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Lance Roberts: The Markets Are Now Waving A Huge Red Flag

Another debt-fueled crisis & and hangover approaches
Thursday, August 16, 2018, 8:15 PM

Lance Roberts sees trouble ahead.

As chief investment strategist of Clarity Financial and chief editor of Real Investment Advice, Lance issues commentary weekly on the financial markets. He sees a major market correction/crash dead ahead, likely in early 2019 as the US economy officially slides back into recession -- though he's open to it happening sooner than that.

Based on the huge debt / deficit excess that have built up in the economy, paired with the tremendous overvaluations in asset prices seen in today's markets, Lance expects economic growth to remain anemic (at best) for the coming decade:

It's a huge red flag. Look, at the end of the day, we can manipulate the bottom line of earnings statements all we want. But if I'm a business, look, I run three businesses, and if I don’t have revenue coming in at the top line, I can manipulate my bottom line through accounting gimmicks. I can do some weight suppression. I can layoff all my employees. I can maintain an illusion of profitability for some period of time. But at some point I've got to have the revenue, which is what happens at the top line of the income statement.

Just to put this into some context: since 2009, total growth of revenues for the S&P 500 is running about 30%. Bottom line profitability has grown by almost 300% during that same timeframe. Earnings per share have grown tenfold over revenue growth because of things like corporate stocks buybacks, weight suppression, employment suppression and accounting gimmicks.

We're at record levels on debt across the board. In fact, I run a chart every now and then that shows what I call total system leverage. And what total system leverage looks at is all the debt: government, margin, corporate, personal debt, all put into one indicator. And we're talking in excess of $120-$130 trillion of total debt outstanding right now, relative to an economy that's growing at $20 trillion.

This is, of course, the highest level ever on record. Corporations have, of course, they’ve used ultra-low interest rates to lever up balance sheets to pay out dividends, to do stock buybacks, etcetera, and a lot of these stock buybacks that have been done using corportate leverage because it was a 'better use of capital': I get to write off the interest on my balance sheet in terms of what I'm borrowing on the debt plus the buyback shares and improve my bottom-line earnings. That's been a win-win for corporations.

The problem, though, eventually, is that a lot of this debt that's been issued is sub-quality credit in terms of investment. When you talk about investment grade investments, BBB or better, a lot of this debt that's outstanding is BB or less. And that's going to be an issue when two things occur: one, when interest rates rise enough that the cost of borrowing is no longer acceptable and two, when you have the next major market crash that causes a massive deleveraging cycle in the markets -- and that will be triggered by an increase in interest rates from the Federal Reserve.

So America can slash taxes; do the things it wants to do -- like trade wars and tariffs -- but all it's going to do is negatively impact the economy because of the fact we're running $21 trillion in debt. And we're going to run a trillion-dollar deficit by the end of this year, one that's going to become $2 trillion over the next five years. With this growth trajectory of debt and decificts, economic growth can only go substantially lower over the next decade.

Click the play button below to listen to Chris' interview with Lance Roberts (53m:51s).

Transcript: 

Chris: Welcome, everyone, to this Peak Prosperity podcast. I am your host, Chris Martenson, and it is August 7, 2018. Today, we are going to be talking with leading market analyst and commentator Lance Roberts. Now look, ever since the Italy scare in May 2018, U.S. stocks have been on a 45 degree upward sloping line. And they're either at or approaching new all-time highs. Is that deserved? What are the possible risks and potential rewards? Well, that's what we're here to find out.

CNBC and The Wall Street Journal and other market cheerleaders want you to believe that everything is awesome. But are things really awesome? Let's find out. Today we're talking with Lance, as I mentioned. He's on of my favorite analysts and commentators, and he has a background of 25 years of private banking and investment management. Lance is currently a silent partner for an RAA in Houston, Texas. The majority of his time is spent analyzing, researching, and writing commentary about investing, investor psychology, and macro views of the markets and economy.

"My thoughts are not generally mainstream and are often contrarian in nature," he says. Well, he's also the chief strategist and economist for Clarity Financial, editor of realinvestmentadvice.com, which you should go to. It's got great, just excellent articles and timely data. It's just astonishing the wealth of information there. And, the talk show host of the Lance Roberts Show at KSEV 700 and publishes regularly on Seeking Alpha. Lance, welcome.

Lance Roberts: Well, thank you so much. And, actually, I have some exciting news today. We are actually changing radio stations starting September 3rd we're going to move to a bigger station. It's called KPRC here in Houston; it's 950 AM. So we're going to be rolling that whole thing out. You'll be able to get the show live on IHeartMedia, so if you go to iheartradio.com and pick up their app you'll be able to track the shows live.

Chris: Congratulations of that. That sounds like really exciting news, and we'll be sure to put that link directly at the bottom of this podcast. So, hey, let's turn right now to the markets, Lance. Equities in the S&P 500 and NASDAQ within whispers of all time new highs. What are your thoughts here?

Lance Roberts: Well, I've been writing about this now for the last couple of months that there's enough momentum in the markets currently that there was a real possibility that we would get back towards from these highs, back from January. Now, mind you, while we're talking about all-time highs, sounds great. We were here just back in January, so in the last six months, technically, the markets haven't gone anywhere which is a little bit discouraging simply from the fact that we're had these blowout earnings over the last two quarters with this caveat: the majority of these earnings, which have been exceptional, no doubt about that, has primarily been due to the substantially low tax rate.

