In this issue of “China, Yields, And The Coming Deflationary Impulse.“
- Market Review And Update
- China Drives Inflation
- Yields Need A New Narrative
- Portfolio Positioning
- #MacroView: Bear Markets Matter More Than You Think
- Sector & Market Analysis
- 401k Plan Manager
Catch Up On What You Missed Last Week
Market Review & Update
Finally, after a week of false starts, the “buy signals” kicked in, and the markets mustered a rally. As we stated last week:
“With markets deeply oversold on a short-term basis and with signals at levels that generally precede short-term rallies, the rally on Thursday and Friday was not unexpected. Notably, the S&P 500 held support at the 50-dma and rallied back into the previous trading range.
On Wednesday, the Nasdaq triggered its short-term “buy signal,” which will likely provide some relative outperformance over the S&P 500. It will be important for the Nasdaq to hold above the 50-dma into next week“
The good news is that we did indeed get the rally we were expecting. The not-so-good news is that the rally already consumed a majority of the “buy signal.” Such does not mean the market is about to correct; it does suggest that upside remains limited near term.
However, the S&P 500 buy signal has a bit more room to run. Such suggests we may see some relative performance pickup between the S&P 500 and the Nasdaq over the next week or so.
Our more significant concern remains the weekly “sell signal.” Historically, these weekly signals typically denote periods of more significant volatility swings or corrections. The biggest correction risk comes when the daily and weekly signals align.
Importantly, these weekly sell signals do not always resolve into a correction. However, by the time you realize a correction has started, it is often too late to do much about it. Therefore, we tend to take these weekly signals at face value and adjust our risk exposures accordingly.
Still Expecting A Bigger Correction
As discussed over the last few weeks, we still expect a more extensive correction this summer. Currently, the markets are in an exceptionally long stretch in the market without a 5% pullback, so the odds are rising.
Importantly, as noted in this week’s “3-Minutes” video below, the one thing we continue to watch very closely is interest rates.
Wall Street analysts continue to ratchet up earnings at one of the fastest paces on record. For earnings to meet these rather lofty expectations, economic growth must sustain a very high growth rate into 2022. However, interest rates peaked a couple of months ago suggesting economic growth will weaken in the months ahead.
If rates are sniffing out slower economic growth as stimulus fades from the system, the earnings are at risk of fairly significant downward revisions. In the market figures this out, a repricing of assets is likely.
Such is why we continue to suspect a 5-10% correction is a higher probability than most think.
Inflation Is Likely Transient
We previously discussed that inflation might indeed be more transitory given the impacts creating increased prices were artificial. (i.e., stimulus, semi-conductor shortages, and pandemic-related shutdowns.) To wit:
“Inflation is and remains an always ‘transient’ factor in the economy. As shown, there is a high correlation between economic growth and inflation. As such, given the economy will quickly return to sub-2% growth over the next 24-months, inflation pressures will also subside.”
“Significantly, given the economy is roughly comprised of 70% consumption, sharp spikes in inflation slows consumption (higher prices lead to less quantity), thereby slowing economic growth. Such is particularly when inflation impacts things the bottom 80% of the population, which live paycheck-to-paycheck primarily, consume the most.”
However, another important factor behind inflationary pressures is an individual’s own actions. As noted last week by Société Générale’s Albert Edwards:
“Surveys suggest that inflation fears have become investors’ number one concern. But why look at it that way? We could equally say it is investors’ own bullishness on the strength of this economic cycle that is driving prices sharply higher in the most cyclically exposed equity sectors and industrial commodities.”
“In inflation, as in many other areas of economic life, perceptions can form reality, and that is certainly true of inflation. The University of Michigan monthly survey of consumers’ expectations perennially shows shoppers foreseeing more inflation than will in fact arrive. The important factor here is the direction of travel. If they are more worried about inflation, they will do more to guard against it, which will tend to push up prices.”
China Drives Inflation
Such is an important point, as Albert notes:
“When investors pile into commodities as an investment vehicle to benefit from rising inflation, they create substantial upstream cost pressures. Beyond the cascading effect of upstream commodity price pressures, headline CPIs are also quickly impacted as food and energy prices rip higher.”
In other words, investors cause inflation by their actions. However, this is where Albert keys in on another critical driver of inflation.
“In addition to this, the observation by investors that industrial commodity prices are rising only serves to reaffirm their belief about cyclical strength and rising inflation, most especially ‘Dr. Copper.” Many investors see copper as extremely sensitive to economic conditions.
