Debt, demographics, defaults, and defla tion — Part Two

Tuesday, 24 May 2022 — London, UK

[7 min read]

Dear Reader,

In 1960, the Nikkei 225 and the Dow Jones were at similar starting levels.

The Nikkei 225 began the year at 1,000 points, and the Dow Jones Index was around 700 points.

But, after that, it was a tale of two indices.

While the US future labour force was making its way out of the labour ward, Japan’s share market was making its way to much higher levels…steadily at first, then exponentially:

Whereas the Dow, well, it was stuck in that sub-1,000-point range for more than two decades.

And, when the Nikkei surged to almost 39,000 points in late 1989, the Dow was nudging a mere 2,500 points:

Then, the Dow played follow the leader.

Repeating an all too familiar pattern…steadily at first, followed by the exponential.

Trends take time (years, decades, and even centuries) to evolve…but what usually happens at the end of a very long trend is a hastening of action borne from conviction.

Society becomes so convinced that what they’re experiencing is a permanent state of affairs. What has been will continue to be so.

Time marches on and so do the dynamics that were instrumental in creating those (as we know it, transitory) state of affairs.

It’s taken decades for the debt and demographic trend in the US to reach a turning point.

Japan’s post-1990 experience provides an insight into the fate that possibly awaits over-overvalued asset markets.

In the end, valuation DOES matter

Prior to the recent downside action on Wall Street, 3EDGE Asset Management — a Boston-based quantitative fund manager — provided a prescient research report.

For the technically minded, this is an explanation of the methodology used to determine the US market’s valuation status (emphasis added):

‘Assessing valuation depends upon making estimates about an equity market’s future earnings streams and discount rates. Without a crystal ball or clairvoyant to help, reasonable assumptions need to be made about how earnings are expected to grow over time and the appropriate cost of capital or discount rate to use. After estimating earnings growth using reasonable assumptions while assuming mean reversion of profit margins over time, the valuation assessment becomes highly dependent upon the discount rates applied to the estimated earnings streams over the short and long term.

‘Employing an equity valuation model that discounts the S&P 500 Index’s earnings stream many years into the future, we have calculated that the only way to conclude that today’s U.S. stock market is fairly valued is to assume that today’s ultra-low corporate bond yields (among the lowest in history) remain at current levels forever. Given the unlikelihood that corporate bond yields remain at ultra-low levels forever, if we make what we believe is a more reasonable assumption that interest rates remain at ultra-low levels for the next 20 years then revert to their long-term mean…’

The episodes in US market history when valuations venture into overvalued territory are, indeed, rare.

And, when they do, they never stay there.

Contrary to popular opinion, historical precedent indicates things don’t bode well for the current market.

The other interesting point about this chart is how far the US market corrected PRIOR TO the Fed’s active meddling in the price discovery process.

The GFC correction was — thanks to the Fed — nowhere nearly as ‘cleansing’ as it should have been.

Some will say, ‘this proves the Fed can and will backstop markets’.

Perhaps.

However, by not taking your medicine when you should, have things been set-up for an even bigger fail?

Will the next downturn come with such force; the Fed is incapable of holding back the tide of panicked selling?

I think so.

And, if I’m correct, then the cushioned downside market action we’ve seen in our investing lifetimes has given us a false sense of security.

This is why the prospect of a 70%-plus fall seems so ridiculous…but that’s only because we’ve never experienced such an event.

In the end, valuations DO matter.

The trend in bubble busting

The 3EDGE report included this comparison with the Japanese share market (emphasis added):

‘In contrast, the Japanese stock market is fairly valued using the same valuation approach. This is not surprising; Japanese stocks were highly overvalued during the 1980s, peaking at the beginning of 1990. A brutal bear market ensued, dropping Japanese equities over 80% from their peak. The appetite in Japan for investing in stocks largely disappeared for decades, and Japan’s Nikkei 225 Price Index is still about 25% below its peak of over 30 years ago.’

Shares have been our go-to asset class for so long, the prospect of equity markets being shunned for decades is…inconceivable.

