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S&P 500 Monthly Valuation & Analysis Review – 4-01-2020

J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.


Fed Trying To Inflate A 4th Bubble To Fix The Third

Over the last couple of years, we have often discussed the impact of the Federal Reserve’s ongoing liquidity injections, which was causing distortions in financial markets, mal-investment, and the expansion of the “wealth gap.” 

Our concerns were readily dismissed as bearish as asset prices were rising. The excuse:

“Don’t fight the Fed”

However, after years of zero interest rates, never-ending support of accommodative monetary policy, and a lack of regulatory oversight, the consequences of excess have come home to roost. 

This is not an “I Told You So,” but rather the realization of the inevitable outcome to which investors turned a blind-eye too in the quest for “easy money” in the stock market. 

It’s a reminder of the consequences of “greed.” 

The Liquidity Trap

We previously discussed the “liquidity trap” the Fed has gotten themselves into, along with Japan, which will plague economic growth in the future. To wit:

“The signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

Our “economic composite” indicator is comprised of 10-year rates, inflation (CPI), wages, and the dollar index. Importantly, downturns in the composite index leads GDP. (I have estimated the impact to GDP for the first quarter at -2% growth, but my numbers may be optimistic)

The Fed’s problem is not only are they caught in an “economic liquidity trap,” where monetary policy has become ineffective in stimulating economic growth, but are also captive to a “market liquidity trap.”

Whenever the Fed, or other Global Central Banks, have engaged in “accommodative monetary policy,” such as QE and rate cuts, asset prices have risen. However, general economic activity has not, which has led to a widening of the “wealth gap” between the top 10% and the bottom 90%. At the same time, corporations levered up their balance sheets, and used cheap debt to aggressively buy back shares providing the illusion of increased profitability while revenue growth remained weak. 

As I have shown previously, while earnings have risen sharply since 2009, it was from the constant reduction in shares outstanding rather than a marked increase in revenue from a strongly growing economy. 

Now, the Fed is engaged in the fight of its life trying to counteract a “credit-event” which is larger, and more insidious, than what was seen during the 2008 “financial crisis.”  

Over the course of the next several months, the Federal Reserve will increase its balance sheet towards $10 Trillion in an attempt to stop the implosion of the credit markets. The liquidity being provided may, or may not be enough, to offset the risk of a global economy which is levered roughly 3-to-1 according to CFO.com:

“The global debt-to-GDP ratio hit a new all-time high in the third quarter of 2019, raising concerns about the financing of infrastructure projects.

The Institute of International Finance reported Monday that debt-to-GDP rose to 322%, with total debt reaching close to $253 trillion and total debt across the household, government, financial and non-financial corporate sectors surging by some $9 trillion in the first three quarters of 2019.”

Read that last part again.

In 2019, debt surged by some $9 Trillion while the Fed is injecting roughly $6 Trillion to offset the collapse. In other words, it is likely going to require all of the Fed’s liquidity just to stabilize the debt and credit markets. 

Bubbles, Bubbles, Bubbles

Jerome Powell clearly understands that after a decade of monetary infusions and low interest rates, he has created an asset bubble larger than any other in history. However, they were trapped by their own policies, and any reversal led to almost immediate catastrophe as seen in 2018.

As I wrote previously:

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s.”

For quite some time now, we have warned investors against the belief that no matter what happens, the Fed can bail out the markets, and keep the bull market. Nevertheless, it was widely believed by the financial media that, to quote Dr. Irving Fisher:

“Stocks have reached a permanently high plateau.”

What is important to understand is that it was imperative for the Fed that market participants, and consumers, believed in this idea. With the entirety of the financial ecosystem more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the “instability of stability” was the most significant risk. 

“The ‘stability/instability paradox’ assumes that all players are rational, and such rationality implies avoidance of complete destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’”

The Fed had hoped they would have time, and the “room” needed, after more than 10-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that had built up in the system. 

Unfortunately, they ran out of time, and the markets stopped “acting rationally.”

This is the predicament the Federal Reserve currently finds itself in. 

Following each market crisis, the Fed has lowered interest rates, and instituted policies to “support markets.” However, these actions led to unintended consequences which have led to repeated “booms and busts” in the financial markets.  

While the market has currently corrected nearly 25% year-to-date, it is hard to suggest that such a small correction will reset markets from the liquidity-fueled advance over the last decade.

To understand why the Fed is trapped, we have to go back to what Ben Bernanke said in 2010 as he launched the second round of QE:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

I highlight the last sentence because it is the most important. Consumer spending makes up roughly 70% of GDP; therefore increased consumer confidence is critical to keeping consumers in action. The problem is the economy is no longer a “productive” economy, but rather a “financial” one. A point made by Ellen Brown previously:

“The financialized economy – including stocks, corporate bonds and real estate – is now booming. Meanwhile, the bulk of the population struggles to meet daily expenses. The world’s 500 richest people got $12 trillion richer in 2019, while 45% of Americans have no savings, and nearly 70% could not come up with $1,000 in an emergency without borrowing.

Central bank policies intended to boost the real economy have had the effect only of boosting the financial economy. The policies’ stated purpose is to increase spending by increasing lending by banks, which are supposed to be the vehicles for liquidity to flow from the financial to the real economy. But this transmission mechanism isn’t working, because consumers are tapped out.”

This was shown in a recent set of studies:

The “Stock Market” Is NOT The “Economy.”

Roughly 90% of the population gets little, or no, direct benefit from the rise in stock market prices.

Another way to view this issue is by looking at household net worth growth between the top 10% to everyone else.

Since 2007, the ONLY group that has seen an increase in net worth is the top 10% of the population.

“This is not economic prosperity. This is a distortion of economics.”

As I stated previously:

“If consumption retrenches, so does the economy.

When this happens debt defaults rise, the financial system reverts, and bad things happen economically.”

That is where we are today. 

The Federal Reserve is desperate to “bail out” the financial and credit markets, which it may  be successful in doing, however, the real economy may not recover for a very long-time. 

With 70% of employment driven by small to mid-size businesses, the shutdown of the economy for an extended period of time may eliminate a substantial number of businesses entirely. Corporations are going to retrench on employment, cut back on capital expenditures, and close ranks. 

While the Government is working on a fiscal relief package, it will fall well short of what is needed by the overall economy and a couple of months of “helicopter money,” will do little to revive an already over leveraged, undersaved, consumer. 

The 4th-Bubble

As I stated previously:

“The current belief is that QE will be implemented at the first hint of a more protracted downturn in the market. However, as suggested by the Fed, QE will likely only be employed when rate reductions aren’t enough.”

The implosion of the credit markets made rate reductions completely ineffective and has pushed the Fed into the most extreme monetary policy bailout in the history of the world. 

The Fed is hopeful they can inflate another asset bubble to restore consumer confidence and stabilize the functioning of the credit markets. The problem is that since the Fed never unwound their previous policies, current policies are having a much more muted effect. 

However, even if the Fed is able to inflate another bubble to offset the damage from the deflation of the last bubble, there is little evidence it is doing much to support economic growth, a broader increase in consumer wealth, or create a more stable financial environment. 

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade, and there is little evidence that growth will recover following this crisis to the degree many anticipate.

There are numerous problems which the Fed’s current policies can not fix:

  • A decline in savings rates
  • An aging demographic
  • A heavily indebted economy
  • A decline in exports
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases

The lynchpin in the U.S., remains demographics, and interest rates. As the aging population grows, they are becoming a net drag on “savings,” the dependency on the “social welfare net” will explode as employment and economic stability plummets, and the “pension problem” has yet to be realized.

While the current surge in QE may indeed be successful in inflating another bubble, there is a limit to the ability to continue pulling forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. 

There is evidence the cycle peak has already been reached.

One thing is for certain, the Federal Reserve will never be able to raise rates, or reduce monetary policy ever again. 

Welcome to United States of Japan.

#MacroView: Fed Launches A Bazooka To Kill A Virus

Last week, we discussed in Fed’s ‘Emergency Rate Cut’ Reveals Recession Risks” that while current economic data may not suggest a possibility of a recession was imminent, other “off the run” data didn’t agree.

We are likely experiencing more than just a ‘soft patch’ currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape, even before the impact of COVID-19, and the ongoing decline of inflationary pressures longer term was already telling us just that.”

The plunge in both 5- and 10-year “breakeven inflation rates,” are currently suggesting that economic growth over the next couple of quarters will drop markedly. The last time there was such a sharp drop in inflation expectations at the beginning of the “financial crisis.”

In the meantime, the markets have been rocked as concerns over the spread of the“COVID-19” virus in the U.S. have shut down sporting events, travel, consumer activities, and a host of other economically sensitive inputs. As we discussed previously:

“Given that U.S. exporters have already been under pressure from the impact of the ‘trade war,’ the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number.”

As noted, with the U.S. now shutting down and entrenching itself in response to the virus, the economic impact will be worsened. However, given that economic data is lagging, and we only have numbers that were mostly pre-virus, the reports over the next couple of months will ultimately reveal the extent of the damage.

We suspect that it will be more significant than most analysts currently expect.

With our Economic Output Composite Indicator (EOCI) at levels which have previously warned of recessions, the “timing” of the virus, and the shutdown of activity in response, will push the indications lower.

“Given the current level of the index as compared to the 6-Month rate of change of the Leading Economic Index, there is a risk of a recessionary drag within the next 6-months.”

(The EOCI is comprised of the Fed Regional Surveys, CFNAI, Chicago PMI, NFIB, LEI, and ISM Composites. The indicator is a broad measure of hard and soft data of the U.S. economy)”

One reason we are confident the economic data will worsen near term is the correlation between the index and the annual rate of change of the S&P 500 index.

The financial markets lead the economy by about 6-months as markets begin to “price in” changes to earnings due to the outlook for economic strength. The recent plunge in the S&P 500 has deviated from the current EOCI index reading suggesting the index will decline towards recessionary levels over the next few months.

What the chart above obfuscates is the severity of the recent market rout. As shown below, in just three very short weeks, the market has reversed almost the entirety of the “Trump Stock Market” gains since he took office on January 20th.

The estimation of substantially weaker economic growth is not just a random assumption. In a post next week, I am going through the math of our analysis. Here is a snippet.

“Over the last sixty years, the yield on the 10-year has approximated real GDP plus inflation (shown in the chart below). Given this historical fact, we can do some basic math to determine what yields are currently predicting for the U.S. economy currently.”

Doug Kass recently did the math:

“Given ZIRP and QE policies around the globe which has pulled an extraordinary amount of sovereign debt into negative territory coupled with secular headwinds to energy prices, I have assumed that the 10 year yield will fall from 1.0x nominal GDP and average about 0.8x nominal GDP. 

According to my pal Peter Boockvar, the 10-year inflation breakeven (in the tips market) stands at 1.41% this morning:

So, let’s solve for what the market expects Real GDP to be (over the next 1-2 years) with this formula:

10-Year Yield (0.744% Actual) = 0.8x (Real GDP + 1.41% Actual (inflation))

The implied U.S. Real GDP of this equation is now negative — at -0.48%. (This compares to the consensus 2020 Real GDP growth forecast of between +1.75% to +2.00%) It also implies that nominal GDP (Real GDP plus Inflation) will be only about +0.93% – substantially below consensus expectations of slightly above 3%.”

Doug’s estimates were before to the recent collapse in oil prices, and breakeven inflation rates. With oil prices now at $30/bbl and 10-year breakeven rates to 0.9%, the math is significantly worse, and that is what the severity of the recent selloff is telling us. Over the next two quarters, we could see as much as a 3% clip off of current GDP.

This data is not lost on the Federal Reserve and is why they have been taking action over the last two weeks.

The Fed Bazooka

It’s quite amazing that in mid-February, which now seems like a lifetime ago, we were discussing the markets being 3-standard deviations above their 200-dma, which is a rarity. Three short weeks later, the markets are now 4-standard deviations below, which is even a rarer event. 

That swing in asset prices has cut the “wealth effect” from the market, and will severely impact consumer confidence over the next few months. The decline in confidence, combined with the impact of the loss of activity from the virus, will sharply reduce consumption, which is 70% of the economy.

This is why the Fed cut rates in an “emergency action” by 0.50% previously. Then on Wednesday, increased “Repo operations” to $175 Billion.

However, like hitting a patient with a defibrillator, the was no response from the market.

Then yesterday, the Fed brought out their “big gun.”  In a statement from the New York Fed:

The Federal Reserve said it would inject more than $1.5 trillion of temporary liquidity into Wall Street on Thursday and Friday to prevent ominous trading conditions from creating a sharper economic contraction.

‘These changes are being made to address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak.’