The circular, or as George Soros terms it, ‘reflexive’ nature of financial markets makes them extremely vulnerable to being whipsawed. Yet because of the current extreme momentum, it would take a very heavy weight of evidence to convince this market to reverse direction.
We continue to highlight that commodity prices are at high risk of a major reversal because of the steep downturn in the Chinese Credit Impulse. We have highlighted this before and we are not alone. Julien Bittel of Pictet Asset Management posted the following chart.”
“When commodity prices do start to fall, expect a major reversal in inflation sentiment. Furthermore, expect momentum to become as self-reinforcing and reflexive on the way down just as it was on the way up.”
As we discussed previously, this is what the bond market is already pricing in.
Yields Need A New Narrative
While investors expect surging inflation, the bond market continues to price in weaker future economic growth. As noted in “No, Bonds Aren’t Over-Valued.”
“The correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.”
Note: The “economic composite” is a compilation of inflation (CPI), economic growth (GDP), and wages.
Currently, as shown in our opening commentary, yields have remained range-bound between 1.5-1.6%. Such suggests that expectations for price pressures have moderated.
While the markets wonder when the Fed will start to talk more about tapering the bond purchases, yields are currently suggesting inflation may not be the real “risk.”
The most considerable risk is a divergence among Fed policymakers which possibly leads to a policy mistake of tapering too quickly or even hiking rates.
The majority of the inflation and economic growth pressures are artificial, stemming from the stimulus injections over the last year. However, with those inputs fading as year-over-year comparisons become more challenging, the “deflationary” impact could be more significant than expected.
There is also one other point about the Fed tapering the purchases. As shown in the chart below, rates rise during phases of QE as money rotates from bonds to stocks for the “risk-on” trade. The opposite occurs when they start to taper, suggesting a decline in rates if “taper talk” increases.
Earnings Yields Are A Problem
Switching from economics to equities, the recent spike in inflation has caused a drop in the “earnings yield” into negative territory.
Let’s start with what is “earnings yield.”
“Earnings yield has been the cornerstone of the ‘Fed Model’ since the early ’80s. The Fed Model states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield, you should invest in stocks and vice-versa.”
The problem here is two-fold.
- You receive the income from owning a Treasury bond, whereas there is no tangible return from an earnings yield. For example, if we purchase a Treasury bond with a 5% yield and stock with an 8% earnings yield, if the price of both assets remains stable for one year, the net return on the bond is 5% while the return on the stock is 0%.
- Unlike stocks, bonds have a finite value. At maturity, the principal gets returned to the holder along with the final interest payment. However, stocks have price risk, no maturity, and no repayment of the principal feature. The risk of owning a stock is exponentially more significant than holding a “risk-free” bond.
If we look at periods of exceptionally low earnings yields compared to the market, we find a better correlation to corrections and outright bear markets.
As shown, there is a reasonable correlation between low earnings yields and low forward returns. Historically speaking, with an earnings yield of 2.66%, forward returns over the next decade should somewhere between +2% and -5%.
But what about the NEGATIVE yield?
Negative Real Yields Are A Bigger Problem
An interesting note this past week from Sentiment Trader discussed the outcomes for markets when inflation-adjusted earnings yields are negative.
“Until recently, one of the main arguments for stocks was that even though they weren’t yielding much, at least they were earning more than Treasuries, even after accounting for inflation. Now that there has been a spike in inflation gauges, the earnings yield on the S&P 500 has turned negative. This is not a condition that investors have had to tackle much over the past 70 years.
When an investor in the S&P adds up her dividend check and share of earnings, then subtracts the loss of purchasing power from inflation, she’s barely coming out even. This is a record low, dating back to 1970, just eclipsing the prior low from March 2000.”
“If we ignore dividends, then there have been five other times when the S&P 500’s inflation-adjusted earnings yield turned negative. You may want to close one eye and use the other to look askance at the table because it’s not pretty.”
The issue of negative earnings yield tells you three things:
- The market is hugely overvalued relative to the strength of underlying earnings.
- Expectations for future earnings growth are unlikely to match current expectations leading to a future repricing of risk.
- Bond yields are confirming that both economic and earnings growth has likely peaked.
This past week we started trimming back on our QQQ index trading position to lock in some recent gains. Given that markets are still bullishly biased, we continue to hold our core equity positions for now.