Amazon had a blowout quarter as an example. That was due to a 3 percent tax rate. Now, that's going to start going away beginning next quarter because now quarter over quarter comparisons become much more challenging. In other words, Amazon's quarter, next quarter, is going to be based on this quarter, so that growth rate is not going to nearly as large around the corner. So my concern is that while markets have been rallying nicely over the last few months, we've set aside trade wars, we've priced that in, we've set aside Russia, we've set aside all these issues on the back of earnings. But that issue of earnings becomes much more challenging in the future.

Chris: Well, the earnings are indeed strong. The Wall Street Journal recently had a front page above the fold article that read: Profits Soar as the Economy Accelerates, and then did note that profits jumped an estimated 23.5 percent in the three months through June. Astonishing. But what was also astonishing, maybe, was that they didn't mention anything about corporate buybacks in there. They did mention that they effect of the tax cuts and all of that. But let's talk about the real momentum behind those earnings. They also noted that while the profits were up 23.5 percent revenues weren't up anywhere close to that. Is that a red flag or not?

Lance Roberts: Oh, it's a huge red flag. Look, at the end of the day, we can manipulate the bottom line of earnings statements all we want. But if I'm a business, look, I run three businesses, and if I don’t have revenue coming in at the top line, I can manipulate my bottom line through accounting gimmicks. I can do some weight suppression. I can layoff all my employees. I can maintain an illusion of profitability for some period of time, but at some point, I've got to have the revenue, which is what happens at the top line of the income statement.

And, just to put this into some context, since 2009, now the number I'm about to give you is not annualized, this is total. total growth of revenues for the S&P 500 since 2009 is running about 30 percent in total, right. So total growth 30 percent. Bottom line profitability has grown by almost 300 percent during that same timeframe. So earnings per share have grown tenfold over revenue growth because of things like corporate stocks buybacks, because of weight suppression, because of employment suppression, because of accounting gimmicks and the things that we have done.

As an example, with the banks we repealed FASB Rule 157 which allowed market to market accounting to kind of go away for banks. That's still been repealed despite the fact that we're ten years into an economic recovery. So how valid these actual bottom line earnings are are something that we really have to dive into. And because of the issues with these accounting things, measures like EBITDA and other issues of surrounding bottom line earnings per share, valuation measure, etcetera, are all heavily skewed. So we really have to look at what's happening at the top line in terms of revenue.

Chris: Now, that's an astonishing statistic of 30 percent growth in top line and 300 percent growth in bottom line. I want to turn now to this idea of corporate buybacks which have been not just a little bit of rocket fuel but breaking all records if 2018 continues as it has for the first six months, just an absolute flood of money coming back in. And the tax cuts were allegedly supposed to be used – the idea was, just the like the one that happened before under Bush – that this money would be repatriated and companies would hire people, pay them more and invest in property, plant and equipment. Do we have any sign of that, or is this mostly – has that money come home and been used to boost CEO pay packages?

Lance Roberts: Well, it depends of what you look at. You know, if you take a look at the mainstream media headlines, mainstream economic data, economic growth 4.1 percent in the last quarter. Great number. Then take a look at wages. We've seen a tick up in actually wages. Finally seeing some growth in wages. But the problem is when you look at those numbers at the top line you have to break out what's happening within the real economy.

So, for instance, you take a look at real disposable incomes. Now, what is disposable income? Disposable income is simply, and the way the government measures it, is simply just income after taxes. But disposable income for the average American family is what did I have come in the door after taxed versus the bills I have to pay, and what's actually left over that "disposable" for me to go buy a new Apple iPhone with, as an example.

Well, the problem is when you look at the bottom 80 percent of the population versus the top 20 percent, there is no wage perk, and disposable income is absolutely nonexistent. In fact, the average household, to maintain their current standard of living, is running at almost $8,000 deficit every single year, which explains why credit card growth is running at rampant paces. And just an article out just yesterday talking about the number of baby boomers now moving into retirement over the age of 65 filing bankruptcy is spiking at very fast levels.

Not surprising based upon the fact that this is what's happening in the underlying situation in America. And any of these economic measures that measure income or net worth, etcetera, it is heavily skewed by the top 10 to 15 percent of the economy which owns almost entirely all the wealth.

Chris: Lance, that's an excellent point. I just got in a little Twitter battle with a Bloomberg journalist who put out an interesting chart that said hey, look, the amount of mortgage service cost for Americans, based on their disposable income, is really at a very low level. And I said, well, hold on, you're trying to express an average when there's no average implied here. That's total disposable income and to total mortgage payments. So, if there is any skewing in this data, if all the disposal income growth has gone to the top five percent, that has no bearing on what the average mortgage service cost is going to be.

I couldn't believe that the plummeting and the statistic was huge. It didn't make sense by anything you could possibly read about actual wage growth. So, it's just those sorts of disconnects are really important to understand. And to me, as I look at this, it's pretty clear that disposable income, that revision that they just did under that last GDP revision, just really, I thought was one of the most inappropriate revisions I've ever seen. Really muddied the waters, I think, for the average reader.

Lance Roberts: Two things there, and if anybody actually looked at the data, there were two things that actually occurred there. There was the big – we revised up by a trillion dollars. Well, that was all an inflation adjustment. All we did was change from 2009 dollars to 2012 dollars. What happened to inflation between 2009 and 2012? It went down. So, the drop in inflation rate basically revised upward the real inflation adjusted value of the economy by almost a trillion dollars.

Same thing for savings. So, when we take a look at the savings rate, savings rate had a big upper revision, and a lot of mainstream media has been coming out and going oh, this is great, look, Americans are just saving more. No, they're not. The top ten percent is saving more because you've had a booming stock market and they're the ones that own the majority of all the wealth in the country in terms of stocks and investable assists.

