations largely return to normal, not every pandemic-era change has gone away.

Image source: Dukas/Universal Images Group via Getty Images

Royal Caribbean Keeps a Change Passengers May Not Like

Royal Caribbean cruises have largely returned to the exact experiences they were before covid. Vaccinated passengers still have to provide proof they got their shots and unvaccinated cruisers must still show negative tests, but once you board, the experience has mostly returned to normal.

Royal Caribbean has decided, however, that it's not going roll back one change, which was first reported by Royal Caribbean Blog. The cruise line discussed the matter in an email to travel agents Sept. 27.

"As we continue to shape the future of cruising, a few experiences may look a bit different to some of your clients. With this, we will no longer be accepting prebookings for onboard entertainment. All guests who would like to attend our entertainment onboard must book these at the Box Office or on the App once onboard," the email said.

Some customers may be angry about this because it creates a sort of rush to book theater shows, Aqua Theater performances, the comedy club, and other onboard entertainment as customers board. 

This could mean people book a cruise and end up unable to see a show they really wanted to see.

In reality, many people don't show up for their reservations, so not getting one generally means that you can line up on a standby basis and still get in.

Royal Caribbean Has Turned a Covid Corner

Royal Caribbean, like Carnival and Norwegian, has struggled to get back to its precovid levels of business. The company has returned its entire fleet to service and has slowly built back to sailing its ships at full capacity. 

Chief Executive Jason Liberty outlined some financial information on the company during its second-quarter-earnings call.

"Another major milestone for the group this past quarter was that our business turned operating cash flow and Ebitda positive," he said. 

"...This achievement further strengthened our liquidity position and positions us well to continue methodically and proactively improving the balance sheet and refinancing near-term maturities as we seek to return to 2019 metrics and beyond swiftly."

Liberty made clear that he expected the company to fully recover.

"This outperformance in Q2 versus our expectations was driven by continued strength in our onboard revenue and accelerating load factors, which hit nearly 90% in June and delivered 82% for the quarter," he said. 

"This combination led us to achieving higher total revenue per guest versus 2019 levels."

 

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How bonds work and why everyone is talking about them right now: a finance expert explains

Investor confidence in the UK is at a low, and the bond market has reacted dramatically.

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The Bank of England is buying bonds again. Just as it was about to start selling the debt it had accumulated as part of its last effort to support the economy during the COVID-19 pandemic, the central bank has been forced to announce a new scheme to shore up investor confidence.

The bank’s £65 billion short-term spree aims to address the slump in bond prices caused by investors rushing to sell after the government’s recent mini-budget. This led to a surge in bond yields that hiked borrowing costs for the government and spread to pensions, housing and the general economy. So far, it has had a limited initial impact on the markets.

We asked an expert in finance to explain what’s going on in bond markets.

What is a bond and what is the difference between bond prices and yields?

A bond is essentially a tradeable IOU. It’s a loan that investors make to issuers such as companies or governments (UK government bonds are often called gilts). A bond has a price at which it can be sold and a yield, which is an annual amount the investor receives for holding the bond, a bit like interest on a savings account, and is expressed as a percentage of the current price.

When the price of a bond falls, it signals less demand for the bond because fewer investors want to own it. At the same time, the yield rises, which represents a higher cost of borrowing for companies or governments that issued the bond because this is what they have to pay to investors.

In the days since the government’s mini-budget, yields on 10-year Treasury bonds – which are issued by the UK government – increased from approximately 3.5% to 4.52% – the highest since the 2007-2008 global financial crisis. The expectation of continued increases prompted the recent intervention by the Bank of England.

UK government 10-year bond yields

United Kingdom 10-year bond yield. Investing.com / Tradingview

What causes bond yields to move?

To understand this, it is important to bear in mind that, while people often talk about the interest rate, there are actually a number of rates. This includes the rate at which the central bank lends to commercial banks (the base rate), the rate that banks lend to each other (the interbank rate), the rate that the government borrows at (Treasury yields) and the rate at which households and firms borrow (commercial loans and mortgages).

When the Bank of England changes the base rate, this cascades through all these rates. As such, the Bank of England carefully considers the state of the economy – that is, growth and inflation – when deciding on the base rate.

When an economy is growing, interest rates and bond yields tend to rise. The occurs for several reasons. Investors sell bonds to buy riskier assets with better returns. Firms and households also look to borrow more money in a growing economy, for example, to invest in new machinery or to move home. More demand for borrowing means lenders can charge higher interest on their loans.