However, we are closely watching our weekly indicators, which continue to approach the next “sell signal.” While such doesn’t mean the markets will have a deep correction, as noted, it typically suggests a pick-up in volatility and investment risk. For us, we would prefer to rebalance exposures and wait for the next buying opportunity to come along.
Let me reiterate from above.
The biggest problem is that technical indicators do not distinguish between a consolidation, a correction, or an outright bear market. As such, if you ignore the signals as they occur, by the time you realize it’s a deep correction, it is too late to do much about it.
Therefore, we must treat each signal with the same respect and adjust risk accordingly. The opportunity costs of doing so are minimal.
If we reduce risk and the market continues to rise, we can quickly increase our exposures. Yes, we sacrifice some short-term performance. However, if we reduce risk and the market declines sharply, we not only protect our capital during the decline but have the cash to deploy at lower price levels.
Such is the biggest problem with “buy and hold” strategies. Yes, you will perform in line with the market, but given that you didn’t “sell high,” there is no cash available with which to “buy low” in the future.
While I agree you can not “time the markets,” you can “manage risk” to improve your long-term outcomes.
For us, that is our primary focus.
If you need help or have questions, we are always glad to help. Just email me.
See You Next Week
By Lance Roberts, CIO
Market & Sector Analysis
Analysis & Stock Screens Exclusively For RIAPro Members
S&P 500 Tear Sheet
The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data. Readings above “80” are considered overbought, and below “20” are oversold. The current reading is 84.70 out of a possible 100.
Portfolio Positioning “Fear / Greed” Gauge
The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.
NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90. The current reading is 84.5 out of a possible 100.
Sector Model Analysis & Risk Ranges
How To Read This Table
- The table compares each sector and market to the S&P 500 index on relative performance.
- “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
- The risk range is a function of the month-end closing price and the “beta” of the sector or market.
- Table shows the price deviation above and below the weekly moving averages.
Weekly Stock Screens
Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.
We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)
S&P 500 Growth Screen
Low P/B, High-Value Score, High Dividend Screen
Fundamental Growth Screen
Aggressive Growth Strategy
Portfolio / Client Update
With the daily “buy signal,” the market has performed as expected. We have made recent gains in our portfolios, and currently, we don’t need to take any aggressive action.
The model is well balanced for now, and we continue to focus on risk management as we enter into the “doldrums of summer.” Volume in the markets has been exceedingly light, and “exuberance” seems to be fading from the market as well. Such aligns with our expectation that we could see a larger correction this summer as concerns on inflation clash with worries the Fed may be close to “tapering” their balance sheet.
What ultimately causes the correction is always unknown, but our weekly signals are suggesting that we are close to a correction than not. However, with that said, we do not expect the correction to any more than a typical 5-10% decline before we see the Fed begin to talk about additional supports and withdraw the idea of any potential taper.
As noted below, we did start taking profits in QQQ and are beginning to shift exposure mildly toward more defensive sector weighting heading into that potential scenario. If the anticipated correction occurs, we will use that opportunistically to add back into our holdings accordingly.
For now, we will be patient and wait and see what next week brings.
During the past week, we made minor changes to portfolios. We post all trades in real-time at RIAPRO.NET.
*** Trading Update – Equity and Sector Models ***
“This morning we reduced our 4% QQQ position in both models by 1% to 3% of the portfolio. The technical signals that led us to buy are getting extended, so we are just taking some profits. When our signals begin to suggest a “sell signal” is approaching we will remove the rest of the position.
We are also adding 2% AMLP in both models as it technically looks strong and we think inflationary stocks will have decent relative outperformance in the coming days. This is a trade for a near-term bump in inflationary pressures and picking up an 8% dividend yield at the same time.
The buy signals on the Dow and S&P are not as extended as the NASDAQ.” – 05/27/21
Equity & ETF Models
- Reduce the 4% position in QQQ to 3% of the portfolio.
- Initiate a 2% position in AMLP
As always, our short-term concern remains the protection of your portfolio. We have shifted our focus from the election back to the economic recovery and where we go from here.
THE REAL 401k PLAN MANAGER
A Conservative Strategy For Long-Term Investors
If you need help after reading the alert, do not hesitate to contact me.
Model performance is a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. Such is strictly for informational and educational purposes only, and one should not rely on it for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril.
Have a great week!