The New York Fed said it would conduct three additional repo offerings worth an additional $1.5 trillion this week, with two separate $500 billion offerings that will last for three months and a third that will mature in one month.

If the transactions are fully subscribed, they would swell the central bank’s $4.2 trillion asset portfolio by more than 35%.” – WSJ

As Mish Shedlock noted,

“The Fed can label this however they want, but it’s another round of QE.”

As you can see in the chart below, this is a massive surge of liquidity hitting the market at a time the market is sitting on critical long-term trend support.

Of course, this is what the market has been hoping for:

  • Rate cuts? Check
  • Liquidity? Check

For about 15-minutes yesterday, stocks responded by surging higher and reversing half of the day’s losses. Unfortunately, the enthusiasm was short-lived as sellers quickly returned to continue their “panic selling.” 

This has been frustrating for investors and portfolio managers, as the ingrained belief over the last decade has been “Don’t worry, the Fed’s got this.”

All of a sudden, it looks like they don’t.

Will It Work This Time?

There is a singular risk that we have worried about for quite some time.

Margin debt.

Here is a snip from an article I wrote in December 2018.

Margin debt is the ‘gasoline,’ which drives markets higher as the leverage provides for the additional purchasing power of assets. However, that ‘leverage’ also works in reverse as it provides the accelerant for larger declines as lenders ‘force’ the sale of assets to cover credit lines without regard to the borrower’s position.

That last sentence is the most important. The issue with margin debt, in particular, is that the unwinding of leverage is NOT at the investor’s discretion. It is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) When lenders fear they may not be able to recoup their credit-lines, they force the borrower to either put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen all at once as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.”

Given the magnitude of the declines in recent days, and the lack of response to the Federal Reserve’s inputs, it certainly has the feel of a margin debt liquidation process. This was also an observation made by David Rosenberg:

“The fact that Treasuries, munis, and gold are getting hit tells me that everything is for sale right now. One giant margin call where even the safe-havens aren’t safe anymore. Except for cash.”

Unfortunately, FINRA only updates margin debt in arrears, so as of this writing, the latest margin debt stats are for January. What we do know is that due to the market decline, negative free cash balances have likely declined markedly. That’s the good news.

Back to my previous discussion for a moment:

“When an event eventually occurs, it creates a rush to liquidate holdings. The subsequent decline in prices eventually reaches a point which triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying ‘collateral,’ the forced sale of assets will reduce the value of the collateral, further triggering further margin calls. Those margin calls will trigger more selling forcing, more margin calls, so forth and so on.

Given the lack of ‘fear’ shown by investors during the recent decline, it is unlikely that the recent drop in margin debt is a function of ‘forced liquidations.’ As I noted above, it will likely take a correction of more than 20%, or a ‘credit related’ event, which sparks broker-dealer concerns about repayment of their credit lines.

The risk to the market is ‘when’ those ‘margin calls’ are made.

It is not the rising level of debt that is the problem; it is the decline which marks peaks in both market and economic expansions.”

That is precisely what we have seen over the last three weeks.

While the Federal Reserve’s influx of liquidity may stem the tide temporarily, it is likely not a “cure” for what ails the market.

However, with that said, the Federal Reserve, and Central Banks globally, are not going to quietly into the night. Expect more stimulus, more liquidity, and more rate cuts. If that doesn’t work, expect more until it does.

We have already reduced a lot of equity risk in portfolios so far, but are going to continue lifting exposures and reducing risk until a bottom is formed in the market. The biggest concern is trying to figure out exactly where that is.

One thing is now certain.

We are in a bear market and a recession. It just hasn’t been announced as of yet.

That is something the Fed can’t fix right away with monetary policy alone, and, unfortunately, there won’t be any help coming from the Government until after the election.

#MacroView: Fed’s “Emergency Rate Cut” Reveals Recession Risks

Last week, I discussed in “Recession Risks Tick Up” that while current data may not suggest a possibility of a recession was imminent, other “off the run” data didn’t agree.

“The problem with most of the current analysis, which suggests a “no recession” scenario, is based heavily on lagging economic data, which is highly subject to negative revisions. The stock market, however, is a strong leading indicator of investor expectations of growth over the next 12-months. Historically, stock market returns are typically favorable until about 6-months prior to the start of a recession.”

“The compilation of the data all suggests the risk of recession is markedly higher than what the media currently suggests. Yields and commodities are suggesting something quite different.”

In this particular case, while the market is suggesting there is an economic problem coming, we also discussed the impact of the “coronavirus,” or “COVID-19,” on the economy. Specifically, I stated:

But it isn’t just China. It is also hitting two other economically important countries: Japan and South Korea, which will further stall exports and imports to the U.S. 

Given that U.S. exporters have already been under pressure from the impact of the “trade war,” the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number. 

With our Economic Output Composite Indicator (EOCI) already at levels which has previously denoted recessions, the “timing” of the virus could have more serious consequences than currently expected by overzealous market investors. 

(The EOCI is comprised of the Fed Regional Surveys, CFNAI, Chicago PMI, NFIB, LEI, and ISM Composites. The indicator is a broad measure of hard and soft data of the U.S. economy)”

“Given the current level of the index as compared to the 6-Month rate of change of the Leading Economic Index, there is a rising risk of a recessionary drag within the next 6-months.”

That analysis seemed to largely bypass the mainstream economists, and the Fed, who were focused on the “number of people getting sick,” rather than the economic disruption from the shutdown of the supply chain.

On Tuesday, the Federal Reserve shocked the markets with an “emergency rate cut” of 50-basis points. While the futures market had been predicting the Fed to cut rates at their next meeting on March 18th, the half-percent cut shocked equity markets as the Fed now seems more concerned about the economy than they previously acknowledged.

It is one thing for the Fed to cut rates to support economic growth. It is quite another for the Fed to slash rates by 50 basis points between meetings.

It smacks of “fear.” 

Previously, such emergency rate cuts have not been done lightly, but in response to a bigger crisis which was simultaneously unfolding.

While we have spilled a good bit of digital ink as of late warning about the ramifications of COVID-19:

“Clearly, the ‘flu’ is a much bigger problem than COVID-19 in terms of the number of people getting sick. The difference, however, is that during ‘flu season,’ we don’t shut down airports, shipping, manufacturing, schools, etc. The negative impact on exports and imports, business investment, and potential consumer spending are all direct inputs into the GDP calculation and will be reflected in corporate earnings and profits.”

This is not a trivial matter.

“Nearly half of U.S. companies in China said they expect revenue to decrease this year if business can’t return to normal by the end of April, according to a survey conducted Feb. 17 to 20 by the American Chamber of Commerce in China, or AmCham, to which 169 member companies responded. One-fifth of respondents said 2020 revenue from China would decline more than 50% if the epidemic continues through Aug. 30..”WSJ

That drop in revenue, and ultimately earnings, has not yet been factored into earnings estimates. This is a point I made on Tuesday:

“More importantly, the earnings estimates have not been ratcheted down yet to account for the impact of the “shutdown” to the global supply chain. Once we adjust (dotted blue line) for a negative earnings environment in 2020, with a recovery in 2021, you can see just how far estimates will slide over the coming months. This will put downward pressure on stocks over the course of this year.”

It is quite possible even my estimates may still be too high.

While the markets have been largely dismissing the impact of the virus, the Fed’s “panic” move on Tuesday was confirming evidence that we are on the right track.

The market’s wild correction over the past two weeks, also begins to align with the Fed’s previous rate-cutting cycles. While it initially appeared “this time was different,” as the market continued to rise due to the Fed’s flood of liquidity, the markets seem to be playing catch up to previous rate-cutting cycles. If the economic data begins to weaken markedly, we may will see an alignment with the previous starts of bear markets and recessions.

Of course, we need to add some context to the chart above. Historically, the reason the Fed cuts rates, and interest rates fall, is because the Fed has acted in response to a crisis, recession, or both. The chart below shows when there is an inversion between the Fed Funds rate, and the 10-year Treasury, it has been associated with recessionary onset. (This curve will invert when the Fed cuts rates further at their next meeting.)

Not surprisingly, as suggested by the historical data above, the stock market has yielded a negative return a year after an emergency rate cut was initiated.

There is another risk the Fed may not be prepared for, an inflationary spike in prices. What could potentially impact the economy, and inflationary pressures, is the shutdown of the global supply chain which creates a lack of supply to meet immediate demand. Basic economics suggests this could lead to inflationary pressures as inventories become extremely lean, and products become unavailable. Even a short-term inflationary spike would put the Federal Reserve on the “wrong-side” of the trade, rendering the Fed’s monetary policies ineffective.

The rising recession risk is also being signaled by the collapse in the 10-year Treasury yield, a point which I have made repeatedly over the last several years in discussing why interest rates were headed toward zero.

“Outside of other events such as the S&L Crisis, Asian Contagion, Long-Term Capital Management, etc. which all drove money out of stocks and into bonds pushing rates lower, recessionary environments are especially prone at suppressing rates further. But, given the inflation of multiple asset bubbles, a credit-driven event that impacts the corporate bond market will drive rates to zero.

Furthermore, given rates are already negative in many parts of the world, which will likely be even more negative during a global recessionary environment, zero yields will still remain more attractive to foreign investors. This will be from both a potential capital appreciation perspective (expectations of negative rates in the U.S.) and the perceived safety and liquidity of the U.S. Treasury market. 

Rates are ultimately directly impacted by the strength of economic growth and the demand for credit. While short-term dynamics may move rates, ultimately the fundamentals combined with the demand for safety and liquidity will be the ultimate arbiter.”

A chart of monetary velocity tells you there is a problem in the economy as lower interest rates fails to spark an uptick in the flow of money.

My friend Caroline Baum summed up the Fed’s primary problem given the issue of plunging rates:

“All of a sudden, the reality of revisiting the zero lower bound, which the Fed now refers to as the effective lower bound (ELB), is no longer off in the distance. It could be right around the corner.

And this at a time when Fed officials are still saying that the economy and monetary policy are ‘in a good place’ and the fundamentals are sound. So what do policymakers do when the good place deteriorates into something mediocre, and the fundamentals turn sour?

Forward guidance, which I like to call talk therapy? Large-scale asset purchases? Unfortunately, the Fed goes to war with the tools it has, not the tools it might want or wish to have.”

Unfortunately, the Fed is still misdiagnosing what ails the economy, and monetary policy is unlikely to change the outcome in the U.S.

The reasons are simple. You can’t cure a debt problem with more debt. Therefore, monetary interventions, and government spending, don’t create organic, sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled.

There is already evidence that lower rates are not leading to expanding consumption, business investment, or economic activity. Furthermore, while QE may temporarily lift asset prices, the lack of economic growth, resulting in lower earnings growth, will eventually lead to a repricing of assets.

Furthermore, there is likely no help coming from fiscal policy, either. As Caroline noted:

“Fiscal-policy measures, which entail tax cuts and government spending, will be difficult to enact in this highly charged political environment. There is little evidence that the Republicans and Democrats can put partisan differences aside to work together.”

Or, as Chuck Schumer said to Ben Bernanke just prior to the “financial crisis:”

“You’re the only game in town.” 

The real concern for investors, and individuals, is the real economy.

We are likely experiencing more than just a “soft patch” currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape, even before the impact of COVID-19, and the ongoing decline of inflationary pressures longer term was already telling us just that.

The Fed already realizes they have a problem, as noted by Fed Chair Powell on Tuesday:

“A rate cut will not reduce the rate of infection. It won’t fix a broken supply chain. We get that.”

More importantly, this is no longer a domestic question, but rather a global one. Since every major central bank is now engaged in a coordinated infusion of liquidity, fighting slowing economic growth, a rising level of negative yields, and a spreading virus shutting down economic activity, it is “all hands on deck.”

The Federal Reserve is currently betting on a “one trick pony” which is that by increasing the “wealth effect,” it will ultimately lead to a return of consumer confidence, and mitigate the effect of a global contagion.

Unfortunately, there mounting evidence it may not work.

S&P 500 Monthly Valuation & Analysis Review – 3-2-2020

J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.


MacroView: The Ghosts Of 2018?

On Jan 3rd, I wrote an article entitled: “Will The Market Repeat The Start Of 2018?” At that time, the Federal Reserve was dumping a tremendous amount of money into the financial markets through their “Repo” operations. To wit:

“Don’t fight the Fed. That is the current mantra of the market as we begin 2020, and it certainly seems to be the right call. Over the last few months, the Federal Reserve has continued its “QE-Not QE” operations, which has dramatically expanded its balance sheet. Many argue, rightly, the current monetary interventions by the Fed are technically “Not QE” because they are purchasing Treasury Bills rather than longer-term Treasury Notes.