One of the biggest misconceptions is that everybody contributes to a 401K plan. No, they don't. Statistic after statistic after statistics shows – even Bankrate just came out, and Fidelity both – just came out with recent studies looking at their 401K plans – because they are the two major providers of 401K plans in this country – about 30 percent of the people actually contribute to the plan in terms of the employees, and most of them contribute very little at all to those plans.

So the majority of the wealth is held in the top 10 or 15 percent like we just said a second ago. And so the revision to the savings rate was simply just adjusting up to the realization that that's where the bulk of the wealth is. And that's due to the booming stock market; that's due to the Federal Reserve interventions that have been liquifying the markets, global Central Bank interventions, a suppression of interest rates that is inured to the wealth of those at the top 10 or 20 percent.

That also goes to wages and executive compensation. When we talked about tax reform a second ago, I wrote article after article, before they even passed tax reform, and said when they pass tax reform the only people that are going to benefit are going to be corporations and executive employees of those companies because of the fact all this money will go to stock buybacks and go to executive compensation through option issuances, as well as stock based compensation increases, as well as salary increase. And that's exactly where it's all gone ever since then.

So, not surprising. You saw an uptick in the savings rate, but it's all skewed to the top end. The bottom 80 percent of America, they're not saving any more. In fact, statistic after statistic after statistic shows they can't come up with $500 in an emergency.

Chris: No. Exactly. And that's, of course, where the strength of the economy is supposed to rest, if you can wake the slumbering masses up and get them to buy more, that's where the strength really comes from. CEOs taking home and extra $10 million doesn't really move the needle in terms of overall consumption.

But let's talk about this corporate buyback. We never really completed that. I'm looking at a chart right here, right now, of corporate debt. It looks a little exponential to me. You mentioned that growth in top line revenue of 30 percent over the past decade, I'm seeing a near doubling of corporate debt over the same period of time. They’ve been piling on the debt, and all I ever read about in the media is about their cash hordes. For example, Apple. Hey, they’ve got $240 billion in cash. Yeah, they also have $220 billion in short and long-term debt. Where do you look at the corporate debt cycle as far as where we are in this cycle?

Lance Roberts: It doesn't really matter how you break it down. Corporate debt is an important point, but if you look at margin debt in terms of investors and how much leverage they're carrying within the market – take a look at household debt; take a look a government debt. We're at record levels on debt across the board. In fact, I run a chart every now and then that shows what I call total system leverage. And what total system leverage looks at is all the debt; government, margine, corporate, personal debt, all put into one indicator. And we're talking in excess of $120, $130 trillion of total debt outstanding right now relative to an economy that's growing at $20 trillion.

So this is, of course, the highest level ever on record, and the impacts of this have been a function – and back to your corporate debt question – corporations have, of course, they’ve used ultra-low interest rates to lever up balance sheets to pay out dividends, to do stock buybacks, etcetera, and a lot of these stock buybacks that have been done have been done through corporate leverage because it was a better use of capital; I get to write off the interest on my balance sheet in terms of what I'm borrowing on the deb,t plus the buyback shares and improve my bottom line earnings. That's been a win-win for corporation.

The problem, though, eventually is that a lot of this debt that's been issued is sub quality credit in terms of investment. When you talk about investment grade investment, BBB or better, a lot of this debt that's outstanding is BB or less. And that's going to be an issue when two things occur: one, when interest rates rise enough that the cost of borrowing is no longer acceptable and two, when you have the next major market crash that causes a massive deleveraging cycle in the markets, and that will be triggered by an increase in interest rates from the Federal Reserve.

Chris: Now, I want to get to those interest rates in just a minute because you’ve had some interesting things to say about the bond market lately, but first, I want to just make a point here which your ideas just triggered for me. Really, when you talk about all of the benefits of this tax cut really accruing and flowing largely to the C suite, CEOs and whatnot, stock buybacks and higher pay packages, etcetera, we go to the other side of this story and we discover that that tax cut really hamstrung the federal government take of revenue in terms of taxes. So, in effect, wasn't this really a taxpayer subsidy to corporations?

Lance Roberts: You could say that. I think it was more of just a corporate gift to make sure that corporations lined up behind the administration and continued funding operations in terms of government reelections. There's a lot of incentive in Congress right now, in particular, to ensure that they have corporate support in terms of passing legislation, etcetera. And so, part of getting the current administration elected was on the back of a lot of donations, etcetera, made by both Wall Street and corporate America, and those debts have to be paid. That's my conspiratorial statement for today.

Chris: Well, it's kind of how our government operates. But what I return on investment that must have been, you know, a few million in donations and a hundred-billion-dollar tax cut. That's a great ROI.

Lance Roberts: And not only that, and I don’t want to get off into a big political bend here, but if you take a look at how the government has kind of been staked with players, really since the current administration has come in, these are a lot of the old guard guys: Wilbur Ross, Navarro, Kudlow, etcetera, these are all Reaganites. And they have this strong belief that they can reignite the Reagan years by doing trickle down economics.

The one thing that all of them have missed, along with the mainstream media, and the majority of the mainstream analysis is this ain't Reagan. We're not in an economy of the Reagan years. Remember, Reagan started, when Reagan went into office he was coming out of a double back to back recession, just coming off the back of a major 1974 bear market crash where valuations were down to six and seven times earnings. Dividend yields were at 6 percent, interest rates were 14 percent, inflation was 14 percent. That was falling. Valuations were low and beginning to rise. Dividend yields were high and, of course, economic growth was already running at 6 percent.