Higher inflation often accompanies economic growth because of the increase in demand for goods and services. This tightens supply and causes prices to rise (including wages for labour). The Bank of England, which is mandated by the government to try to keep inflation as close to 2% as possible, will respond to higher inflation by raising base rates, which, as noted, feeds through to the different rates.

Investors will often anticipate the increase in base rates and look to act before it goes up by selling Treasury bonds and buying alternative, higher return, assets. This causes bond yields to rise further. As a result, the Treasury bond yield is often seen as a predictor of future Bank of England base rate changes.

So, if yields are rising, does this mean that investors are expecting future economic growth in the UK?

No, not at the moment. When the government raises money by issuing bonds, it does so over a range of time periods (called maturities), from one day to 30 years. When an economy is expected to grow, the yield on longer-term bonds will be higher than the yield on shorter-term bonds.

This relationship between yields across different maturities is referred to as the term structure or yield curve. An upward sloping yield curve implies a growing economy. At the moment, the UK yield curve is flat, or even downward-sloping across some maturities. My research shows that a falling yield curve is a good predictor of a coming recession.

Yield curve for UK government bonds

Line graph showing downward-sloping yield curve for UK gilts
UK gilts 40-year yield curve. *The curve on the day of the previous MPC meeting is provided as reference point. Bloomberg Finance L.P., Tradeweb and Bank of England calculations

It’s important to remember that these different yields act as a benchmark for commercial lending rates of equivalent lengths. The approximate jump to 4.5% in 2-year and 5-year yields has been reflected in mortgage rates, which is why some lenders have pulled available mortgage deals recently while they reassess the lending rates charged to households.


Read more: Is the UK in a recession? How central banks decide and why it's so hard to call it


But if the UK economy is not expected to perform well, why have bond yields been rising after the chancellor’s mini-budget announcement?

The rising bond yields we are seeing relate to an additional factor: the amount of government debt. The mini-budget introduced tax cuts and increased spending and investors know the government will need to increase borrowing to meet these commitments. Some estimates put potential government borrowing at £190 billion due to this plan.

An increase in the amount a homeowner borrows versus the value of their home (called the loan-to-value) causes the mortgage rate charged to the borrower to rise. Similarly, an increase in the amount of bonds that the government will be looking to sell (the amount it wants to borrow) will push down the price of existing bonds, increasing yields. More importantly, more debt without growth raises the risk level of the UK economy.

Anticipating this, investors triggered a large-scale bond sell-off after the government’s mini-budget announcement. This contributed to the fall in the value of the pound as investors selling UK Treasury bonds bought US bonds instead, essentially swapping pounds for dollars.

So will the Bank of England’s plan work?

The intervention will have a short-term positive impact, which started as soon as it was announced. But the bank is really only buying time. Any ultimate success depends on the government restoring investor confidence in its economic plans.

Unfortunately, rising yields and borrowing costs for the UK economy is the price we are now paying for the government’s recent fiscal announcement.

David McMillan does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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Yom Kippur is coming soon – what does Judaism actually say about forgiveness?

Many religions value forgiveness, but the details of their teachings differ. A psychologist of religion explains how Christian and Jewish attitudes co…

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Two women embrace before a Yom Kippur service held outdoors during the COVID-19 pandemic in Los Angeles. Al Seib/Los Angeles Times via Getty Images

The Jewish High Holidays are fast approaching: Rosh Hashana and Yom Kippur. While the first really commemorates the creation of the world, Jews view both holidays as a chance to reflect on our shortcomings, make amends and seek forgiveness, both from other people and from the Almighty.

Jews pray and fast on Yom Kippur to demonstrate their remorse and to focus on reconciliation. According to Jewish tradition, it is at the end of this solemn period that God seals his decision about each person’s fate for the coming year. Congregations recite a prayer called the “Unetanah Tokef,” which recalls God’s power to decide “who shall live and who shall die, who shall reach the ends of his days and who shall not” – an ancient text that Leonard Cohen popularized with his song “Who by Fire.”

Forgiveness and related concepts, such as compassion, are central virtues in many religions. What’s more, research has shown that it is psychologically beneficial.

But each religious tradition has its own particular views about forgiveness, as well, including Judaism. As a psychologist of religion, I have done research on these similarities and differences when it comes to forgiveness.