However, ‘Mr. Market’ doesn’t see it that way. As the old saying goes, ‘if it looks, walks, and quacks like a duck…it’s a duck.'” 

As I noted then, despite commentary to the contrary, there were only two conclusions to draw from the data:

  1. There is something functionally “broken” in the financial system which is requiring massive injections of liquidity to try and rectify, and;
  2. The surge in liquidity, whether you want to call it a “duck,” or not, is finding its way into the equity markets.

Let me remind you this was all BEFORE the outbreak of the Coronavirus.

The Ghosts Of 2018

“Well, this past week, the market tripped ‘over its own feet’ after prices had created a massive extension above the 50-dma as shown below. As I have previously warned, since that extension was so large, a correction just back to the moving average at this point will require nearly a -6% decline.”

“I have also repeatedly written over the last year:

‘The problem is that it has been so long since investors have even seen a 2-3% correction, a correction of 5%, or more, will ‘feel’ much worse than it actually is, which will lead to ’emotionally driven’ mistakes.’

The question now, of course, is do you “buy the dip” or ‘run for the hills?’”

Yesterday morning, the markets began the day deeply in the red, but by mid-morning were flirting with a push into positive territory. By the end of the day, the Dow had posted its largest one-day point loss in history.”

That was from February 6th, 2018 (Technically Speaking: Tis But A Flesh Wound)

Here is a chart of October 2019 to Present.

Besides the reality that the only thing that has occurred has been a reversal of the Fed’s “Repo” rally, there is a striking similarity to 2018. That got me to thinking about the corollary between the two periods, and how this might play out over the rest of 2020.

Let’s go back.

Heading in 2018, the markets were ebullient over President Trump’s recently passed tax reform and rate cut package. Expectations were that 2018 would see a massive surge in earnings growth, due to the lower tax rates, and there would be a sharp pickup in economic growth.

However, at the end of January, President Trump shocked the markets with his “Trade War” on China and the imposition of tariffs on a wide variety of products, which potentially impacted American companies. As we said at the time, there was likely to be unintended consequences and would kill the effect of tax reform.)

“While many have believed a ‘trade war’ will be resolved without consequence, there are two very important points that most of the mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs.”

Over the next few months, the market dealt, and came to terms with, the trade war and the Fed’s tightening of the balance sheet. As we discussed in May 2018, the trade war did wind up clipping earnings estimates to a large degree, but massive share repurchases helped buoy asset prices.

Then in September, the Fed did the unthinkable.

After having hiked rates previously, thereby tightening the monetary supply, they stated that monetary policy was not “close to the neutral rate,” suggesting more rate hikes were coming. The realization the Fed was intent on continuing to tighten policy, and further extracting liquidity by reducing their balance sheet, sent asset prices plunging 20% from the peak, to the lows on Christmas Eve.

It was then the Fed acquiesced to pressure from the White House and began to quickly reverse their stance and starting pumping liquidity back into the markets.

And the bull market was back.

Fast forward to 2020.

“The exuberance that surrounded the markets going into the end of last year, as fund managers ramped up allocations for end of the year reporting, spilled over into the start of the new with S&P hitting new record highs.

Of course, this is just a continuation of the advance that has been ongoing since the Trump election. The difference this time is the extreme push into 3-standard deviation territory above the moving average, which is concerning.” – Real Investment Report Jan, 5th 2018

As noted in the chart below, in both instances, the market reached 3-standard deviations above the 200-dma before mean-reverting.

Of course, while everyone was exuberant over the Fed’s injections of monetary support, we were discussing the continuing decline in earnings growth estimates, along with the lack of corporate profit growth To wit:

With equities now more than 30% higher than they were then, the Fed mostly on hold in terms of rate cuts, and ‘repo’ operations starting to slow, it certainly seems that expectations for substantially higher market values may be a bit optimistic.

Furthermore, as noted above, earnings expectations declined for the entirety of 2019, as shown in the chart below. However, the impact of the ‘coronavirus’ has not been adopted into these reduced estimates as of yet. These estimates WILL fall, and likely markedly so, which, as stated above, is going to make justifying record asset prices more problematic.”

Just as the “Trade War” shocked the markets and caused a repricing of assets in 2018, the “coronavirus” has finally infected the markets enough to cause investors to adjust their expectations for earnings growth. Importantly, as in 2018, earnings estimates have not been revised lower nearly enough to compensate for the global supply chain impact coming from the virus.

While the beginning of 2020 is playing out much like 2018, what about the rest of the year?

There are issues occurring which we believe will have a very similar “feel” to 2018, as the impact of the virus continues to ebb and flow through the economy. The chart below shows the S&P 500 re-scaled to 1000 for comparative purposes.

Currently, the expectation has risen to more than a 70% probability the Fed will cut rates 3x in 2020. Historically, the market tends to underestimate just how far the Fed will go as noted by Michael Lebowitz previously:

“The graph below tracks the comparative differentials (Fed Funds vs. Fed Fund futures) using the methodology outlined above. The gray rectangular areas represent periods where the Fed was systematically raising or lowering the Fed funds rate (blue line). The difference between Fed Funds and the futures contracts, colored green or red, calculates how much the market over (green) or under (red) estimated what the Fed Funds rate would ultimately be. In this analysis, the term overestimate means Fed Funds futures thought Fed Funds would be higher than it ultimately was. The term underestimate, means the market expectations were lower than what actually transpired.”

Our guess is that in the next few weeks, the Fed will start using “forward guidance” to try and stabilize the market. Rate cuts, and more “quantitative easing,” will likely follow.

Such actions should stabilize the market in the near-term as investors, who have been pre-conditioned to “buy” Fed liquidity, will once again run back into markets. This could very well lift the markets into second quarter of this year.

But it will likely be a “trap.”

While monetary policy will likely embolden the bulls short-term, it does little to offset an economic shock. As we move further into the year, the impact to the global supply chain will begin to work its way through the system resulting in slower economic growth, reduced corporate profitability, and potentially a recession. (See yesterday’s commentary)

This is a guess. There is a huge array of potential outcomes, and trying to predict the future tends to be a pointless exercise. However, it is the thought process that helps align expectations with potential outcomes to adjust for risk accordingly.

A Sellable Rally

Just as in February 2018, following the sharp decline, the market rallied back to a lower high before failing once again. For several reasons, we suspect we will see the same over the next week or two, as the push into extreme pessimism and oversold conditions will need to be reversed before the correction can continue.

While 2019 ended in an entirely dissimilar manner as compared to 2018, the current negative sentiment, as shown by CNN’s Fear & Greed Index is back to the extreme fear levels seen at the lows of the market in 2018.

On a short-term technical basis, the market is now extremely oversold, which is suggestive of a counter-trend rally over the next few days to a week or so.

It is highly advisable to use ANY reflexive rally to reduce portfolio risk, and rebalance portfolios. Most likely, another wave of selling will likely ensue before a stronger bottom is finally put into place. 

Lastly, our composite technical overbought/oversold gauge is also pushing more extreme oversold conditions, which are typical of a short-term oversold condition.

In other words, in 2019 “everyone was in the pool,” in 2020 we just found out “everyone was swimming naked.” 

Rules To Follow

One last chart.

I just want you to pay attention to the top panel and the shaded areas. (standard deviations from the 50-dma)

We were not this oversold even during the 2015-2016 decline, much less the two declines in 2018.

Currently, not only is the market extremely oversold on a short-term basis, but is currently 5-standard deviations below the 50-dma.

Let me put that into perspective for you.

  • 1-standard deviation = 68.26% of all possible price movement.
  • 2-standard deviations = 95.45% 
  • 3-standard deviations = 99.73%
  • 4-standard deviations = 99.993%
  • 5-standard deviations = 99.9999%

Mathematically speaking, the bulk of the decline is already priced into the market.

“I get it. We are gonna get a bounce. So, what do I do?”

I am glad you asked.

Step 1) Clean Up Your Portfolio

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Take profits in positions that have outperformed during the rally.
  3. Sell laggards and losers (those that lagged the rally, probably led the decline)
  4. Raise cash, and rebalance portfolios to reduced risk levels for now.

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

  1. Determine areas where exposure needs to be increased, or decreased (bonds, cash, equities)
  2. Determine how many shares need to be bought or sold to rebalance allocation requirements.
  3. Determine cash requirements for hedging purposes
  4. Re-examine the portfolio to ensure allocations are adjusted for FORWARD market risk.
  5. Determine target price levels for each position.
  6. Determine “stop loss” levels for each position being maintained.

Step 3) Be Ready To Execute

  • Whatever bounce we get will likely be short-lived. So have your game plan together before-hand as the opportunity to rebalance risk will likely not be available for very long. 

This is just how we do it.

However, there are many ways to manage risk, and portfolios, which are all fine. What separates success and failure is 1) having a strategy to begin with, and; 2) the discipline to adhere to it.

The recent market spasm certainly reminds of 2018. And, if we are right, it will get better, before it gets worse.

MacroView: The Next “Minsky Moment” Is Inevitable

In 2007, I was at a conference where Paul McCulley, who was with PIMCO at the time, was discussing the idea of a “Minsky Moment.”  At that time, this idea fell on “deaf ears” as the markets, and economy, were in full swing.

However, it wasn’t too long before the 2008 “Financial Crisis” brought the “Minsky Moment” thesis to the forefront. What was revealed, of course, was the dangers of profligacy which resulted in the triggering of a wave of margin calls, a massive selloff in assets to cover debts, and higher default rates.

So, what exactly is a “Minskey Moment?”

Economist Hyman Minsky argued that the economic cycle is driven more by surges in the banking system, and in the supply of credit than by the relationship which is traditionally thought more important, between companies and workers in the labor market.

In other words, during periods of bullish speculation, if they last long enough, the excesses generated by reckless, speculative, activity will eventually lead to a crisis. Of course, the longer the speculation occurs, the more severe the crisis will be.

Hyman Minsky argued there is an inherent instability in financial markets. He postulated that an abnormally long bullish economic growth cycle would spur an asymmetric rise in market speculation which would eventually result in market instability and collapse. A “Minsky Moment” crisis follows a prolonged period of bullish speculation which is also associated with high amounts of debt taken on by both retail and institutional investors.

One way to look at “leverage,” as it relates to the financial markets, is through “margin debt,” and in particular, the level of “free cash” investors have to deploy. In periods of “high speculation,” investors are likely to be levered (borrow money) to invest, which leaves them with “negative” cash balances.

While margin balances did decline in 2018, as the markets fell due to the Federal Reserve hiking rates and reducing their balance sheet, it is notable that current levels of “leverage” are still excessively higher than they were either in 1999, or 2007.

This is also seen by looking at the S&P 500 versus the growth rate of margin debt.

The mainstream analysis dismisses margin debt under the assumption that it is the reflection of “bullish attitudes” in the market. Leverage fuels the market rise. In the early stages of an advance, this is correct. However, in the later stages of an advance, when bullish optimism and speculative behaviors are at the peaks, leverage has a “dark side” to it. As I discussed previously:

“At some point, a reversion process will take hold. It is when investor ‘psychology collides with ‘leverage and the problems associated with market liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite, and throwing it into a tanker full of gasoline.”

That moment is the “Minsky Moment.”

As noted, these reversion of “bullish excess” are not a new thing. In the book, The Cost of Capitalism, Robert Barbera’s discussed previous periods in history:

The last five major global cyclical events were the early 1990s recession — largely occasioned by the U.S. Savings & Loan crisis, the collapse of Japan Inc. after the stock market crash of 1990, the Asian crisis of the mid-1990s, the fabulous technology boom/bust cycle at the turn of the millennium and the unprecedented rise and then collapse for U.S. residential real estate in 2007-2008.

All five episodes delivered recessions, either global or regional. In no case was there as significant prior acceleration of wages and general prices. In each case, an investment boom and an associated asset market ran to improbably heights and then collapsed. From 1945 to 1985 there was no recession caused by the instability of investment prompted by financial speculation — and since 1985 there has been no recession that has not been caused by these factors. 

Read that last sentence again.

Interestingly, it was post-1970 the Federal Reserve became active in trying to control interest rates and inflation through monetary policy.

As noted in “The Fed & The Stability Instability Paradox:”

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s. As shown in the chart below, when the Fed has lifted the short-term lending rates to a level higher than the 2-year rate, bad ‘stuff’ has historically followed.”

The Fed Is Doing It Again

As noted above, “Minsky Moment” crises occur because investors, engaging in excessively aggressive speculation, take on additional credit risk during prosperous times, or bull markets. The longer a bull market lasts, the more investors borrow to try and capitalize on market moves.