You don't have that environment today. So there was no way that trickle down Reaganomics is or will work in the current environment. So you can slash taxes; you can do the things you want to do; you can do trade wars and tariffs, but all you're going to do is negatively impact the economy because of the fact we're running $21 trillion in debt, we're going to run a trillion-dollar deficit be the end of this year. That's going to become two trillion over the next five years. And the growth trajectory of debt and, of course, where we are in terms of economic growth, that will only substantially go lower by next decade.

Chris: Lance, that was an absolutely brilliant summary of the difference between those two eras, and I want to talk on one more piece of that: GDP which we touched on before. Very strong 4.1 percent print for Q2. According to statistics unemployment is at multi decade lows. We have companies, obviously, we talked about reporting inflationary pressures and raising prices all consistent with a strong economy. Yet, when we really look at the past data, and you have great charts on this, the past decade has been really subpar. Is there any reason to suspect that 4.1 percent print is the beginning of something extraordinary?

Lance Roberts: No. And if you take a look at where we were in the first quarter, we have the same environment that happens every year. We have a weak fourth quarter, and we have a weak first quarter. The Bureau of Economic Analysis has done everything they can to try to fix that first quarter weakness that we have. They doubled the rate of standard adjustments. They’ve done all kinds of manipulations of the math. But you can do mathematical adjustments, but you can't change reality.

And the function is is that we have a winter every year, and we during winter periods, surprise, things slow down because people can't get to work; they're snowed in. If you live up in the northeast you know exactly what that is. Down here in Texas we have tremendous amounts of rainfall, etcetera, so you can't build houses, you can't throw up jack rigs, you can't do a lot of things when it's pouring down rain on you. So economic activity tends to slow down in the fourth quarter, in the first quarter, and that's just part of that. And then you have a restocking cycle. So things kind of bleed out in the fourth and first quarters, and then you have a restocking cycle in the second, third quarter, so you get an economic uptick. That's the way it works. We go through these cycles.

Now, this cycle, this second quarter, this 4.1 percent, that's going to be a onetime number because of the administration's push on trade tariffs and these types of issues. We have a huge stockpiling of commodities in anticipation that prices on those commodities like steel, etcetera, are going to rising sharply. So we saw a pickup in stockpiling, we saw a pickup in activity to get ahead of the tariffs, but that's going to fade. So basically all we did was pull forward economic activity. We've seen this happen before and very likely we're going to see the next three to four quarters will be subpar, weaker growth as that begins to reverse itself.

Chris: I heard that up to half a percent of that print was due to Chinese pre-buying soybeans because of the tariffs. So that's an example. They'll pull that forward. They're not going to buy that many soybeans next quarter, obviously. That might reverse that entirely.

Let's talk about bonds now. What sort of signals are bonds sending? I note that you're looking at some technical signals that might say lower bond yields on the way.

Lance Roberts: A couple things. Let's remember that interest rates are a function of the economy. So Jamie Dimon out yesterday saying that interest rates should be 4.0 percent, and they're going to 5.0 percent, so get ready for higher yields. That sounds great. Sounds fantastic. The problem is that if you go back through history there's a very high correlation between interest rates and economic growth. Surprise. If interest rates are rising that means the cost of borrowing is going up, and that means that as a consumer I have to make a decision. So I want to buy a house or I want to buy a car or I want to finance some type of product that I want to buy, I look at the payment, and if they payment fits within my budget then I'll buy it, I'll finance it. I'll buy a car, I'll buy a house or finance a new iPhone at $1,000; that's about the only way people can afford it these days. So I'll finance it.

But if the interest rate goes up on that to a point to where I can't afford it within my budget, well, I either have to buy something else at a much lower price or I postpone the payment. And, of course, as interest rates go up, this specifically works to slow economic active. That's why the Federal Reserve lifts interest rates. Why do they lift interest rates? They're not lifting interest rates because they expect the economy to boom from this, they're actually trying to slow economic growth to quail inflationary pressures. That's why we lift interest rates; it increases the cost of borrowing.

The problem is that we're not in an environment currently, economically speaking, to support higher interest rates. See, back in the 40s, 50s and 60s and 70s, you can go back and look at that period of time and look at economic growth. Economic growth was rising during that period. So quarter over quarter, year over year, economic growth was increasing because, remember we were coming back from World War II, we have bombed out the entirety of the rest of the known world and Europe and everywhere else, and we were helping them rebuild manufacturing. We were industrial power housed in America. We were manufacturing and rebuilding the rest of the world.

As a function of that activity, that increase in productivity, that increase in output, we were growing our economy. So, as a function of that, as the economy was growing, interest rates were also rising because individuals were making more money, they were saving more, productivity was going up, economic growth up which means that we could sustain higher levels of interest rates. There's a relationship there.

Beginning in 1980, we reversed our economy and moved from a manufacturing base to a servicing base which has a much lower output. Inflation and interest rates were under attack by the Federal Reserve, and they had begun this long trend lower. And, as a consequence, interest rates have followed the rate of economic growth, which has been lower.

The annual rate of economic growth back in the late 70s, early 80s, was between 6 and 8 percent. We're at 2 percent today. And that's been declining substantially every single decade over the last forty years. And here were are today at roughly running 2.0. 2.5 percent, which means that interest rates on the ten-year treasury should run 2.0, 2.5 percent. Not 4.0, not 5.0 because you don’t have economic growth on sustainable basis running at 4.0 or 5.0 percent. Inflation, interest rates, wages and economic growth are all pretty much tied to it because they are all part and parcel built on one thing, the consumer, which is 70 percent of the economy.