Person to person

Several specific attitudes about forgiveness are reflected in the liturgy of the Jewish High Holidays, so those who go to services are likely to be aware of them – even if they skip out for a snack.

In Jewish theology, only the victim has the right to forgive an offense against another person, and an offender should repent toward the victim before forgiveness can take place. Someone who has hurt another person must sincerely apologize three times. If the victim still withholds forgiveness, the offender is considered forgiven, and the victim now shares the blame.

The 10-day period known as the “Days of Awe” – Rosh Hashana, Yom Kippur and the days between – is a popular time for forgiveness. Observant Jews reach out to friends and family they have wronged over the past year so that they can enter Yom Kippur services with a clean conscience and hope they have done all they can to mitigate God’s judgment.

The teaching that only a victim can forgive someone implies that God cannot forgive offenses between people until the relevant people have forgiven each other. It also means that some offenses, such as the Holocaust, can never be forgiven, because those martyred are dead and unable to forgive.

Many people dressed in black and white stand in a courtyard between ancient walls.
Thousands of Jewish pilgrims attend penitential prayers at the Western Wall in Jerusalem ahead of the Jewish High Holiday of Rosh Hashana. Menahem Kahana/AFP via Getty Images

To forgive or not to forgive?

In psychological research, I have found that most Jewish and Christian participants endorse the views of forgiveness espoused by their religions.

As in Judaism, most Christian teachings encourage people to ask and give forgiveness for harms done to one another. But they tend to teach that more sins should be forgiven – and can be, by God, because Jesus’ death atoned vicariously for people’s sins.

Even in Christianity, not all offenses are forgivable. The New Testament describes blaspheming against the Holy Spirit as an unforgivable sin. And Catholicism teaches that there is a category called “mortal sins,” which cut off sinners from God’s grace unless they repent.

One of my research papers, consisting of three studies, shows that a majority of Jewish participants believe that some offenses are too severe to forgive; that it doesn’t make sense to ask someone other than the victim about forgiveness; and that forgiveness is not offered unconditionally, but after the offender has tried to make things right.

Take this specific example: In one of my research studies I asked Jewish and Christian participants if they thought a Jew should forgive a dying Nazi soldier who requested forgiveness for killing Jews. This scenario is described in “The Sunflower” by Simon Wiesenthal, a writer and Holocaust survivor famous for his efforts to prosecute German war criminals.

A color photograph of an older, balding man in a blue shirt and striped tie.
Simon Wiesenthal at the White House during the Reagan administration. Diana Walker/The Chronicle Collection via Getty Images

Jewish participants often didn’t think the question made sense: How could someone else – someone living – forgive the murder of another person? The Christian participants, on the other hand, who were all Protestants, usually said to forgive. They agreed more often with statements like “Mr. Wiesenthal should have forgiven the SS soldier” and “Mr. Wiesenthal would have done the virtuous thing if he forgave the soldier.”

It’s not just about the Holocaust. We also asked about a more everyday scenario – imagining that a student plagiarized a paper that participants’ friends had written, and then asked the participants for forgiveness – and saw similar results.

Jewish people have a wide variety of opinions on these topics, though, as they do in all things. “Two Jews, three opinions!” as the old saying goes. In other studies with my co-researchers, we showed that Holocaust survivors, as well as Jewish American college students born well after the Holocaust, vary widely in how tolerant they are of German people and products. Some are perfectly fine with traveling to Germany and having German friends, and others are unwilling to even listen to Beethoven.

In these studies, the key variable that seems to distinguish Jewish people who are OK with Germans and Germany from those who are not is to what extent they associate all Germans with Nazism. Among the Holocaust survivors, for example, survivors who had been born in Germany – and would have known German people before the war – were more tolerant than those whose first, perhaps only, exposure to Germans had been in the camps.

Forgiveness is good for you – or is it?

American society – where about 7 in 10 people identify as Christian – generally views forgiveness as a positive virtue. What’s more, research has found there are emotional and physical benefits to letting go of grudges.

But does this mean forgiveness is always the answer? To me, it’s an open question.

For example, future research could explore whether forgiveness is always psychologically beneficial, or only when it aligns with the would-be forgiver’s religious views.

If you are observing Yom Kippur, remember that – as with every topic – Judaism has a wide and, well, forgiving view of what is acceptable when it comes to forgiveness.

Adam B. Cohen does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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