However, it hasn’t just been investors tapping into debt to capitalize on the bull market advance, but corporations have gorged on debt for unproductive spending, dividend issuance, and share buybacks. As I noted in last week’s MacroView:

“Since the economy is driven by consumption, and theoretically, companies should be taking on debt for productive purposes to meet rising demand, analyzing corporate debt relative to underlying economic growth gives us a view on leverage levels.”

“The problem with debt, of course, is it is leverage that has to be serviced by underlying cash flows of the business. While asset prices have surged to historic highs, corporate profits for the entirety of U.S. business have remained flat since 2014. Such doesn’t suggest the addition of leverage is being done to ‘grow’ profits, but rather to ‘sustain’ them.”

Over the last decade, the Federal Reserve’s ongoing liquidity interventions, zero interest-rates, and maintaining extremely “accommodative” policies, has led to substantial increases in speculative investment. Such was driven by the belief that if “something breaks,” the Fed will be there to fix to it.

Despite a decade long economic expansion, record stock market prices, and record low unemployment, the Fed continues to support financial speculation through ongoing interventions.

John Authers recently penned an excellent piece on this issue for Bloomberg:

“Why does liquidity look quite so bullish? As ever, we can thank central banks and particularly the Federal Reserve. Twelve months ago, the U.S. central bank intended to restrict liquidity steadily by shrinking the assets on its balance sheet on “auto-pilot.” That changed, though. It reversed course and then cut rates three times. And most importantly, it started to build its balance sheet again in an attempt to shore up the repo market — which banks use to access short-term finance — when it suddenly froze up  in September. In terms of the increase in U.S. liquidity over 12 months, by CrossBorder’s measures, this was the biggest liquidity boost ever:”

While John believes we are early in the global liquidity cycle, I personally am not so sure given the magnitude of the increase Central Bank balance sheets over the last decade.

Currently, global Central Bank balance sheets have grown from roughly $5 Trillion in 2007, to $21 Trillion currently. In other words, Central Bank balance sheets are equivalent to the size of the entire U.S. economy.

In 2007, the global stock market capitalization was $65 Trillion. In 2019, the global stock market capitalization hit $85 Trillion, which was an increase of $20 Trillion, or roughly equivalent to the expansion of the Central Bank balance sheets.

In the U.S., there has been a clear correlation between the Fed’s balance sheet expansions, and speculative risk-taking in the financial markets.

Is Another Minsky Moment Looming?

The International Monetary Fund (IMF) has been issuing global warnings of high debt levels and slowing global economic growth, which has the potential to result in Minsky Moment crises around the globe.

While this has not come to fruition yet, the warning signs are there. Globally, there is roughly $15 Trillion in negative-yielding debt with asset prices fundamentally detached for corporate profitability, and excessive valuations on multiple levels.

As Desmond Lachman wrote:

“How else can one explain that the risky U.S. leveraged loan market has increased to more than $1.3 trillion and that the size of today’s global leveraged loan market is some two and a half times the size of the U.S. subprime market in 2008? Or how else can one explain that in 2017 Argentina was able to place a 100-year bond? Or that European high yield borrowers can place their debt at negative interest rates? Or that as dysfunctional and heavily indebted government as that of Italy can borrow at a lower interest rate than that of the United States? Or that the government of Greece can borrow at negative interest rates?

These are all clear indications that speculative excess is present in the markets currently.

However, there is one other prime ingredient needed to complete the environment for a “Minsky Moment” to occur.

That ingredient is complacency.

Yet despite the clearest signs that global credit has been grossly misallocated and that global credit risk has been seriously mispriced, both markets and policymakers seem to be remarkably sanguine. It would seem that the furthest thing from their minds is that once again we could experience a Minsky moment involving a violent repricing of risky assets that could cause real strains in the financial markets.”

Desmond is correct. Currently, despite record asset prices, leverage, debt, combined with slowing economic growth, the level of complacency is extraordinarily high. Given that no one currently believes another “credit-related crisis” can occur is what is needed to allow one to happen.

Professor Minsky taught that markets have short memories, and that they repeatedly delude themselves into believing that this time will be different. Sadly, judging by today’s market exuberance in the face of mounting economic and political risks, once again, Minsky is likely to be proved correct.

At this point in the cycle, the next “Minsky Moment” is inevitable.

All that is missing is the catalyst to start the ball rolling.

An unexpected recession would more than likely due to trick.

S&P 500 Monthly Valuation & Analysis Review – 2-1-2020

J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.


MacroView: The Fed’s View Of Valuations May Be Misguided

On Wednesday, the Federal Reserve concluded their January “FOMC” meeting and released their statement. Overall, there was not much to get excited about, as it was virtually the same statement they released at the last meeting.

However, Jerome Powell made a comment which caught our attention:

“We do see asset valuations as being somewhat elevated” 

It is an interesting comment because he compares it to equity yields.

“One way to think about equity prices is what’s the premium you’re getting paid to own equities rather than risk-free debt.”

As we have discussed previously, looking at equity yield, which is the inverse of the price-earnings ratio, versus owning bonds is a flawed and ultimately dangerous premise. To wit:

“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.

1. 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%. Which one had the better return?  Furthermore, this has been especially true over the last two decades where owning bonds has outperformed owning stocks. (Data is total real return via Aswath Damodaran, NYU)

2. Unlike stocks, bonds have a finite value. At maturity, the principal is returned to the holder along with the final interest payment. However, while stocks may have an “earnings yield,” which is never received, stocks have price risk, no maturity, and no repayment of principal feature. The risk of owning a stock is exponentially more significant than owning a “risk-free” bond.

This flawed concept of risk, as promoted by the Federal Reserve, also undermines their view of current valuations.

I have spilled an enormous amount of “digital ink” discussing the importance of valuations on future returns for investors, and most recently, why high starting valuations are critically important to individuals at, or near, retirement.

“Over any 30-year period, beginning valuation levels have a tremendous impact on future returns. As valuations rise, future rates of annualized returns fall. This should not be a surprise as simple logic states that if you overpay for an asset today, the future returns must, and will, be lower.”

Not surprisingly, valuations are often dismissed in the short-term because there is not an immediate impact on price returns. Valuations, by their very nature, are not strong predictors of 12-month returns. This was a point made by Janet Yellen in 2017:

“The fact that [stock market] valuations are high doesn’t mean that they’re necessarily overvalued. For starters, high valuations don’t portend lackluster returns in the near term. History shows that valuations provide no reliable signal as to what will happen in the next 12 months.”

That is correct. However, over long periods, valuations are strong predictors of expected returns, which is what matters for investors.

As my friends over at Crescat Capital, Kevin Smith and Tavi Costa, recently penned:

“The problem is that P/E, even Shiller’s cyclically adjusted P/E ratio (CAPE), is a potential value-trap measure in the current economy because of three issues:

  1. Profit margins are unsustainably high today, not only within this business cycle but compared to other business cycles making P/E ratios understated;
  2. The P/E ratio completely ignores debt in its valuation, not a good idea at a time when corporations have record leverage; and
  3. The most common measures of total market P/E use the mean rather than median company valuation which understates the average company’s multiple today by putting more weight on bigger, more profitable companies – the median better captures the valuation of the breadth of the market.

We believe median enterprise value to sales is one of the best measures to understand the extent of the bubble in the stock market today compared to history. By looking at sales and not earnings, we control for today’s likely fleeting, record-high profit margins. And because EV includes debt as well as equity in the total valuation of the company, it properly reflects the valuation of the business. Finally, our focus on the median company’s valuation illustrates the breadth of the valuation extreme in the market today.”

Let’s break down Crescat’s important points visually.

Since the economy is driven by consumption, and theoretically, companies should be taking on debt for productive purposes to meet rising demand, analyzing corporate debt relative to underlying economic growth gives us a view on leverage levels.

As Scott Minerd, CIO of Guggenheim Investments tweeted on Friday:

The problem with debt, of course, is it is leverage that has to be serviced by underlying cash flows of the business. While asset prices have surged to historic highs, corporate profits for the entirety of U.S. business have remained flat since 2014. Such doesn’t suggest the addition of leverage is being done to “grow” profits, but rather to “sustain” them. 

However, when it comes to GAAP earnings per share, which have been heavily manipulated by massive levels of “share buybacks,” the deviation between what investors are paying for earnings is the largest on record, far surpassing the “Dot.com” bubble era.

“The average investor does not need an advanced finance degree to understand these valuation points. It is a worthy endeavor to avoid getting caught up in the popular delusions associated with late-cycle market euphoria. We believe investors will need a good grounding in valuation and business cycle analysis to reject the common buy-the-dip advice that is soon to become prevalent in the still early stages of what is likely to become a brutal bear market.” Crescat Capital

As I stated above, what price-to-earnings (P/E) ratios tell us is that high valuations lead to lower future returns over time. However, what Jerome Powell misses in comments that valuations are elevated, but not concerning, is that it isn’t just P/E’s which are elevated.

“Below is another way to visualize the current market valuation extremes to understand the risks of a severe market downturn ahead. Here we look at each sector of the S&P 500 and compare its valuation today to compared to prior market peaks in the tech and housing bubbles in 2000 and 2007. We can see that an unprecedented 8 out of 11 sectors are at top-decile, historical valuations illustrating the breadth of the current market excess.” – Crescat Capital

“Below we show the gamut of measures currently at record high fundamental valuation for the market at large based on their historical percentile ranking. Data for MAPE and CAPE ratios go back prior to 1929! The other measures are based on the entire history of available data which goes back at least two and half business cycles:” – Crescat Capital

Low Interest Rates Support Higher Valuations

This is where we generally hear a common refrain from the mainstream media:

“Low levels of interest rates justify higher valuations.” 

To analyze the relative value argument, let’s look at the interaction of interest rates and stock valuations over the broad sweep of time. As shown, extremely high stock market valuations occurred in 1929, 2000, and recently. However, interest rates were extremely low only once (recently) during those three occurrences. If low interest rates coincide with extremely high stock valuations only one time out of three, then it is obvious that low interest rates do not cause, or justify, high stock valuations. Yet “low interest rates justify high stock valuations” is one of the certainties of the current mainstream narrative.

Source:  Robert Shiller, multipl.com.  Data through June 2017.

If we isolate the times when interest rates were extremely low, the 1940s and currently, we find in the 1940s stock valuations were low. So, the statement that low interest rates justify high stock valuations is only supported by one event….now.

A better understanding is achieved by the relative value argument that extremely high interest rates coincide with extremely low stock market valuations, which occurred in 1921 and 1981. Although a sample size of two observations is not enough to draw a statistically-significant conclusion, at least it is two events with the same outcome.

The historical relationship between extremes in stock market valuations with extremes in interest rates is as follows:

  • Extremely high interest rates, which have occurred twice, coincided with low stock market valuations.
  • Extremely low interest rates, which have occurred twice, have coincided with high stock market valuations only once; today.
  • Extremely high stock valuations have occurred three times. Only once (1/3 probability) did high stock valuations coincide with low interest rates; today.
  • If extremely low interest rates do not justify extremely high stock market valuations, then a rise in rates should not necessarily cause a decline in stocks, but rising rates do lead to market corrections and bear markets.

Crescat Capital also weighed in on this point as well:

“A common argument today is that low interest rates justify today’s high equity valuations. That is not true at all. When low interest rates are due to low growth and excessive debt, as is the case today, no valuation premium is justified.”

Make No Mistake

Jerome Powell clearly understands that a decade of monetary infusions and low interest rates has created an asset bubble larger than any other in history. However, they are trapped by their own policies as any reversal leads to the one outcome they can’t afford – a broad market correction.

As I wrote previously:

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s.”

This is the problem facing the Fed.

Currently, investors have been led to believe that no matter what happens, the Fed can bail out the markets and keep the bull market going for a while longer. Or rather, as Dr. Irving Fisher once uttered:

“Stocks have reached a permanently high plateau.”

Interestingly, the Fed is dependent on both market participants, and consumers, believing in this idea. With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the “instability of stability” is now the most significant risk.

The “stability/instability paradox” assumes that all players are rational, and such rationality implies avoidance of complete destruction. In other words, all players will act rationally, and no one will push “the big red button.”

The Fed is highly dependent on this assumption as it provides the “room” needed, after more than 10-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that have built up in the system.

Simply, the Fed is dependent on “everyone acting rationally.”

The problem comes when they don’t.

MacroView: Elites View The World Through “Market Colored” Glasses

It is easy to suggest the economy is booming when your net worth is in the hundreds of millions, if not billions, of dollars, or when your business, and your net worth, directly benefit from surging asset prices. This was the consensus from the annual gaggle of the ultra-rich, politicians, and media stars in Davos, Switzerland this past week.