Chris: Well, Lance, let's talk a bit about the role of the Federal Reserve, the other Central Banks, because what they wanted to do, what their theory was, hey, if we can just drive interest rates lower, this will spur more economic growth. Now, it's done a variety of things: it spurred corporations to borrow a lot of debt and buy back shares; it's encouraged housed prices to rise a lot. But the fact that my mansion goes from two million to five million, somewhere in Palo Alto – not a mansion – I guess that's just split-level ranch – if that happens, nothing really new got developed, although the Fed would record that as a big win. Hey, look at all this asset price inflation we've gotten. So did the Fed get it wrong by saying lower interest rates actually spur economic growth when you're saying, wait, it's more complex, these all tie together? In fact, when you really drive rates down you're going to get all these other unintended consequences, including some of the things I just mentioned?

Lance Roberts: That's exactly the point. See, this kind of falls into the bucket of tax cuts and tax reform, falls in the buckets of interest rates and the economy, and believe this all ties together into one pool, which is simply that a consumer-based economy, which is what we have today – as I said a second ago, you take a look at our GDP calculation, 70 percent of that is driven by personal consumption expenditures. It's what you buy, I buy, it's what we do as American's every single day, that's what drives the economy.

So, any policy that is going to create real economic growth has to impact the entirety of the economy, not just a select segment of the economy. It has to affect and provide benefit to everyone in the economy. So, what happened with the Federal Reserve? The Federal Reserve, in 2008, they're in the middle of this financial crisis and said we've got to slash interest rates. We're going to create a wealth effect in the economy that's going to spur economic growth.

The mistake they made was not allowing the debt default reduction cycle to complete itself, what we call a deleveraging cycle. We never allowed individuals in this country to fully delever, and instead we did all these different programs to try to keep people in their assets. We didn't want people out of their houses, so we came up with HAMP and HARP and all kinds of bailouts for mortgages and homeowners to keep them in houses that A) they couldn't afford and B) they were in areas where there were not jobs: Chicago, Detroit, you name the cities.

So people were locked into these houses in an area where they couldn't migrate. In other words, what we did was remove mobility. We kept individuals from being able to move to other areas of the country where jobs were available and wages would grow naturally as a function of demand. And so we created all these artificial imbalances in the economy by wanting to create a wealth effect, and we ultimately created the wealth effect by shifting a big chunk of the wealth from the middle class, the bottom 80 percent, to the top 20 percent.

We worried about this before is that the quantitative easing, in its theory, worked, but it only worked from the standpoint of creating a mass transfer of wealth from the bottom class to the upper class, and that's why we've been unable to sustain real economic growth of more than about 2.0 percent, which, by the way, is the rate of population growth.

Chris: Wouldn't that make sense? And I've often been critic of the Fed by saying that they are not this magical, wealth creating body. That's not what they do. They're a wealth redistributive body. They take from the bottom to the top, but they did something else too. Let me get your thought on this. They steal from the future and bring it to the present.

Lance Roberts: Yes. And that's exactly what quantitative easing does. When you do anything, suppress interest rates, when you do anything like adding more liquidity to the market – so, in other words, for the average American we don’t save any money. We know that. So if I give you – this is the whole myth behind giving people a payout or doing some type of government bonus to Americans. It would be great. We could give every American in this country $5,000 today and they would all go out and spend it today, and then the benefit is over, and you're right back to where you were before because you'll create these little short terms pops in economic activity by doing things.

But unless you create a sustainable rate of wealth growth, in other words, helping people grow their wealth by giving them jobs and higher wages and these types of things – I'm talking about real employment. I'm not talking about employment at the rate of population growth which is all we've had since 2009. Since 2009, we've created roughly about 20 million jobs, the economy has grown by 24 million working age Americans, so there's still about a four to six-million-person gap between just the people entering the workforce and that people who are getting hired. And this is when we take a look at all the employment statistics; employment to population ratios at the lowest levels since 1965, and they go well, that's the baby boomers. Okay, fine. Let's strip out everybody over the age of 55, let's assume the went Logan's Run way and they were just all eliminated – if you don’t know what that reference is, look it up on the internet – it's from the 1970s – it for old people who remember.

Chris: I remember it.

Lance Roberts: I know you do. And if we take out all the people under the age of 24. So let's just – they're all in school. Okay, so fine. We'll take out everybody in the workforce under the age of 24. Why is it that 24 to 55-year-old, that population, only 50 percent of them have full time jobs? I mean, that's what's happening in the economy. And you can't create economic prosperity when you have real unemployment still at much higher rates than what the government statistics would suggest.

But, again, doing any type of activity where I give you a benefit, I give you ultra-low interest rates, zero percent financing if you'll come buy a car today. Hey, I'm there. Right. But ultimately, I’ve got to make payments. And while I can create short term incentives to move forward future purchases in order to create sustainable economic growth, I need to focus on creating the ability to consume more in the future because I have more money with which to consume.

Chris: Indeed, the statistics show that we've had what we would call subpar growth for well over a decade now. And from my standpoint this all makes a lot of sense because you have to understand the role of debt in that story and you have to understand the role of energy in that story. So I have a story that says yeah, subpar is the new normal, and that's just something that we have to get used to.

But the Fed is trying to recreate conditions as if subpar wasn't the new normal. They want the 50s and 60s to reemerge. Not going to happen. So you're saying – the summary of that, one summary, is that interest rates could fall from here, and they should fall if they're going to match the level of economic activity. But let me take a devil's advocate on that. You said the magic thing before, which was a one trillion-dollar Federal deficit going to two, isn't that an upward pressure on bond yields, potentially?

