SPROTT'S THOUGHTS Flawed Fundamentals Won’t Fly

IF ECONOMISTS DESIGNED AIRPLANES, WOULD YOU FLY?

By Albert Lu

Source: https://commons.wikimedia.org (cropped)

It’s a fair question. Would you?

Are their models robust? Are their predictions reliable? In other words, is their science sound? Don’t kid yourself; you know the answer.

I suspect even economists would refuse to fly if their colleagues designed the planes.

That’s because as far as scientists go, economists are held to a low standard, very low. We expect them to be wrong, and they rarely disappoint.

When economists mess up, we call the FDIC to clean up the mess. When real scientists and engineers mess up, we call the NTSB — that’s the difference.

THE FUNDAMENTALS

The fundamentals are strong; that’s what they’ve told us for months. Even as the stock market struggled, economists assured us that the economy was fundamentally healthy. The economy has been expanding, the unemployment rate is low, job growth is strong and so on.

There’s no collapse coming, they say, just a return to moderate growth. Isn’t that what the experts said about real estate in 2006?

Here’s the problem: The fundamentals look good, until they don’t. And then it’s too late.

KEY ECONOMIC INDICATOR PLUNGES

The Institute for Supply Management (ISM) upended markets last week when its key manufacturing indicator, the Purchasing Managers’ Index (PMI), missed expectations. The December figure came in at 54.1, versus an estimate of 57.9. The figure was the lowest going back to November 2016. Any reading below 50 corresponds to an economic contraction.

While the decline in the index itself is cause for concern, the survey responses are equally alarming.

“Growth appears to have stopped. Resources still focused on re-sourcing for U.S. tariff mitigation out of China.” (Computer & Electronic Products)
“Brexit has become a problem due to labeling changes.” (Chemical Products)
“Customer demand continues to decrease [due to] concerns about the economy and tariffs.” (Transportation Equipment)
“Starting to see more and more inflationary increases for raw materials. Also, suppliers [are] forcing price increases due to tariffs.” (Food, Beverage & Tobacco Products)
“Business is steady, but pace of incoming orders are slowing.” (Furniture & Related Products)
“Caution seems to be the outlook. Are we in a correction, or is the market getting ready to slow over time?” (Fabricated Metal Products)

Tariff concerns, slowing demand, increasing raw material costs. Indeed, the market has cause for concern.

APPLE’S $5 BILLION MISS

Don’t take my word for it. Ask Tim Cook, the CEO of Apple, or one of the many hedge fund investors who together lost over $2 billion on Apple stock when the company missed its revenue projection last week. Warren Buffett’s Berkshire Hathaway, whose Apple holdings make up 21% of the company’s portfolio, lost over $3.8 billion on the drop.

Apple revised its quarterly revenue forecast down to $84 billion from $89 billion. However, just 60 days earlier, the company had predicted it would exceed last year’s figure of $88.3 billion.

The news sent stocks spiraling — the Dow Jones Industrial Average lost 660 points in Thursday trading before recovering on Friday.

In a letter to shareholders, Cook blamed weaker demand in China for the surprise cut in revenue outlook, the first in almost two decades.

THE BLAME GAME

While Cook and others are quick to blame China, Brexit, currency fluctuations and a host of other external factors for their troubles, their real problems lie closer to home.

Zero percent interest rates, quantitative easing, tax cuts and government spending only go so far. Eventually, the fiscal and monetary spell wears off and problems resurface.

In the case of Apple, perhaps a failure to innovate in a saturated and increasingly competitive market is partly to blame?

Before long, the trade war with China will pass, as will Brexit. But our real problems will remain.

THE CRASH TO SAFETY

Apple’s revenue warning, which came late Wednesday, caught traders off guard and triggered a stampede into the yen. The Japanese safe-haven currency jumped 8% against the Australian dollar and 10% versus the Turkish lira in what some observers are calling an “FX flash crash.”

“The yen is excessively undervalued and we’re now seeing that unwind, largely because risk aversion increased,” was one currency trader’s explanation to Bloomberg.

U.S. Treasuries also benefited from the dash to safety. The 10-year Treasury yield fell by six basis points to 2.56%.

Gold, the historical safe-haven asset, reached its highest price in almost seven months, rising 0.7% to $1,293.61 per ounce.

POWELL TO THE RESCUE

A better than expected U.S. jobs report and dovish rhetoric from Fed Chairman Powell combined to propel stocks upward on the first Friday of the year. The Dow Jones Industrial Average rose over 800 points before finishing the session up 746.

In a statement aimed to calm markets, Powell assured investors, “As always, there is no preset path for policy,” before adding, “we will be patient as we watch to see how the economy evolves.”

Regarding the plan to reduce its balance sheet, Powell said the central bank would not hesitate to change the plan if it caused problems.

It seems the Fed put is alive and well. The Dow extended last Friday’s gains with a strong rally this week, briefly topping 24,000 on Thursday — I suppose the fundamentals are good once again?

THE LESSON

Last week’s panic provides an illustrative lesson for prudent investors. Despite the inevitability of a U.S. recession (sooner or later), the market is clearly not pricing one in today. When the outlook shifts and fundamentals deteriorate, it will be far too late to act.

Better to prepare now than to trust the assurances of a pseudo-science that just won’t fly.

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