As J.P. Morgan Chase CEO Jamie Dimon told CNBC on Wednesday the stock market is in a “Goldilocks place.” 

Of course, it is when you bank receives an annual dividend from the Federal Reserve’s balance sheet expansion. This isn’t the first time I have picked on Dimon’s delusional view of the world. To wit:

“This is the most prosperous economy the world has ever seen and it’s going to be a very prosperous economy for the next 100 years. The consumer, which is 70% of the U.S. economy, is quite strong. Confidence is very high. Their balance sheets are in great shape. And you see that the strength of the American consumer is driving the American economy and the global economy. And while business slowed down, my current view is that, no, it just was a slowdown, not a petering out.”  

Jamie Dimon during a “60-Minutes” interview.

If you’re in the top 1-2% of income earners, like Jamie, I am sure it feels that way.

For everyone else, not so much. Here are some stats via the WSJ:

The median net worth of households in the middle 20% of income rose 4% in inflation-adjusted terms to $81,900 between 1989 and 2016, the latest available data. For households in the top 20%, median net worth more than doubled to $811,860. And for the top 1%, the increase was 178% to $11,206,000.”

Put differently, the value of assets for all U.S. households increased from 1989 through 2016 by an inflation-adjusted $58 trillion. A full 33% of that gain—$19 trillion—went to the wealthiest 1%, according to a Journal analysis of Fed data.

The problem that is missed is that the “stock market” is NOT the “economy.”

This is a point President Trump misses entirely when he tweets:

“Stocks are hitting record highs. You’re welcome.”

As discussed earlier this week, 90% of the population gets little, or no, direct benefit from the rise in stock market prices.

Another way to view this issue is by looking at household net worth growth between the top 10% and everyone else.

Since 2007, the ONLY group that has seen an increase in net worth is the top 10% of the population. This is not economic prosperity. This is simply a distortion of economics.

Another example of President Trump’s misunderstanding of the linkage between the economy and the stock market was displayed in his presser on Wednesday.

“Now, had we not done the big raise on interest [rates], I think we would have been close to 4% [GDP]. And I – I could see 5,000 to 10,000 points more on the Dow. But that was a killer when they raised the [interest] rate. It was just a big mistake.”President Donald Trump via CNBC

That is not actually the case. From 2009-2016, the Federal Reserve held rates at 0%, and flooded the financial system with 3-consecutive rounds of “Quantitative Easing” or “Q.E.” During that period average real rates of economic growth rates never rose much above 2%.

Yes, asset prices surged as liquidity flooded the markets, but as noted above “Q.E.” programs did not translate into economic activity. The two 4-panel charts below shows the entirety of the Fed’s balance sheet expansion program (as a percentage) and its relative impact on various parts of the real economy. (The orange bar shows now many dollars of increase in the Fed’s balance sheet that it took to create an increase in each data point.)

As you can see, it took trillions in “QE” programs, not to mention trillions in a variety of other bailout programs, to create a relative minimal increase in economic data. Of course, this explains the growing wealth gap which currently exists. Furthermore, while the Fed did hike rates slightly off of zero, and reduce their bloated balance sheet by a negligible amount, there was very little impact on asset prices or the trajectory of economic growth.

Not understood, especially by the Fed, is that the natural rate of economic growth is declining due to their very practices which incentivize non-productive debt. While QE and low rates may boost growth a little and for a short period of time, they actually harm future growth.

The Goldilocks Warning

While Jamie Dimon suggests we are in a “Goldilocks economy,” and President Trump says we are in the “Greatest Economy Ever,” such really isn’t the case. Despite a severe economic slow down globally, Dimon believes the domestic economy will continue to chug along with not enough inflation to push the Fed into hiking rates, but also won’t fall into a recession.

It is a “just right” economy, which will allow corporate profits to grow at a strong enough rate for stocks to continue to rise at 8-10% per year. Every year, into eternity.

This is where Jamie’s delusion becomes most evident. As shown in the chart below, since 2014, the S&P 500 index has soared to record heights, yet corporate profits for the entire universe of U.S. corporations have failed to rise at all. This is the clearest evidence of the disconnect between the markets and the real economy.

Note: It is worth mentioning the last time we saw a period where corporate profits were flat, while stock market prices surged higher was from 1995-1999. Unfortunately, as is repeatedly the case throughout history, prices “catch down” with profits and not the other way around.

Interestingly, in the rush to come up with a “bullish thesis” as to why stocks should continue to elevate in the future, many have forgotten the last time the U.S. entered into such a state of “economic bliss.”

“The Fed’s official forecast, an average of forecasts by Fed governors and the Fed’s district banks, essentially portrays a ‘Goldilocks’ economy that is neither too hot, with inflation, nor too cold, with rising unemployment.” – WSJ Feb 15, 2007

Of course, it was just 10-months later that the U.S. entered into a recession, followed by the worst financial crisis since the “Great Depression.”

The problem with this “oft-repeated monument to trite” is that it’s absolute nonsense. As John Tamny once penned:

A “Goldilocks Economy,” one that is “not too hot and not too cold,” is very much the fashionable explanation at the moment for all that’s allegedly good. “Goldilocks” presumes economic uniformity where there is none, as though there’s no difference between Sausalito and Stockton, New York City and Newark. But there is, and that’s what’s so silly about commentary that lionizes the Fed for allegedly engineering “Goldilocks,” “soft landings,” and other laughable concepts that could only be dreamed up by the economics profession and the witless pundits who promote the profession’s mysticism.

What this tells us is that the Fed can’t engineer the falsehood that is Goldilocks, rather the Fed’s meddling is what some call Goldilocks, and sometimes worse. Not too hot and not too cold isn’t something sane minds aspire to, rather it’s the mediocrity we can expect so long as we presume that central bankers allocating the credit of others is the source of our prosperity.”

John is correct. An economy that is growing at 2%, inflation near zero, and Central banks globally required to continue dumping trillions of dollars into the financial system just to keep it afloat is not an economy we should be aspiring to.

The obvious question we should be asking is simply:

“If we are in a booming economy, as supposedly represented by surging asset prices, then why are Central Banks globally acting to increase financial stimulus for the market?”

The problem the Fed and other central banks confront is that, when market levels are predicated on ever-cheaper cash being freely available, even the faintest threat that the cash might become more expensive or less available causes shock waves.

This was clearly seen in late 2018, when the Fed signaled it might increase the pace of normalizing monetary policy, the markets imploded, and the Fed was forced to halt its planned continued shrinking of its balance sheet. Then, under intense pressure from the White House, and still choppy markets, they reduced interest rates to bolster asset markets and stave off a potential recessionary threat.

The reality is the Fed has left unconventional policies in place for so long after the “Financial Crisis,” the markets can no longer function without them. Risk-taking, and a build-up of financial leverage, has now removed their ability to “normalize” financial policy without triggering destructive convulsions.

Given there is simply too much debt, too much activity predicated on ultra-low interest rates, and confidence hinging on inflated asset values, the Fed has no choice but to keep pushing liquidity until something eventually “pops.”

Unfortunately, when trapped in a “Goldilocks” economy, realities tend to become blurred as inherent danger is quickly dismissed. A recent comment from another “Davos elite,” Bob Prince, who helps oversee the world’s biggest hedge fund at Bridgewater Associates, made this clear.

“The tightening of central banks all around the world wasn’t intended to cause the downturn, wasn’t intended to cause what it did. But I think lessons were learned from that and I think it was really a marker that we’ve probably seen the end of the boom-bust cycle.”

No more “booms” and “busts?”

Thomas Palley had an interesting take on this:

The US is currently enjoying another stock market boom which, if history is any guide, also stands to end in a bust.

For four decades the US economy has been trapped in a ‘Groundhog Day’ cycle in which policy engineered new stock market booms to cover the tracks of previous busts. But as each new boom ameliorates, it does not recuperate the prior damage done to income distribution and shared prosperity.”

Well, except for those at the top, as Sven Henrick concluded last week:

“In a world of measured low inflation and weak wage growth easy central bank money creates vast price inflation in the assets owned by the few making the rich richer, but also enables the taking on ever higher debt burdens leaving everyone else to foot the ultimate bill.

There are two guarantees in life: The rich get obscenely rich, everybody else gets to carry ever more obscene public debt levels.”

That is the measured outcome of the central bank easy money dynamic that has been with us now for decades, but has taken on new obscene forms in the past 10 years with absolutely no end in sight.”

While the elites are certainly taking in the “view through market colored” glasses, the reality is far different for most.

It is true the bears didn’t eat “Goldilocks” at the end of the story, but then again, there never was a sequel either.

MacroView: 2020 Market & Investment Outlook

On Tuesday, Michael Lebowitz and I held private events with our high net worth clients to review our investment strategy and outlook for the rest of the year. The purpose of these events was to provide clarity on portfolio allocation, weightings,  and the risks that could potentially lead to large losses of capital.

As we noted in last weekend’s newsletter, we recently took profits in our various portfolio strategies to raise cash slightly, and reduce excess portfolio risk. Given our portfolios are already hedged with early exposures to value positioning, gold, and short-duration Treasuries, there currently isn’t a need to become overly defensive given the ongoing, liquidity fueled, momentum of the markets. 

Currently, the bullish exuberance, extreme complacency, and technical deviations are issuing warning signs which investors should NOT readily dismiss. These are the issues we cover in the following video presentation:

  1. The “risks” to the current “bullish view,” 
  2. Why we reduced risk in portfolios
  3. The importance of valuations
  4. The Fed’s ongoing liquidity programs.
  5. Future expected returns, and more.

If you have any questions, please email us.


 

MacroView: Has The Fed Trapped Itself?

“Don’t fight the Fed”

That’s how I started out last week’s “Macroview.”

“That is the current mantra of the market as we begin 2020, and it certainly seems to be the right call. Over the last few months, the Federal Reserve has continued its ‘QE-Not QE’ operations, which has dramatically expanded its balance sheet. Many argue, rightly, the current monetary interventions by the Fed are technically ‘Not QE’ because they are purchasing Treasury Bills rather than longer-term Treasury Notes.

However, ‘Mr. Market’ doesn’t see it that way. As the old saying goes, ‘if it looks, walks, and quacks like a duck…it’s a duck.'” 

As we discussed, there is something “broken” in the financial system when it requires massive injections of capital to maintain sufficient liquidity. This was a point noted by Curvature Securities’ Scott Skyrm in his daily “Repo Market Commentary” via Zerohedge:

“Indeed, something appears amiss, because the total overnight and term Fed RP operations on Friday were greater than on year end! On year-end, the Fed had pumped a total of $255.95 billion into the market verses $258.9 billion on Friday.”

When these excessive “Repurchase Operations” initially began in late September, we were told they were to meet corporate tax payments. The issue with that excuse is that corporate tax payments come due every quarter and are easy to forecast weeks in advance. Why was last October’s payment period so different? But, following October 15th, the “repo” operations should have been no longer needed, however, the funding not only continued, but grew.

As the end of the year approached, we were told liquidity was needed to meet “the turn,” as 2019 ended, and 2020 began. Once again, this excuse falls short as, without exception, every year ends on December 31st. So, after nearly a decade of NO “repo” operations, as shown below, what is really going on?

What is clear, is the Fed may be trapped in their own process, a point made by Mark Cabana of BofAML:

“It seems implausible to me that the Fed will be able to stop their repo operations by the end of January.”

The Fed’s New Liquidity Trap

We previously discussed the “liquidity trap” the Fed has gotten themselves into, along with Japan, which will plague economic growth in the future. To wit:

“The signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

Our “economic composite” indicator is comprised of 10-year rates, inflation (CPI), wages, and the dollar index. Importantly, downturns in the composite index leads GDP.

The Fed’s problem is not only are they caught in an “economic liquidity trap,” where monetary policy has become ineffective in stimulating economic growth, but are also captive to a “market liquidity trap.”

As Mr. Skrym noted:

“The problem with the broken repo market, and the Fed’s respective Repo operations, is similar to the problem observed with QE, and the Fed’s balance sheet in general, over the past decade. The market has gotten addicted to the easy Fed liquidity.” 

This can be seen in the chart below.

Whenever the Fed, or other Global Central Banks, have engaged in “accommodative monetary policy,” such as QE and rate cuts, asset prices have risen. However, as denoted by the “red” shaded areas, when those activities are not present, asset prices have declined.

In short, the market has become addicted to QE, and like any drug addict, when the drug was taken away in 2018, as the Fed hiked rates and reduced their balance sheet in an attempt to normalize policy, the market dropped by nearly 20%.

