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Stock Market One Step Back From the Ledge

Stock-Markets / Stock Markets 2015 Oct 12, 2015 - 11:57 AM GMT

By: Michael_Pento

I started Pento Portfolio Strategies three years ago with the knowledge that the unprecedented level of fiat credit creation had rendered the globe debt disabled and would result in mass global sovereign default. As a consequence, there would be wild swings between inflation and deflation dependent upon the government provisions of fiscal stimulus, Quantitative Easing and Zero Interest Rate Policies...

For much of the third quarter the US Federal Reserve has avowed to raise rates. This in turn caused a sharp stock market correction on a worldwide basis. The flattening of the Treasury yield curve and the strengthening of the US dollar were the primary culprits. But then the September Non-Farm Payroll Report came in with a net increase of just 142k jobs, which was well below Wall Street's expectation. The unemployment rate held steady at 5.1% but the labor force participation rate dropped to the October 1977 low of 62.4%. Average hourly earnings fell 0.04% and the workweek slipped to 34.5 hours. There were also significant downward revisions of 22k and 37k jobs for the July and August reports respectively.

The jobs data had previously been heralded by the Fed and Wall Street as the one bright spot in an otherwise dull economic picture; and gave the Fed extra incentive to move off of zero -- as if offering free money to banks for seven years wasn't compelling enough. But at least for now the weak data has caused the Fed to step back from jumping of the cliff on raising rates, which has caused a swift move lower in the value of the dollar and boosted the prospects for multi-national corporate earnings.

The reasons why Wall Street is so enamored with ZIRP and QE are clear. Here is a partial list of what will start to occur once the Fed moves away from the zero-bound range:

• Debt service payments will begin to rise on the soaring outstanding $44 trillion in total non-financial US debt -- $12 trillion of which was accumulated in the last decade. This will render the already debt-disabled consumer increasingly unable to borrow and spend.

• The value of US high-yield (junk) debt outstanding has doubled since 2009. Many companies have survived by rolling over this debt at record-low and perpetually falling yields. Default rates will spike as Junk-bond prices begin to fall and yields start to rise.

• Rising rates will decrease the home ownership rate of 63.4%, which is already at its lowest level since 1967. A rate rise will also cause home prices to fall back toward the historic home price to income ratio of 2.6; it is now 4.4.

• The Mean reversion of interest rates on the $13.2 trillion of US publicly traded debt would then take about 30% of all the Federal tax revenue. Rising rates would also cause annual deficits to jump back to $1.5 trillion as they did in the great recession, causing outstanding debt levels to rise inexorably, thus eating up a much greater portion of tax revenue.

• There is $9.6 trillion of US dollar denominated debt owned by non-US borrowers. As the US dollar rises debt payments become more challenging to manage and would cause rising defaults on marginal foreign corporate holders.

• It will sharply attenuate the amount of stock buy backs, which were done mostly by taking on new debt ($2.9 trillion worth since March of 2009) for the purpose of artificially boosting EPS. This would cause EPS and PE multiple contraction, sending the stock market into freefall.

• The impaired credit of hundreds of trillions' worth of interest rate derivatives, such as credit default swaps and interest rate swaps, which will need an unprecedented bailout from the government once the counterparties become insolvent.

• Finally, pension plans will become bankrupt once the Fed succeeds in flattening the yield curve and completely crashing the stock market and the economy. Pension plans need 9% annual returns to fulfill their obligations. But the stock market has gone nowhere in the past 14 months even though the Fed has assured the country that there would be no competition for stocks from the fixed income sector for the past 7 years. Rising rates would most likely cause the stock market to lose half its value for the third time in the last 15 years.

Those are the reasons why the Fed is so afraid to start hiking interest rates.

The highly accurate Atlanta Fed's GDP model is predicting Q3 growth of just 1.1%. As a consequence, the Fed Funds Futures Market now is predicting that ZIRP will be in place until March of 2016. Will five more months of ZIRP be enough to levitate stocks? The answer to that question is probably yes in the short term; but it will lead to a catastrophe in the long term.

The simple truth is QE and ZIRP blow up asset prices to an unsustainable level, but do nothing in the way of supporting viable economic growth. The proof of this can best be found in Japan, where the Bank of Japan is printing 80 trillion yen ($665 billion dollars) per annum but has rendered the nation in a perpetual recession. Indeed, after three years of Abenomics the nation will probably suffer through its third recession in as many years -- Q2 GDP came in at an annualized minus 1.6%.

Further evidence of the ineffectiveness of central planning can be found in the United States, where we have experienced sub-par 2% growth for the last 5 years despite unprecedented monetary easing. And 2015 is now on track to underperform that low five-year bar.

The IMF recently lowered its global growth projection by 0.2 percentage points to 3.1%. This includes an overly optimistic 6.8% read on China growth.

The Real Danger

The real danger is that the higher asset prices get pushed by central banks and governments with fiscal and monetary stimuli, the more precariously they become perched high on top of a hollow economic foundation.

With ZIRP in place for another five months, this ominous condition should only worsen. However, it also means that whenever the Fed resumes its bluster about raising rates, the markets will careen lower from an even higher level. In addition, central banks' inability to engender the promised prosperity is rapidly eroding confidence in these institutions. Therefore, there is a growing risk that the markets will collapse despite perpetually free money -- especially in real terms. Such will be the unfortunate but inevitable consequences of obliterating honest money and free markets.

Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

Respectfully,

Michael Pento
President
Pento Portfolio Strategies
www.pentoport.com
mpento@pentoport.com

Twitter@ michaelpento1
(O) 732-203-1333
(M) 732- 213-1295

Michael Pento is the President and Founder of Pento Portfolio Strategies (PPS). PPS is a Registered Investment Advisory Firm that provides money management services and research for individual and institutional clients.

Michael is a well-established specialist in markets and economics and a regular guest on CNBC, CNN, Bloomberg, FOX Business News and other international media outlets. His market analysis can also be read in most major financial publications, including the Wall Street Journal. He also acts as a Financial Columnist for Forbes, Contributor to thestreet.com and is a blogger at the Huffington Post.
               
Prior to starting PPS, Michael served as a senior economist and vice president of the managed products division of Euro Pacific Capital. There, he also led an external sales division that marketed their managed products to outside broker-dealers and registered investment advisors. 
       
Additionally, Michael has worked at an investment advisory firm where he helped create ETFs and UITs that were sold throughout Wall Street.  Earlier in his career he spent two years on the floor of the New York Stock Exchange.  He has carried series 7, 63, 65, 55 and Life and Health Insurance Licenses. Michael Pento graduated from Rowan University in 1991.
       

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