Lance Roberts: Look, there's the fundamental backdrop and then there's the technical backdrop. Okay. So, the fundamental backdrop, and this is the belief right now, and we're about to do this, right – we haven't had a budget in ten years with our federal government. The end of September is the end of the 2018 fiscal year, and we've passed two contining resolutions last year of roughly about two trillion dollars all together to fund last years spending. We're going to have to pass another continuing resolution by October the 1st to fund the 2019 fiscal year. That's already estimated that first round, which will not make it the entire fiscal year, mind you – it'll make it about six months – is $1.3 trillion.

Well, that means that this is new debt to be issued by the government. That means that people are going to have to buy them, and the concern is right now there's simply not enough people to buy that debt. China is not buying as much debt as they were, and of course, the Federal Reserve is not buying bonds at this moment. In fact, they're trying to reduce their balance sheet – they're selling $50 billion a month. But yet the ten-year treasury rate remains below 3.0 percent, now, along with other factors that suggested that's going to be the case.

But, technically, interest rates are at a level that have historically, whether you look at it on a weekly basis, a daily basis, a monthly basis, a quarterly basis or an annual basis, interest rates now, and this goes back into going back the 1940s, 1950s when rates were rising and economic growth was rising. So it doesn't matter whether economic growth and rates are rising or falling, but it does show that every time that interest rates technically – now look, this is just technical – this is just the function of rate movement – technically, every time rates have been this overbought historically on any measure of timeframe, it has denoted a peak within the economic cycle and has also denoted a peak within the financial markets. And it doesn't mean that the markets always crash, although they did sometimes, but it also meant that we had periods where they stuck exceptionally low. And, more importantly, rates fell.

So how do those two marry up? How does this fundamental backdrop marry up to the fact that technicals are suggesting an entirely different outcome which would suggest that yields are going to fall? Let me tell you how I think it plays out and why I think that the technical may be right over the fundamental view for now. The first reason is that interest rates are rising in an environment where we have slower economic growth and we are ten years into a stellar stock market run that has been fueled by a lot of artificial stimuluses. I don’t know what will be the cause or the catalyst, but as you mentioned before and we talked about, we have debt leverage and speculation at the highest levels on record.

I'm doing a chart right now for an article I'm writing for Thursday showing household equity ownership is a percentage of total net worth. Any time that number is above 40, which right now we're at 42.3, it has equated to a very not good outcome for investors in the financial markets. So what would cause rates to fall despite the fact we're having record treasury issuances? That would be a major event within the financial and/or credit markets. Now, I don’t know what it'll be. I can't tell you whether it's going to be an Italian blow up or something in America or mortgage crisis. You won't know until it happens. Just like we didn't know about the financial crisis until Lehman popped up.

We don’t know what the trigger will be. We know we have all the ingredients. You and I talked about this previously. We have all the ingredients from leverage and speculation in place, but all we're missing is the match to light the fuse. And whatever that catalyst is will create an environment where QE4 will come from the Federal Reserve, the bond buying will come back in as a flight to safety.

Now, let me be really clear – when I'm talking about interest rates we are only talking about U.S. government treasuries because the place you do not want to be is in corporate bonds, high yield debt or any other type of state and local government issued debt, municipalities, etcetera because one of the big factors coming up in the next crisis, no matter what it is and what causes it, will be a devastation of U.S. pension funds, which have a $5 trillion hole sitting there, and they will not be recoverable this time around, even with a bailout. The pension system will come crashing down if that even is severe enough to trigger that because they are so underfunded now and are so dependent upon 7.0 annualized rates of return that another big drawdown at this point, after two previous ones, will provide a scenario where they cannot get caught up. Period.

Chris: Plus, they're 60 exposed to equities, not bonds, in this cycle. What a setup for that. Let's look at this for a second. Here's a quote from your Twitter feed which is @lanceroberts. You said, "Just three words – every cycle ends" and they you have another – there's a great article out that you referenced, and I'm not sure if it was yours or not called "Foobared, Fanged Up Beyond All Reason." I love that. So let's talk, FANG, Tesla, Netflix, cash burring machines. But when you say every cycle ends, the way I connect that is to that well, the cycle ends when you have these giant leader companies that half the market returns are all based on these FANGs. Let's talk about that. You say every bubble is in search of pin, whatever that pin is, but, you know, the biggest companies having, at least part of that, they need the story. Has the FANG story finally encountered a pin?

Lance Roberts: Probably not yet. And the reason I say that is the spike you had results from Facebook that failed to meet expectations. You had results from Netflix that kind of failed to meet expectations. I think it's too early. The belief in these companies and in the tech space itself is still rampant. And no matter – talking about Amazon - look, I think Amazon's a great company. If my wife ever quits shopping there they're going to go out of business. But it's a function that when we look at how they grew their earnings, yes, their AWS, their cloud services did great, but a big chunk of that bottom line profitability came from tax rates.

And if you take a look at revenue growth, they kind of actually missed expectations. We're starting to see a slowdown. And, of course, Amazon is very economically sensitive. I don’t care. When you're selling product, when people hit a bump in the road and they are having to contract and they're going through bankruptcy or restructuring type situations like we saw in 2008, revenue for Amazon is going to fall sharply because they are directly tied to the consumer.

So, that story is going to play itself out. There will be another big downturn in these tech related companies, and a lot of them are tied to the consumer. Apple is another good example of this. But we're in the middle of that cycle. I shouldn't say the middle – were towards the end of that cycle. This is, for those tech stocks, we're in the 1999 period now in those tech companies. And small little blips, they're quickly forgiven because it's about eyeballs per page, or it's about clicks per page or whatever it is, whatever metric you want to use, that's going to be the case.