To understand why this is important we have to go back to what Ben Bernanke said in 2010 as he launched the second round of QE:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

I highlight the last sentence because it is the most important. Consumer spending makes up roughly 70% of GDP, therefore increased consumer confidence is critical to keeping consumers in action. The problem is the economy is no longer a “productive” economy, but rather a “financial” one. A point made by Ellen Brown recently:

“The financialized economy – including stocks, corporate bonds and real estate – is now booming. Meanwhile, the bulk of the population struggles to meet daily expenses. The world’s 500 richest people got $12 trillion richer in 2019, while 45% of Americans have no savings, and nearly 70% could not come up with $1,000 in an emergency without borrowing.

Central bank policies intended to boost the real economy have had the effect only of boosting the financial economy. The policies’ stated purpose is to increase spending by increasing lending by banks, which are supposed to be the vehicles for liquidity to flow from the financial to the real economy. But this transmission mechanism isn’t working, because consumers are tapped out.”

If consumption retrenches, so does the economy.

When this happens debt defaults rise, the financial system reverts, and bad things happen economically.

For this reason the Federal Reserve has been engaged in an ongoing campaign to “avoid the pain” experienced during the financial crisis. This was a question asked of Janet Yellen during her semi-annual Humphrey-Hawkins testimony by Rep. Edward Royce. I am going to break this down for clarity.

“ROYCE: I’m worried that the Federal Reserve has created a third pillar of monetary policy, that of a stable and rising stock market. And I say that because then-Chairman Bernanke, when he appeared here, stated repeatedly that, ‘the goal of QE was to increase asset prices like the stock market to create a wealth effect.’”

As stated, Ben Bernanke clearly states the goal of Q.E. was to increase asset prices. As Royce continues he clearly identifies the Fed’s “new liquidity trap:”

“ROYCE: That seems as though that was goal. It would stand to reason then that in deciding to raise rates and reduce the Fed’s QE balance sheet standing at a still record $4.5 trillion, one would have to be prepared to accept the opposite result, a declining stock market, and a slight deflation of the asset bubble that QE created.

Yet, every time in the past three years when there has been a hint of raising rates and the stock market has declined accordingly, the Fed has cited stock market volatility as one of the reasons to stay the course and hold rates at zero.

Read the last paragraph again.

Royce understands that in order to normalize monetary policy, and return markets to a more normal state of operation, some pain would have to be expected.

So, what was Yellen’s response.

YELLEN: It is not a third pillar of monetary policy. We DO NOT target the level of stock prices. That is not an appropriate thing for us to do.”

Yes, the Fed absolutely targets the financial markets with their policies. However, as Royce notes above, it will require a level of pain to wean the markets off of ongoing liquidity. In 2018, the Fed learned their lesson of what would happen as the small adjustment to monetary policy they did make resulted in a market decline of nearly 20%, yield curves inverted, and threats of a recession rose.

They aren’t willing to make that mistake again. The subsequent policy reversal pushed the markets to new record highs, which has been a function of  valuation expansion due to the lack of improvement in underlying fundamentals and earnings.

The Inextricable Problem

The problem is that stopping the current “repo” operations is that it could well spark another “repo market crisis,” especially with $259 billion in liquidity pumped currently. Notably, that is even more than what was at year end to fulfill “the turn.”

The BIS recently explained why these operations lift asset prices.

Repo markets redistribute liquidity between financial institutions: not only banks (as is the case with the federal funds market), but also insurance companies, asset managers, money market funds and other institutional investors. In so doing, they help other financial markets to function smoothly. Thus, any sustained disruption in this market, with daily turnover in the U.S. market of about $1 trillion, could quickly ripple through the financial system. The freezing-up of repo markets in late 2008 was one of the most damaging aspects of the Great Financial Crisis (GFC).

You really have to ask what is going on here. Wall Street veteran Caitlin Long provided a clue.

U.S. Treasuries are the most rehypothecated asset in financial markets, and the big banks know this. [They] are the core asset used by every financial institution to satisfy its capital and liquidity requirements, which means that no one really knows how big the hole is at a system-wide level.

This is the real reason why the repo market periodically seizes up. It’s akin to musical chairs – no one knows how many players will be without a chair until the music stops.

As ZeroHedge noted, this isn’t just a bank issue.

Hedge funds are the most heavily leveraged multi-strategy funds in the world, taking something like $20 billion to $30 billion in net assets under management and levering it up to $200 billion. As noted by The Financial Times:

“Some hedge funds take the Treasury security they have just bought and use it to secure cash loans in the repo market. They then use this fresh cash to increase the size of the trade, repeating the process over and over and ratcheting up the potential returns.”

So….it’s a hedge fund problem, right?

Probably.

“The repo-funded [arbitrage] was (ab)used by most multi-strat funds, and the Federal Reserve was suddenly facing multiple LTCM (Long-Term Capital Management) blow-ups which could have started an avalanche. Such would have resulted in trillions of assets being forcefully liquidated as a tsunami of margin calls hit the hedge funds world.”

Think “Lehman crisis” multiplied by a factor of four.

The Fed’s position is they must continue inflating a valuation bubble despite the inherent, and understood, risks of doing so. However, with no alternative to “emergency measures,” the Fed is trapped in their own process. The longer they continue their monetary interventions, the more impossible it becomes for the Fed to extricate itself without causing the crash they want to avoid.

Stated simply, the longer the Fed avoids normalizing monetary policy, and weaning the “crack addicted” markets off of their “liquidity drug,” the bigger the “reversion” will be “when,” not “if,” it occurs.

The only question is how much longer can Jerome Powell continue “pushing on a string.”

Technically Speaking: Markets Dismiss Iran As The Fed “Put” Remains

You would think that with the U.S. taking out a top Iranian commander, threats of military action flying between the U.S. and Iran, not to mention the Selective Service” website crashing over concerns of World War III, the markets would be in full “sell” mode.

If you thought that would be the case, you were wrong.

Here is the market from the beginning of the year through yesterday’s close.

The dismissal by the market of the situation with Iran suggests only a couple of things:

  1. The market sees no inherent risk from Iran other than a lot of “saber rattling,” or
  2. Given the Federal Reserve’s recent transition to a “do anything” monetary policy stance, all “risks” are being dismissed under the assumption the Fed has become a “cure all” for any market ill.

Since this is a technical post on the financial markets and investing, I won’t get into all the risks inherent from a conflict with Iran. However, if we assume there are indeed “risks” with Iran, then it becomes apparent the market is betting on the Fed.

As I noted in this past weekend’s missive, the Fed has been dumping massive amounts of liquidity into the system over the last few weeks. To wit:

“But concerns over potential Iranian conflict quickly abated as the markets returned their focus to the Federal Reserve, and the continued pump of monetary liquidity into the markets. 

Currently, we are told there is ‘nothing to worry about’ concerning the financial system. Maybe, but the amount of liquidity being injected dwarfs all previous injections by massive proportions.

Those injections continue to run unabated currently, which has lulled the markets into a more extreme state of complacency. This can see in the low reading of bearish investors and the suppressed levels of the put/call ratio. Both suggest there is “no fear” of a market correction currently. (h/t Soberlook)

Here is the investor conundrum.

With the market currently on registering of the monthly buy signals, which confirmed the bull market in the S&P 500 had resumed following the 2018 Fed/Trade induced sell-off, there is also the risk of a short-term correction. Previously, when the market was this extended, deviated from longer-term means, and excessively bullish, a correction has always occurred. The problem for investors is maintaining patience in the process.

The chart below shows the issues. When the market becomes more than 2-standard deviations above the 200-WEEK (4-year) moving average, you have gotten a correction, or a deeper mean-reverting event. However, since this a weekly chart, those corrective processes can take some time to occur. This lures investors into thinking “this time is different,” just before an event has tended to reduce their investment capital

Optimistically Cautious Short-Term

In the short-term, our outlook remains optimistically cautious due to the aforementioned ongoing liquidity injections from the Federal Reserve. As we noted to our RIAPro Subscribers yesterday (Try Free For 30-Days):

“The markets remain positively biased but have gotten overly extended in the short-term. We suggest remain long current holdings, but take profits and rebalance risks in positions accordingly. We will likely have a much better entry point in the next couple of months to ‘buy’ into.”

While we remain optimistic on stocks over the next couple of months, as we are in the “seasonally strong period” of the year, there are several risks which need monitoring closely.

The most obvious risk is a reversal of the Fed’s monetary policy. Currently, the Fed’s balance sheet has almost entirely reversed last year’s decline. Subsequently, changes in the S&P 500 have closely tracked weekly changes to the Fed’s balance sheet. As noted last week:

Of course, it should be expected that if the Fed reverses those flows, then equities will likely follow suit.

Secondly, ultimately, will be valuations.

Yes, I know that “valuations” do not seem to matter currently, however, it is important to realize they will eventually matter, and they will matter a lot.

Currently, the S&P 500 trading roughly 20x current reported earnings estimates of $161.87 per share for the end of 2020, based on data from S&P Dow Jones. Going back to the year 1988, on average, the S&P 500 trades for around 16x times trailing earnings estimates. But it isn’t just P/E ratios which are rich. As we discussed yesterday, multiple measures of the markets are trading at levels which have denoted much lower rates of returns going forward.

What this suggests is that for equities to see a continued, and significant, advance in 2020, it will require investors to continue paying higher prices for equity ownership. While this may seem to make sense in a “low-interest rate” world, historically overpaying for earnings growth has often turned out poorly.

In other words, what investors are betting on is that earnings will catch up with price. However, currently, there is no evidence such will be the case as earnings have been repeatedly ratcheted lower since April 2019.

As shown in the chart below, earnings for the entire 2020 period started at $174.29/share. At that time, the beginning of April, the S&P 500 was trading at 2892. While the forward P/E seemed reasonable at 16.5x earnings, which was roughly equal to the long-term average, this assumed earnings estimates were correct. However, with the S&P 500 trading, as of yesterday’s close, at 3246, estimates for 2020 have fallen to just $161.87. That $12 decline in estimates, combined with a 354 point (an 11.8% advance) in the market, brings that forward P/E multiple to a rather expensive 20.05x reported earnings.

Of course, the risk to investors is that earnings growth fails to recover as we head further into 2020. Currently, there is evidence from the manufacturing, employment and wage data which suggests such could indeed be the case.

The Path Ahead

What is clear is that the path ahead for stocks is much less certain than a year ago when we were coming off deeply depressed sentiment levels, and the Fed was rapidly reversing monetary policy from “tightening” to “easing.”  With equities now 30% higher than they were then, the Fed mostly on hold in terms of rate cuts, and “repo” operations slated to end in the next couple of months, it certainly seems that expectations for substantially higher market values may be a bit optimistic.

Furthermore, as noted, if signs of economic improvement don’t start to lift expectations for earnings growth into the last half of the year, it could prove problematic given current valuations.

However, if the economy does show improvement, it could result in yields rising on the long-end of the curve, which could also make stocks less attractive. This would effectively keep a lid on just how much risk some investors will be willing to take, and the price they are willing to pay.

One thing is for certain, the sharp rise in stocks in 2019 has left prices at levels that already seem expensive on numerous measures. As such it will required investors to take on increasing levels of risk if prices are going to push higher this year. While this is certainly not an improbability given the current levels of complacency and optimism, it is just worth noting that outcomes of such endeavors have always been poor.

There is one true axiom of the market which is always forgotten.

“The market has a habit of sucking investors in to inflict the most pain possible.”

Just make sure you aren’t one of them.

If you feel you must chase the markets currently, then at least do it with a set of guidelines to follow in case things turn against you. We printed these a couple of weeks ago, but felt there are worth mentioning again.

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
  1. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move.This could be disastrous if the market reverses sharply in the short term. Again, move slowly.
  1. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tend to lead when markets fall. Like “weeds choking a garden,” pull them.
  1. Add to sectors, or positions, that are performing with, or outperforming, the broader market.
  1. Move “stop loss” levels up to current breakout levels for each position. Managing a portfolio without “stop loss” levels is like driving with your eyes closed.
  2. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.
  1. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

While we remain optimistic on the markets currently, we are also taking precautionary steps of tightening up stops, adding non-correlated assets, raising some cash, and looking to hedge risk opportunistically.

Just because it isn’t raining right now, doesn’t mean it won’t. Nobody has ever gotten hurt by keeping an umbrella handy.

MacroView: Will The The Market Repeat The Start Of 2018?

“Don’t fight the Fed”

That is the current mantra of the market as we begin 2020, and it certainly seems to be the right call. Over the last few months, the Federal Reserve has continued its “QE-Not QE” operations, which has dramatically expanded its balance sheet. Many argue, rightly, the current monetary interventions by the Fed are technically “Not QE” because they are purchasing Treasury Bills rather than longer-term Treasury Notes.

