Tuesday, October 24, 2017

Warning Signs on the Economy

Last month we wrote about rising debt levels in the U.S. and worldwide. They are too high to be paid now and will never be paid because they are rising faster than incomes. And in July we wrote that central banks are buying not only government debt—thereby increasing their money supplies—but are buying common stocks in American companies, which has the same effect. The leader in this has been the Swiss National Bank, which is the Swiss central bank just as the Federal Reserve is the U.S.'s central bank.

Four-fifths of the SNB's reserves are in bonds. Euro denominated assets make up about 40% of its reserves; dollar-denominated assets, 35%; with the rest being yen, sterling and others. Japan's central bank buys government bonds, common stocks, and even real estate to increase its money supply. It owns 62 percent of the Japanese market in ETFs (exchange traded funds).

Stock markets worldwide have been on a tear, just like the rise in worldwide debt. In the last eighteen months the increase in the market capitalization of global stocks has been roughly equal to the entire value of world stocks in 2009. The Dow Jones Industrial average advanced a thousand points, from 20,000 to 21,000, in just 24 days. The DJIA is composed of large, profitable companies which are what is desired by central banks—which helps to explain why the DJIA has been outperforming smaller, less well known stocks. As we pointed out in a previous posting, the SNB bought almost 4 million shares of Apple in the first three months of this year and also has over $1 billion each in the stocks of the giants Exxon Mobile and Johnson & Johnson, which are in the DJIA.

Stock prices have been bid up on the anticipation of rising earnings, but in the third quarter, investors pulled $36 billion out of U.S. stock mutual and exchange traded funds. Thus far in 2017 more money has flowed out than has flowed in, and trading volumes have been collapsing. The stock indexes have been going higher, but investors are trading them less and less. Volumes and volatility go hand in hand. The CBOE Volatility Index this month fell to its lowest level in over 20 years. The average daily trading volume this month across the NYSE, Nasdaq, NYSE American, and NYSE Arca is 12% below below this year's average and 22% below last year's average. MCSI Europe, which tracks stocks across 15 developed European countries has fallen to its lowest level in five years.

An inflow of money from foreign investors and sovereign wealth funds helped to offset outflows from U.S. stock funds. So far this year, foreign investors have put $40 billion into U.S. stocks, compared to about $3.5 billion in net outflows last year, according to Deutsche Bank. The foreign inflow is unlikely to continue at the recent rate, according to some analysts, because foreign opportunities are beginning to appear more attractive due to the relative value of the dollar to other currencies.

The decline in trading volume isn't good news for banks that generate fees from investors trading. At J.P. Morgan Chase & Co., third quarter equity trading revenue fell 4% in the third quarter, and Goldman Sachs reported 7% decline for that revenue over the same period.

We ended our posting last month by noting that the Fed completely missed predicting the Great Recession. So today's forecasts of continued good times—despite the warning signs listed above—should perhaps be regarded with some skepticism. Need another reminder? Here's a quote by Ben Bernanke himself, when he was chairman of the Fed in 2007 before the collapse of the economy:

We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” —Ben Bernanke, May 17, 2007.

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