But, ultimately, when you talk about these companies – Facebook, Google, as an example – which are heavily tied to advertising dollars, etcetera, my question has always been – you take a look at Twitter just recently purged 20 million fake viewers. When are companies going to start asking the question exactly what they're paying for in terms of their advertising? When are people going to ask, well, exactly what am I getting on my dollar for giving you these millions of dollars in advertising on Facebook? Am I really getting the return on investment in terms of metrics you're giving me versus tying it to actual sales. What sales are actually generated from Facebook, from Google, from these areas? And that's going to be a question at some point that I think companies are going to ask.

The other problem with Facebook in particular at ten, eleven times sales, is that in order to justify those evaluations, you’ve got to own virtually own every advertising dollar in the world. That's never going to happen. and we saw this back in 1999 too with Yahoo, others, and we said exactly the same thing then. And, of course, that ultimately came to pass, as well. So, again, and take a look at Tesla. Tesla comes out, they meet a production number, he makes some positive comments and the stock rallies eight, nine, ten percent the next day. That company is on the verge of bankruptcy. It is only a function of time until Tesla goes bankrupt.

And if the government, which, by the way is a real possibility here, the fact that we're talking with other European countries about cutting their subsidies and their tariffs, we've got to talk about – ultimately, we've got to come to the table because Donald Trump is talking about fair trade, free trade, where there are no tariffs. There are not subsidies. Great. That means subsidies for ethanol, subsidies for Tesla go away. That's the only way that Tesla survives at the moment is because of that government subsidy. So, if these things change there's a lot of risk to those companies, if things change in the future, and I think that you've got to be really aware of that.

Now, I'm not saying go out and sell all your FANG stocks. Right now, in our portfolios, we're long Apple and long Microsoft. Why? Because they're going up. And I have to – no matter how bearish you think I am longer term and look, my outlook longer term over the next five to ten years is not optimistic. Debt, leverage, valuations, etcetera, all suggest substantially lower rates of return. But I can't sit in cash as a portfolio manager; I won't have any clients. So yes, we own equities, we're long in the markets right now because markets are going up. There will be a time where markets stop going up and I will be all in cash and treasuries. But we're not there yet.

Chris: Timing always is the hard part, but, as you mentioned, I just don't know what to do besides just follow what the market is doing at this point. I thought that we had, what the Face Plant, that there was potentially a little bit of a moment of reality coming back into the markets, and there was for a couple of days. But then when I saw TesFlix [Laugher]

Lance Roberts: There's something there.

Chris: You're right. I'm going to hone that. I'll work that into something. So when I saw Tesla, it doubled its losses quarter over quarter on a yearly comparison basis, it barely made its 7,000 car per week thing after pushing every possible grunting noise out of its tent factory, and investors said wow, this company isn't worth $50 billion, it's worth $59 billion, taking it way past Ford on a valuation basis in terms of market cap. And Ford can crank out that many cars in an hour. It really told me the story is not cooked yet because I couldn’t look at Tesla any possible way and say this is fantastic except Elon said hey, we're going to be becoming profitable later this year, which he said in 2016 and 2017. And here he is saying it in 2018.

Lance Roberts: And you hit the nail right on the head with Ford and others. Look, Porsche has a new, all electric Porsche coming to market. It's beautiful. It's a gorgeous car. BMW, Mercedes, Ford, Chevy, they're all going to produce electric cars at some point if they become really popular, mainstream and can justify doing that. The problem still becomes, for all these cars, is simple the energy conversion problem. I can fill up a car with gasoline and go a lot further on a tank of gasoline than I can on charged up batteries. And in Texas we drive trucks and SUVs because we've all got big families and we have to haul our cow around with us. I'm joking there.

But the point is is that until these electric vehicles become suitable for families and affordable for families; again, the majority of Americans can't afford an $80,000 vehicle. They're buying $20,000 and $30,000 vehicles, and they're financing those for eight years in order to get their payments right. So until these become much more affordable and much more mainstream, I think Tesla's got a little bit of a niche right now. But, ultimately, when they reach that point of mainstream capability, Tesla is going to be dominated by the major players, which, to your point, can automate and produce cars very, very rapidly, very efficiently. They have all the logistical pieces in place to do distribution. They've got the dealerships to sell them, a lot of things that Tesla is going to have to develop, ultimately. My outlook for Tesla is simply at some point that stock price is going to fall to around $50 a share, and then they’ll be acquire by a major for basically parts.

Chris: That seems possible, given the erosion on the balance sheet on this last earnings statement was atrocious by my standards. But for the people who are listening who say you have to be invested in one way or another unless you're just willing to sit in cash at this point, how are you distributed right now in your portfolio and what signs are you looking for that say it's time to go to cash and treasuries?

Lance Roberts: Great question. In every investment cycle the issue that I see a lot of people go I'm a fundamental investor. Okay. There is no fundamental value in the market right now, so what are you going to buy? So then we have companies that say oh, I'm buying Facebook because I can make a fundamental valuation case for that. No, you not. You're fudging fundamentals to fit a narrative, and you're not buying fundamental value.

Momentum guys say hey, I'm buying momentum. Okay, great. We're in a momentum market. That's the way to go right now, but momentum markets are always what happens at the last of an investment cycle. So, for us and the way we manage our portfolio, we are fundamental investors; we are momentum investors; we are value investors; we are growth investors depending on where we are within the cycle. Now, fundamentals always drive what we buy. Technicals tell us when we buy them or when we sell them, and we marry these two together.

So, for instance, I said, hey, we're long Apple and Microsoft right now because A) we're in a momentum market cycle. Those are two of the momentum players. We also own KLAC and Micron and some other of the Momo names, and we're participating with the market because that's where markets are working at the moment. When this market changes and we begin to violate technical trends and the trend of this market turns from positive to negative, we will reduce our exposure to equities. I'll give you an example early this year.