However, “Mr. Market” doesn’t see it that way. As the old saying goes, “if it looks, walks, and quacks like a duck…it’s a duck.” 

Those liquidity flows most notably have been chasing the largest of large caps – namely Apple (AAPL) and Microsoft (MSFT). As Ed Dowd noted, there are many similarities between now and the last time the Fed was fighting a perceived liquidity shortage before the “turn of the century” over concerns of “Y2K.”

But here is what jumped out at me.

Going back to 2016, as the world faced a “Brexit” crisis, the Fed, ECB, and the BOE all joined forces to provide liquidity to the markets. Then, just before the 2016 election, as the world was concerned a “Trump Election” would crash the market, the Fed provided a huge boost of liquidity. All along the way, each dip in the market was met by liquidity support.

Currently, we are being told there is “nothing to worry about” with respect to the financial system. Maybe, but the amount of liquidity being injected dwarfs all previous injections by massive proportions.

You can see the issue more clearly looking at a rolling 4-week change to the Federal Reserve’s balance sheet.

So, despite commentary to the contrary, there are only two conclusions to draw from the data:

  1. There is something functionally “broken” in the financial system which is requiring massive injections of liquidity to try and rectify, and;
  2. The surge in liquidity, whether you want to call it a “duck,” or not, is finding its way into the equity markets.

January 2018 Redux

“The exuberance that surrounded the markets going into the end of last year, as fund managers ramped up allocations for end of the year reporting, spilled over into the start of the new with S&P hitting new record highs.

Of course, this is just a continuation of the advance that has been ongoing since the Trump election. The difference this time is the extreme push into 3-standard deviation territory above the moving average which is concerning.” – Real Investment Report Jan, 5th 2018

At the beginning of 2018, following the passage of “tax reform,” the market was pushing 3-standard deviations of the 50-dma. It eventually pushed 3-standard deviations above the 200-dma before it came crashing back to earth. The second time it pushed the same deviation was in October of 2018, which was again followed by a marked decline.

Currently, that push into a 3-standard deviation extreme is once again present. Does that mean a sharp correction is coming? Not necessarily. However, it does suggest gains are likely limited in the short-term.

As I stated in 2018:

“That extension, combined with extreme overbought conditions multiple levels, has historically not been met with the most optimistic of outcomes. But, as I will discuss next, “exuberance” of this type is not uncommon during a market ‘melt-up’ phase.”

Currently, “exuberance” has returned with a vengeance, as noted by my friend and colleague Doug Kass:

“2019 ended in an entirely dissimilar manner compared to the way that 2018 ended. (As an example the CNN Fear & Greed Index was under 10 a year ago, its at 90 this week).

Despite a continued manufacturing recession, ongoing weakness in many global economies, political discord (and a Presidential impeachment), little resolution of the U.S./China trade differences and a flat year for S&P profits – valuations exploded (from 14.5x to nearly 19x) as confidence in an extended domestic economic recovery was heightened.”

But it isn’t just sentiment which has gotten extraordinarily extended, but also investor positioning on many levels both individual and professional.

Lastly, our composite technical overbought/oversold gauge has also hit extremes.

In other words, “everyone is in the pool,” including the “life guards.” 

While the levels of exuberance are quite astonishing, it certainly isn’t surprising. This is what has been witnessed during previous market “melt-ups” throughout history. Jeremy Grantham of GMO previously wrote an excellent piece on market “melt-ups” and potential outcomes. To wit:

“As a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market. 

The classic examples are not just characterized by higher-than-average prices. Price alone seems to me now to be by no means a sufficient sign of an impending bubble break. Among other factors, indicators of extremes of euphoria seem much more important than price.

Let’s look at what is missing in the way of psychological and technical signs of a late-stage bubble and what is beginning to fall into place. On the topic of classic bubbles, I have long shown Exhibits 1 and 2. They recognize the importance of a true psychological event of momentum increasing to a frenzy. That is to say, acceleration of price.

Grantham is certainly very correct in his analysis. As shown in the chart below, the reversion of oversold, to extreme overbought (top panel in blue) has been extremely rapid. Historically speaking, such extreme overbought, overconfident, and extended markets tend not to stay that way for long.

From S&P 3300 to 3500, & Back Again

While we penned our initial target for the bull cycle at 3300 in July, given the extreme level of Federal Reserve monetary interventions, I certainly WOULD NOT rule out the possibility of a further melt up to 3500.

It is a possibility which must be considered. However, you must also balance that possibility with the probability of an eventual reversion. As noted by George Soros’ “Theory of Reflexivity:”

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.”

Asymmetric-bubbles

In the latter stages of the advance, money simply chases price. This is the point in the cycle where everything rises regardless of fundamental underpinnings or value.

2019 was such a year.

Eric Parnell recently noted the same:

“It’s a marshmallow world for capital markets as we enter 2020. Name the asset class, and it had a stellar year in 2019. U.S. stocks? Up over +30%. Stocks across the rest of the world? Higher by more than +20%. Investment grade corporate bonds? Up nearly +20%. High yield bonds? +14%. Long-Term US Treasuries? +15%. Gold and silver? +16% each. Even long struggling commodities posted high single-digit returns this year. If you were allocated to risk assets in 2019, you likely enjoyed a good year.”

However, as Eric notes, when everything is “as good as it can get,” that only leaves one other option.

“Past performance can present future challenges. Most significantly, such universally good returns are difficult to maintain. Typically, capital markets assign winners and losers even when the % stimulus is pumping full throttle as it is today. So whether such good times can continue in 2020 across all asset classes remains to be seen, but investors are well served to consider what categories may be best positioned to continue to climb and those that may be set to take a breather in the year ahead.”

In particular, stocks are facing increasingly challenging headwinds from sluggish economic growth, to weaker earnings growth. Currently, economists are predicting economic growth below 2% in 2020, as noted by FactSet:

“While the odds of a near-term recession appear to have diminished, growth is projected to slow in the coming quarters due to a weaker global outlook and reduced global trade flows. U.S. economic growth is expected to continue to slow into 2020, with analysts surveyed by FactSet projecting 2.3% annual growth in 2019 followed by 1.8% in 2020.”

Despite the S&P 500 being up 353% (total return since January 1st, 2009), economic growth has been the weakest in history.

This is why the differential between GAAP earnings and corporate profits is going to be a major challenge for investors going forward.

This was a point Eric noted:

“Stocks are facing a slowing corporate earnings problem in 2020. Quarterly GAAP earnings on the S&P 500 declined by more than -6% on a year-over-year basis in 2019 Q3. This marked the first quarterly year-over-year decline since 2015 Q4 and 2016 Q1 when oil prices were cascading to the downside and the U.S. economy appeared headed toward recession were it not for a major monetary policy intervention stick save.

Thus, corporate earnings growth is not only slowing, but it may be set up to disappoint in the coming quarters.”

As such, stocks will likely once again be reliant on both multiple expansion and share buybacks for further gains in 2020. However, there are limits to just how many shares a company can repurchase given balance sheet constraints of both liquid cash and debt levels.

The bullish case does remain as both fiscal and monetary stimulus remains excessively abundant. Given the recent passage of another $1.4 trillion continue resolution to increase spending without the constraint of a “debt ceiling,” and the Fed continuing with monetary interventions, the amount of money sloshing around the system has to go somewhere.

This is why, despite excessive technical deviations, extraordinary complacency, and extreme bullishness, we remain allocated toward equity risk in portfolios currently.

But, these words were the same as 2018 opened for trading. Just a few weeks later, as Trump launched the “trade war,” exuberance was replaced with pessimism as stocks wiped out all the gains for the month.

What could trip up the markets this January?

In a word, “much.” 

S&P 500 Monthly Valuation & Analysis Review – 1-1-2020

J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.


2020: The Futility Of Predictions & Understanding The Risk

“Predictions Are Difficult…Especially When They Are About The Future” – Niels Bohr

We can’t predict the future. If we could, fortune tellers would win all of the lotteries. They don’t, we can’t, and we are not going to try to.

However, we can analyze what has happened in the past, weed through the noise of the present, and discern the possible outcomes of the future. The biggest problem with Wall Street, both today and in the past, is the consistent disregard of the unexpected and random events they inevitability occur.

There was once a study done of the accuracy of “predictions.” The study took predictions from a broad range of professions from psychics to weathermen. The study came to two conclusions. The first was that “weathermen” are the MOST accurate predictors of the future. The second conclusion was that the predictive ability was only accurate out to 3-days. Beyond 3-days, and the predictive ability was no better than a coin flip.

When it comes to trying to predict what will happen in the financial markets over the next year, which is an annual event, it is essentially an act of futility. Given the markets are affected by a broad spectrum of inputs from economics, to geopolitics, monetary policy, rates, and financial events, any prediction should be taken with a very high degree of skepticism.

So, with that said, here is how we are preparing for 2020.

Odds Have It

In our portfolio management practice, we begin with the basic assumption there is a 69% chance the market will finish the coming year at a level greater than where it started. That 69% probability comes from the fact that over the last 120-years, the market has (on a total real return basis) finished the year in positive territory 83 times, and negative only 37 times.

Therefore, from an “odds” perspective, markets are more likely to finish positive on any given year, than not. By starting our forecast with this basic assumption, it removes all the “guess work” of what has to go “right,” leaving us with only having to focus on the things which could potentially “go wrong.” 

At the core of our portfolio management process is a risk management thesis. That philosophy was well defined by Robert Rubin, former Secretary of the Treasury, when he said;

“As I think back over the years, I have been guided by four principles for decision making.  First, the only certainty is that there is no certainty.  Second, every decision, as a consequence, is a matter of weighing probabilities.  Third, despite uncertainty we must decide and we must act.  And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”

It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin’s approach, and mine, goes beyond that. For starters, although it may seem contradictory, embracing uncertainty reduces risk while denial increases it. Another benefit of acknowledged uncertainty is it keeps you honest.

“A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions.  It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”

The reality is that we can’t control outcomes. The most we can do is influence the probability of certain outcomes through the management of risks, and investing based on probabilities, rather than possibilities, which is important to capital preservation and investment success over time.

So, as we head into 2020, here is a short-list of the things we are either currently hedging portfolios against, or will potentially need to:

  1. China fails to comply with the terms of the “Phase One” trade deal which reignites the trade war.
  2. Earnings growth fails to recover, and valuations finally become a concern for the markets.
  3. Corporate profits, which have been essentially flat since 2014, deteriorate due to slower economic growth both domestically and globally.
  4. Excessively high consumer confidence converges with low levels of CEO Confidence as employment begins to weaken.
  5. Interest rates rise which trips up heavily leveraged consumers and corporations.
  6. Investors become concerned about excess valuations.
  7. A credit-related event causes a market liquidity crunch. (Convent-Lite, Leveraged Loans, BBB-rated downgrades all pose a potential threat)
  8. The Fed’s “repo-crisis” continues to grow and turns out to be something much more significant.
  9. Similar to 2016, a shocking election result.

While I am not going to address all of these concerns, I do want to touch a few that we feel are significant risks heading into the first half of the decade.

Valuations

While valuations are a terrible market timing device, they do impact long-term returns and investment outcomes. Currently, at 30x earnings, valuations are elevated, which suggests that the next decade of returns will be significantly lower than the last. Statistically, returns in the very low single digits should be expected.

However, it isn’t just PE ratios which are extended, but both Price-to-Sales and Enterprise Value to EBITDA (Earnings Before Interest Taxes Depreciation Amortization) are at or near all time highs.

Record highs in stocks, near-record lows in bond yields, and historically tight credit spreads present significant challenges for investors. Economic data has improved, but many fundamental economic gauges remain soft relative to pre-crisis averages, and are inconsistent with current asset price levels and valuations.

Importantly, it is worth noting that negative returns tend to cluster during periods of declining valuations. These “clusters” of negative returns are what define “secular bear markets.” 

Most investors do not seem at all concerned as money continues to move into risky asset classes, a classic sign of a bubble. While a defensive posture seems prudent, the technical picture remains supportive of further gains. One should respect the momentum behind these moves for the foreseeable future, but be mindful that liquidity can evaporate quickly.

The Debt Risk

One of the common misconceptions in the market currently, is that the “subprime mortgage” issue was vastly larger than what we are talking about currently.

Not by a long shot. 

Combined, there is about $1.15 trillion in outstanding U.S. leveraged loans — a record that is double the level five years ago — and, as noted, these loans increasingly are being made with less protection for lenders and investors.