As crazy as the notion of shares being abandoned by a whole generation of investors might sound, remember, markets ALWAYS move in cycles.

In his extensive research on the rise and fall of empires, Ray Dalio observed (emphasis added):

‘… going from one extreme to another in a long cycle has been the norm, [is] not the exception—that it is a very rare country in a very rare century that doesn’t have at least one boom/harmonious/prosperous period and one depression/civil war/revolution, so we should expect both.

‘Yet, I saw how most people thought, and still think, that it is implausible that they will experience a period that is more opposite than similar to that which they have experienced.’

Human nature is why the patterns, down through the ages, are so repeatable.

While the US and Japan are not a perfect overlay, the similarities in debt funded economic ‘success’; transitioning out of the demographic sweet spot and the exponential asset pricing phase that comes with trend extrapolation, are too great to ignore.

In my opinion, the US is going to continue to play follow the Japanese leader.

Which is why a 60%, 70%, or even 80% collapse on Wall Street will come as no surprise.

The only unknown is…how long it takes.

Will it take two decades for the ‘loss of share investing appetite’ trend to exhaust itself?

I don’t know.

But the cleansing process has begun…and, if the Nikkei 225 is any guide, is far from finished.

The bursting of bubbles tends to commence in a similar fashion. An initial rout of 20–25%:

Then comes the clarion call from the perma-bulls…buy the dip. There’s the inevitable bounce. We’re told ‘the worst is now behind us…onwards and upwards’.

Little do investors realise what lies ahead.

People fail to recognise that the cycle has turned from bull to bear. Debt growth slows. Defaults increase. A deflationary consumer mood takes hold. A newfound restraint replaces wanton consumerism.

We are moving into the contraction phase of the cycle.

The 150-year barometer on social mood

The Shiller PE 10 Ratio is one of best barometers we have on changes in social mood (moving from fear to greed to fear).

The emotional ebb and flow of investors is captured in the expansion and contraction of the multiple paid for earnings since 1870.

The 150-year average of the Shiller PE 10 is around 15 times…the rational level.

However, investors rarely act rationally.

The return to rationality has started with the recent downside action on Wall Street…but there’s still a long way to go.

As the long overdue wealth destruction process gathers pace (and, intensity), deflation NOT inflation is likely to be Public Enemy Number One.

Baby boomers beware

I’ll leave you with a thought from the graph that inspired this two-part series:

That Western world baby boom bulge is now moving its way into retirement…at precisely the time when the primary wealth creator of boomer retirement capital (shares) is poised to spring a very nasty cyclical about-face.

The choices we make today are likely to have a profound impact on the trend each of our lives take in the coming years and decades.

Regards,

Vern Gowdie,
Editor, The Daily Reckoning Australia

Dear Reader,

‘Let’s drink to the hard working people
‘Let’s drink to the lowly of birth
‘Raise your glass to the good and the evil
‘Let’s drink to the salt of the earth

‘Say a prayer for the common foot soldier
‘Spare a thought for his back breaking work
‘Say a prayer for his wife and his children
‘Who burn the fires and who still till the earth’

‘Salt of the Earth’ by The
Rolling Stones (watch here)

Oh my…

Today, we say a prayer for the hard-working people…the factory girls and long-haul truckers…they’re going to need it.

Fox News:

‘The national average cost of a regular gallon of gasoline hit $4.589 early Thursday morning. This price topped Wednesday’s previous record of $4.567, which had beat Tuesday’s record of $4.523, which in turn had beat Monday’s record of $4.470.’

And here’s CBS News, looking ahead:

‘California drivers are grappling with the most expensive gas in the nation, shelling out an average $6.06 per gallon as of Thursday. That could soon be the fate of drivers in the rest of the nation, according to a JPMorgan analyst, who predicts the national average per gallon price could reach $6.20 this summer.’

Rising house prices (thanks to the Fed’s ultra-low interest rates) forced middle- and lower-income workers to move further and further away from their work. Now, they may commute 40 miles or more just to get to the job. That’s about two gallons of gas…or about US$12 worth — one way. At an average blue-collar wage, commuting alone costs more than 10% of income.