In December of 2017 we started seeing deterioration within the momentum of the markets, and seeing some concerns that led us to really looking closely at where we were invested wise. And, of course, remember in January we had this scathing stock market running up. Well, in early February that ended, that momentum shifted. We registered a cell signal, and we reduced our portfolio allocations by 25 percent to equities, and we waited and watched at that point. We said, okay, is this the beginning of the next bear market or is this just going to be one of the buy the dip opportunities?

So, by reducing our exposure to equities then and raising some cash, we had the opportunity to sit back and wait and watch to see what we going to happen. Of course, as it turns out, the markets bottomed around the February, March lows and began in April kind of forming this upturn. And since April, we've been taking that cash we were holding and putting that back to work. Now, we're still currently a little bit underweight in our equity portfolio and our 60/40 allocation model we're running right around 50. 52 percent equity. Our bonds are fully exposed – right now we're at 35 percent bond exposure. We always maintain a cash buffer in our portfolio of about 3 to 5 percent to meet client withdraw needs and always have opportunity cash available for something that may show up opportunistically.

So we're a little bit underweight in terms of our cash allocation of our equity allocation because we're not yet convinced that we're about to break out the all-time new highs and go running off to the moon. We are simply going back to where we were in January. We're very overbought on both a weekly and daily basis, which suggest that very likely – and most importantly, we're moving into August and September, which technically have been weaker months of the year. So, we're keeping a little bit of cash available here so if we get a pullback, still maintain the bullish trend, still maintain kind of the risk levels where we are. We'll put that cash to work and move toward the full allocation.

Now, at some point, don't know when, we're going to get our signals that are going to register that suggest that we are not only moving into another correctional cycle, but also potentially a bear market. I don’t expect that to really happen until potentially next year. I think that will occur next year with the onset of a recession. The yield curve itself is already suggesting that's very likely the case somewhere around mid-2019. If we do move in towards a recessionary cycle then, stocks will follow. The average decline of the stock market during a recession is about 33 percent on average historically. And so when our indicators begin to turn negative and, more importantly, we break this bullish trend that has been intact and has not been violated since 2009, when we break that trend we will be primarily in cash and treasuries, and that will be it.

Chris: Well, Lance, another absolutely incredible answer and I assume that people will be able to follow that and all of your work at realinvestmentadvice.com. So that's all the time we have. I have ten more questions here we never got to and I wish we could, but we just don't have time. So, please tell our listeners the best way to follow you, your excellent work and your advice?

Lance Roberts: Again, every week on our website at realinviestmentadvice.com we produce a weekly newsletter. Simply click on the newsletter link. It's absolutely free. If you want to have it emailed to you just click the subscribe button. But in there, we actually post our model that we follow in terms of how much equity allocation we have to the market versus not. And as you'll see, just last week, we have been increasing that equity allocation model as we go along. So, we write about that every week, we keep you updated there. And, of course, as you were saying earlier, we post daily articles on our website. And then next week we're going to be launching a pro version of our website, which has our equity portfolios and ETF portfolios actually listed for you. So you can follow along with what we're doing.

Chris: Oh. That's fantastic. Well, Lance, thank you so much for you time and your expert commentary today. Really appreciate it.

Lance Roberts: No problem. Save those other ten questions. We'll get to them next time.

Chris: Excellent. Talk to you next time.

Lance Roberts: Thank you.

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3 Comments

treebeard's picture
treebeard
Status: Platinum Member (Offline)
Joined: Apr 18 2010
Posts: 627
Excellent interview

Best explanation for the underlying basis for interest rates that I have heard.  Great discussion about the lack of acceptance of the new normal and the financial state of the majority of Americans.  I know there is a lot of pent up anger about the level of corruption and injustice, and in a way that fuels a lot of the apopolectic predictions about future events.  Despite our fears about a dystopian future, it is in an odd way, a wish for justice served.  But I am afraid that brutal reccessions, and a continuing slow downward grind are the more likely outcomes.  I think our fears of a meaningless grind, unfulfilled oportunities, and an ordinary life not fully lived are a far greater.  As good as this discussion was, in a way it was far more chilling that the more apocalyptic ones.  It comes on like a cold grey morning, when reality comes at you all at once. The dream from the night before of dramatic events waking a sleeping humanity disapates, and we are left beneath the yoke of a vapid dysfunctional culture marching aimlessly into the future.

cestin's picture
cestin
Status: Member (Offline)
Joined: Sep 26 2010
Posts: 12
timing of getting out of the market

Seems like if you believe as Lance says, that things aren't going to start affecting the equities market until 2019, then you're trying to time the popping of the bubble.  Waiting for an inverted yield curve is a bit risky, given the way things like that can easily be manipulated behind the scenes.  

No question that rising interest rates are going to negatively affect corporate buybacks.  Conversely tax credits are enhancing buybacks.  The only question is timing.  If you're a nimble investor and want to take a chance on waking up some morning to a waterfall stock market as your signal to decide whether it's a real crash or a "pre-crash" that will recover first - then sounds like a fun timing game.  The upside is the few percentage points you might make before the market does crash.  The downside, is you blow it and things just keep waterfalling, some recovery, then more waterfall.  Like in 1929.  

not a game that seems like it's conserving one's wealth. Maybe ok for fund managers, who have to maximize their profits, and think they can time the fall.  But not for an individual.. 

richcabot's picture
richcabot
Status: Silver Member (Offline)
Joined: Apr 5 2011
Posts: 226
Another difference in the 80's

The 80's were also the era of the microprocessor and personal computers.  The efficiency improvements were dramatic, allowing significant improvements in profitability across a wide range of industries.

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