Normally, equity valuations reflect the present value of future cash flows that are primarily a function of current cash flows, growth expectations, and then the discount rate. Most fundamentalists will look at the cash flow generation in both the short and long-term. With equity valuations at their record highs, investors, in theory, are showing confidence in short-term cash flows not declining materially. The interpretation normally would be that they are betting on no recession and on stable long-term growth. However, is this analysis just sophistry?

The probability of a recession is much higher than what global equities are currently reflecting. Then there are people pointing to the yield curve and yelling, “See, a crash is coming!” They argue this is a leading indicator, sending the strongest warning signals to investors. Nevertheless, history begs to differ with that analysis for it has often shown a final bullish move in equities despite clear evidence of an oncoming recession. Is this precisely what we are facing? Others point to the Fed, claiming that the first rate cut is often a reliable signal that a recession is coming, which reduces short-term cash flows and raises return expectations as investors become more risk-averse.

There are those who look at all of these factors and then argue that long-term profit growth expectations are way too high. Others argue that corporate debt is too high and we have also reached debt saturation, especially technology companies.

All things considered, we are facing a slightly different future. Doing simple correlations of equities to interest rates reveals that the share markets have NEVER peaked twice with the same level of interest rates because the real issue is the differential between the cost of money and expectation of inflation or future price gains. We are in a similar pattern where interest rates are so low that even a 3% dividend from shares looks fantastic. When we look at the extremes, we also see that the PE ratio hits its extremes, not at speculative booms, but at the bottom. There comes times like in 2009 where capital no longer trusts the banks, governments, and is just looking to get its money back intact. This is when they will buy blue-chip shares without expectation of future profits and cash flow, but the preservation of capital. So while many see the share markets as totally disconnected, perhaps they need to look at the other side of the equation — who do you trust?

COMMENT: It is fascinating how your work has been so accurate on forecasting the business cycle, yet you are probably the most ignored by the mainstream media. The only possible reason for this is that they are not interested in someone who can forecast the business cycle when the general belief is that governments can manipulate it.

Keep up the great work

HS

REPLY: You are correct. They are not ready to accept that the business cycle can be forecast. That undermines politics as we know it today.

The OECD’s leading indicators on the global economy are still declining with the latest numbers marking the 19th consecutive monthly decline. The global economy is at its weakest point since July 2008, and the probability of a recession is still elevated and not fully reflected in equity valuations. South Korea, one of the world’s economies most tuned to globalization, is showing significant weakness with its leading indicators declining for 25 straight months to levels not seen since early 2012. The South Korean economy has historically been one of the best indicators for the global economy, so we expect more pain to come in the second half of the year.

The only major economy that has turned positive among the OECD’s leading indicators is China. This is not a big surprise, given the recent major improvement in the credit impulse, although it is still negative. But China’s improved industrial sector is driven by a major national push from the government and is likely driving domestic demand more than global demand. Meanwhile, the country’s car sales (which serve as a proxy for the consumer sector) remain weaker than at the bottom of the financial crisis, highlighting elevated uncertainty among Chinese consumers. In fact, May data shows that sales growth weakened again.

The problem is the entire Keynesian-Marxist agenda whereby governments believe their own propaganda. Nobody is willing to publicly look at our model because it highlights the entire problem with the assumption that governments are in control when they are just aggravating the trend.

QUESTION: I was told that none of the big bankers during the Great Depression went to jail either. Doesn’t the government understand that this is the very image of draining the swamp?

DK

ANSWER: The bankers own the reign of government from the courts to the White House. In the years that followed the 2008 financial crisis, the Securities and Exchange Commission brought charges against more than 150 people and institutions and won $2.68 billion in penalties. The SEC loves big fines. Keep in mind if they charge the individual banker, it will never be profitable. Charge the bank and promise no criminal prosecutions and you get the big bucks. So yes, not one of the bankers went to jail from that financial meltdown that they created which left 8.8 million Americans jobless. It also led to a $700 billion government bailout to save the bankers which never stimulated the economy.

Your question was whether it was this way during the Great Depression. Virtually no bankers were jailed in the wake of the Great Depression. However, they were at least charged but beat the criminal charges.

Beginning in 1932, the Senate Committee on Banking and Currency opened a public inquiry into the stock market crash. The Pecora Commission, as the investigation came to be known, led to indictments for several of the era’s finance giants. However, this was all before the SEC and Glass-Steagall, which Goldman Sachs had the Clintons repeal. Since banking laws did not guard against the kind of speculation that fueled the crash, most escaped prosecution for they did not violate any law.

Charles Mitchell was the president of the National City Bank, now Citibank. Mitchell built the bank into the nation’s largest by splitting it into two branches which fed each other. One half became its investment arm, while the other was its banking arm. Hence, this was the reason Glass-Steagall was enacted. The banks sold investments to clients, often financed with money borrowed from the bank. They also knew, as they did in 2007-2009, that the investments were toxic. When the market crashed, clients lost everything after listening to the advice of the bankers and the banks would often collapse. Mitchell resigned and admitted to the Pecora Commission that he knew his bank was pushing bad investments onto its clients, as was the case many alleged with Goldman Sachs in 2007. Mitchell was indicted for tax evasion but was ultimately acquitted. He paid a $1 million civil fine instead.

Then there was the utility magnate Samuel Insull who also appeared before the Pecora Commission. He fled the country in June 1932, which was about eight months before prosecutors brought fraud charges against him. Insull pioneered the concept of a holding company, in which one company holds partial or complete interest in another company. At the height of his success, Insull controlled businesses worth as much as $500 million in assets with just $27 million in equity. When the crash hit, 65 of his businesses failed, ruining 600,000 investors. Insull was eventually returned to the U.S. nearly two years later but he also beat the charges.

The Pecora Commission went after the individuals. The SEC and Justice Department protect those bankers today. The Securities and Exchange Commission is now controlled by the people from Goldman Sachs. The likelihood of the SEC ever prosecuting anyone from the banking industry is ZERO,