‘Too bad…’ say the elite. ‘But this will encourage them to use less fossil fuel. They should buy electric cars.’

If that weren’t galling enough, there are early signs that the two legs of middle-class prosperity — housing and jobs — are beginning to buckle.

Unsteady she goes

First, the labour market may be rolling over. The New York Post:

‘The number of Americans filing new claims for unemployment benefits unexpectedly rose last week, reaching a four month-high and potentially hinting at some cooling in demand for workers amid tightening financial conditions.’

Second, house prices are rising at a double-digit annual rate. But with mortgage rates edging up, who can afford to buy them? This from CNBC: ‘Home sales drop 18% in April’:

‘The April drop in closings is the largest one-month decline since July 2010, when the homebuyer tax credit, a federal stimulus resulting from the subprime mortgage crash, expired.’

The average new house in the US now sells for US$523,000. That’s up from US$400,000 in January of last year. Interest rates are also up — by nearly 3%. If the entire amount were financed, that would mean a monthly mortgage payment of about US$1,500 higher.

So the other day, we were wondering…

How come…with so many problems here in the US — stocks crashing…consumer prices rising by double digits…the baby formula crisis…and people killing shoppers in retail establishments or robbing them on the streets…

…our leaders go to a foreign country, give the folks there US$40 billion, and promise undying support for their war with Russia?

‘You do the dying’, they say…‘we’ll just send you our taxpayers’ money’.

McConnell, Pelosi, Yellen...et al — from both wings of the Deep, Deep State…Republican and Democrat — are supposed to represent ‘the people’. And yet…where’s the love?

We turn to Newsweek: ‘The Divide Isn’t Right v. Left; It’s Us Blue Collar Workers Fighting Elite Contempt’.

Charles Stallworth thinks the real divide is not a matter of Republican versus Democrat or Black versus White. It’s a matter of ‘class’. He says the people who do the real work — butchers, carpenters, truck drivers — don’t get any respect. For example, in the COVID panic, the elite kept drawing their paycheques — working remotely — while the factories and workshops were shut down. The only working-class people with jobs were the ones who delivered DoorDash food and Amazon packages to white-collar homes.

Rules for thee

And now that the COVID Panic has faded, the class divide is more visible than ever. In restaurants, stores, and banks — clerks and servers wear masks; customers don’t.

Salt-of-the-earth commoners pay taxes to support local schools…where their children are taught their non-college-educated parents are failures. The youngsters are told that the only route to success is via ‘higher education’. They are assured that if they go to college, they will not only do more meaningful work — saving the planet! — they will also earn more money.

And now, the Biden Administration wants to cancel student debt. Who benefits? The fellows waiting tables, driving trucks, or swinging hammers? Or the college graduates who waited tables and paid their own way through school? From Bloomberg:

‘At least 30 senior White House staffers have student loan balances, according to 2021 financial disclosures Bloomberg News obtained from the Office of Government Ethics, including Biden’s new press secretary, Karine Jean-Pierre, and Bharat Ramamurti, deputy director of the National Economic Council.’

The poor working stiffs will end up paying the elite’s college expenses…and then, the educated upper classes can thank them:

‘Waiter…I said no ice in my [imported from Italy] sparkling water. I care about the environment. Thank you.’

Mr Stallworth doesn’t mention the Fed. Twice this century, it bailed out the rich man’s stock portfolio with trillions of dollars in crisp new bills. But not a penny for the sweating masses.

We are waiting to see if it will repeat the trick. Already, some US$30 trillion has been lost worldwide in the retreat from Peak Bubble. As the losses mount, the class divide will come front and centre: Grosso modo, the ruling elite, benefits from rising asset prices. The middle and lower classes benefit from falling consumer prices. It’s one or the other. The Fed can try to bail out the fund managers once again. But it will mean much higher prices for the truck drivers. Or it can tackle inflation…but the elite will lose trillions.

Which way will it go? Say a prayer for the hardworking people.

More to come…

Regards,

Bill Bonner,
For The Daily Reckoning Australia