Just to put this into some context, the amount of sub-prime mortgages peaked slightly above $600 billion or about 50% less than the current leveraged loan market.

Of course, that didn’t end so well.

Currently, the same explosion in low-quality debt is happening in another corner of the US debt market as well.

As noted by John Mauldin:

“In just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion—an all-time high. To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder.

And there’s a reason BBB-rated debt is so plentiful. Ultra-low interest rates have seduced companies to pile into the bond market and corporate debt has surged to heights not seen since the global financial crisis.”

The biggest risk currently is refinancing the debt as over the next 5-years, more than 50% of the debt is maturing. A weaker economy, recession risk, falling asset prices, or rising interest rates could well lock many corporations out of refinancing their share of this $5 trillion debt. Defaults will move significantly higher, and much of this debt will be downgraded to junk.

This is a problem the Fed can not fix with more liquidity.

Technically Troubling

In last week’s Technically Speaking we discussed the more extreme deviations in the market. To wit:

The first chart shows the monthly buy/sell signals stretched back to 1995 (25 Years). As shown, these monthly ‘buy’ and ‘sell’ indications are fairly rare over that stretch. What is interesting is that since 2015 there have been two-major sell signals, both of which were arrested by Central Bank interventions.”

With these “buy signals” in place, and the market pushing higher on conclusions of “trade deals” and the election of the conservative party in the U.K. (which clears the way for Brexit), the markets rallied further toward our target of 3300.

In the short-term it is entirely feasible, particularly with the Federal Reserving pushing billions of dollars into the financial system currently, the bull market could easily eclipse our target of 3300. However, in the longer-term, virtually all of our primarily technical measures are stretched to levels normally seen near market tops rather than at the beginning of a new stretch of gains.

There are several measures used to justify current valuations, but they sound similar to those used in the dot-com Tech bubble. The relationships between valuation and fundamentals, on which cash flows are ultimately based, are grossly dislocated. Markets may well move higher, but to advocate a full allocation to equities under current circumstances ignores warnings of bubbles past.

Stock market cap-to-GDP, price-to-sales, margin balances, cyclically-adjusted price-to-earnings ratios, and others argue convincingly that the stock market is either near historic valuations, or well through them. Owning well-selected, single-name companies because they are fundamentally cheap, not relatively cheap, makes sense. Otherwise, limiting general equity allocation exposures is prudent until reasonable opportunities return. We suggest setting stop losses, and/or options strategies to help limit downside risk and retain any additional upside.

Sentiment Is Excessively Bullish

This past summer everyone was convinced a recession was near, now there is no such concern and investors are literally as “bullish” as they can get.

From a contrarian point of view, this is a fairly obvious warning to reduce risk in the market. However, the “Fear Of Missing Out,” is overriding investor logic at the moment. The recent market surge, which started coincidentally with the Fed’s restart of “QE, Not QE,” is very reminiscent of the surge in asset prices we saw at the end of 1999 as the Fed flooded the system with liquidity in advance of the potential “Y2K” issues.

As noted in our RIAPRO Daily Market Commentary:

“Today’s ‘Chart of the Day’ shows the surge in the NASDAQ index, which occurred during the last few months of 1999. Most people attribute the massive gain to the feverish pitch in the dot com bubble. We believe the real culprit was the Fed which added substantial amounts of repo liquidity to the banking sector due to concerns of Y2K and the potential for mass computer malfunctioning. Those repo funds gravitated to the financial markets.

For more, please read the following WSJ article from 1999- Federal Reserve Clears Loan Facility Linked To Y2K Computer Problems.

“The graph below shows the 10x surge in repo during late 1999 and its quick removal shortly after the New Year. Note the recent surge, on the right side of the graph, dwarfs the 1999 experience and that is before an expected $500 billion spike in repo financing over the next week or two.”

Unlike 1999, we have our doubts as to how quickly the graph normalizes, as the Fed continues to underestimate the scope of the growing overnight funding issues.

To quote Yogi Berra “it’s deja vu, all over again.”

Conclusion

Statistically speaking, the odds suggest that the market could indeed be higher in 2020. However, there are numerous risks which could derail the markets which should not be dismissed.

This is not a “bearish forecast.” It is just an assessment of trends, statistics, and probabilities given the current monetary, financial and economic backdrop.

If we are wrong, and stocks do post gains in the coming year, being more conservative will only mean a small relative under-performance in your portfolio next year.

If we are right, the preservation of capital will be far more beneficial. As we have stated previously, participating in the bull market over the last decade is only one-half of the job. The other half is keeping those gains during the second half of the full market cycle.

One of my favorite quotes is by Howard Marks and is a principle that we live by in our little shop;

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that “being too far ahead of your time is indistinguishable from being wrong.”)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

As we enter into 2020 it may pay to be a little more cautious after such a large rise in the financial markets.

Let me leave you with Bob Farrell’s 10 Rules:

  1. Markets tend to return to the mean over time
  2. Excesses in one direction will lead to an opposite excess in the other direction
  3. There are no new eras — excesses are never permanent
  4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
  5. The public buys the most at the top and the least at the bottom
  6. Fear and greed are stronger than long-term resolve
  7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
  8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
  9. When all the experts and forecasts agree — something else is going to happen
  10. Bull markets are more fun than bear markets

Our job is managing risk to conserve principle and create absolute returns over time. What matters most to us is that we provide a disciplined management process suitable for our clients who seek long-term performance as measured by annualized and risk-adjusted returns, and conservation of investment principle.

We wish you a prosperous 2020.

The Stock Market Has Become A Private Club For The Elite

A recent Peter G Peterson Foundation poll, as reported by the Financial Times, revealed a statistic that we have suspected for quite some time. To wit:

“Nearly two-thirds of Americans say this year’s record-setting Wall Street rally has had little or no impact on their personal finances, calling into question whether one of the strongest bull markets in a decade will boost Donald Trump’s re-election chances.

A poll of likely voters for the Financial Times and the Peter G Peterson Foundation found 61-percent of Americans said stock market movements had little or no effect on their financial well-being. 39-percent said stock market performance had a “very strong” or “somewhat strong” impact.

The survey suggested most Americans are not aware of market movements, with just 40-percent of respondents correctly saying the stock market had increased in value in 2019. 42-percent of likely voters said the market was at “about the same” levels as at the start of the year, while 18-percent believed it had decreased.”

Another article by Shawn Langlois via MarketWatch revealed much the same discussing a recent publication from the Economic Policy Institute. That study also revealed the increasingly inadequate retirement savings of Americans, as well as the dispersion of wealth among income earners.

As Shawn penned:

“The big gap between the mean retirement savings of $120,809 and the median retirement savings is yet another example of how the rich are getting richer and the poor are getting poorer in this country.”

This isn’t anything new.

We have been reporting on this issue over the last few years, and just recently dug into current details in our discussion on the “Savings Rate.” To wit:

“The calculation of disposable personal income (which is income less taxes) is largely a guess, and very inaccurate, due to the variability of income taxes paid by households. More importantly, the measure is heavily skewed by the top 20% of income earners, and even more so by the top 5%. As shown in the chart below, those in the top 20% have seen substantially larger median wage growth versus the bottom 80%. (Note: all data used below is from the Census Bureau and the IRS.)”

The reality is the majority of Americans are struggling just to make ends meet, which has been shown in a multitude of studies.

“The [2019] survey found that 58 percent of respondents had less than $1,000 saved.” – Gobankingrates.com

Such levels of financial “savings” are hardly sufficient to support individuals through retirement, much less leave enough savings to actively participate in the “booming stock market.” Such confirms the Peterson study that the “longest bull market in history” has largely bypassed a vast majority of Americans.

It also confirms why, after a decade-long bull market, that a rising trend of individuals over the age of 55 remain in the workforce. 

“Growing numbers of U.S. ­boomers—currently 55 to 73—are working beyond the traditional retirement age, going back to school, and choosing to age in place in familiar neighborhoods instead of moving to senior communities. 

For the first time in history, there are multiple generations alive together for long stretches of time.

It’s not that “Boomers” don’t want to retire, it’s because they “can’t afford to.” 

The Expanding Problem

Despite Central Bank’s best efforts globally to stoke economic growth by pushing asset prices higher, the effect has been entirely consumed by those with actual savings, and discretionary income, available to invest.

In other words, the stock market has become an almost “exclusive” club for the elite.

While monetary policies increased the wealth of those that already have wealth, the Fed has been misguided in believing that the “trickle down” effect would be enough to stimulate the entire economy.

It hasn’t.

The sad reality is that these policies have only acted as a transfer of wealth from the middle class to the wealthy and created one of the largest “wealth gaps” in human history. Via Forbes:

“‘The top 10% of the wealth distribution—the purple and green areas together—hold a large and growing share of U.S. aggregate wealth, while the bottom half (the thin red area) hold a barely visible share,’ Fed economists write in a paper outlining the new data set on inequality, which is more timely than exisiting statistics. The chart show that ‘while the total net worth of U.S. households has more than quadrupled in nominal terms since 1989, this increase has clearly accrued more to the top of the distribution than the bottom.'”

Lack Of Capital

The current economic expansion is already the longest post-WWII expansion on record. Of course, that expansion was supported by repeated artificial interventions rather than stable organic economic growth. As noted, while the financial markets have soared higher in recent years, it has bypassed a large portion of Americans NOT because they were afraid to invest, but because they have NO CAPITAL to invest with.

The ability to simply “maintain a certain standard of living” has become problematic for many, which forces them further into debt.

“The debt surge is partly by design, a byproduct of low borrowing costs the Federal Reserve engineered after the financial crisis to get the economy moving. It has reshaped both borrowers and lenders. Consumers increasingly need it, companies increasingly can’t sell their goods without it, and the economy, which counts on consumer spending for more than two-thirds of GDP, would struggle without a plentiful supply of credit.” – WSJ

I often show the “gap” between the “standard of living” and real disposable incomes. Beginning in 1990, incomes alone were no longer able to meet the standard of living, so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $2600 annual deficit that cannot be filled. (Note: this deficit accrues every year which is why consumer credit keeps hitting new records.)

The debt-to-income problem keeps individuals from building wealth, and government statistics obscure the basic reality. We discussed this point in detail in “Dimon’s View Of Economic Reality Is Still Delusional:”

“The median net worth of households in the middle 20% of income rose 4% in inflation-adjusted terms to $81,900 between 1989 and 2016, the latest available data. For households in the top 20%, median net worth more than doubled to $811,860. And for the top 1%, the increase was 178% to $11,206,000.

Put differently, the value of assets for all U.S. households increased from 1989 through 2016 by an inflation-adjusted $58 trillion. A third of the gain—$19 trillion—went to the wealthiest 1%, according to a Journal analysis of Fed data.

‘On the surface things look pretty good, but if you dig a little deeper you see different subpopulations are not performing as well,’ said Cris deRitis, deputy chief economist at Moody’s Analytics.” – WSJ

The One Problem The Fed Can’t Fix

The problem with the Fed’s ongoing liquidity interventions is that they continue to benefit those in the top 20% of population which exacerbates the wealth gap between them and everyone else.  Importantly, the current gap between household net worth and GDP is the greatest on record, and those previous gaps were filled by reversions with the most painful of outcomes.

While such a reversion in “net worth” will have the majority of its impact at the upper end of the income scale; it will be the job losses through the economy that will further damage and already ill-equipped population in their prime saving and retirement years.

Compound that problem with the massive amount of corporate debt, which if it begins to default, will trigger further strains on the financial and credit systems of the economy.

The reality is that the U.S. is now caught in the same liquidity trap as Japan. With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs. Combine this with:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

While the stock market may be an exclusive club for its members currently, the combined issues of #debt, #deflation, and #demographics is a problem the Fed can’t fix.

It isn’t a question of “if.” It is simply a function of “when.”

The next crisis will repair the “wealth gap” to some degree only because 2/3rds of American’s never participated in the bull market to begin with.

Technically Speaking: How To Pick Up A Porcupine

Last week, I discussed the registering of the monthly buy signals, which confirmed the bull market in the S&P 500 had resumed following the 2018 Fed/Trade induced sell off. Here is a snippet of our history in this regard:

“In April of 2018, I penned an article entitled ‘10-Reasons The Bull Market Ended,in which we discussed the yield curve, slowing economic growth, valuations, volatility, and sentiment. Of course, 2018 turned out to be a tough year culminating in a 20% slide into the end of the year. Since then, we have daily reminders we are ‘close to a trade deal,’ and the Fed has completely reversed course on hiking rates and extracting liquidity. In July, we published “S&P 3300, The Bull Vs. Bear Case.”

While volatility and sentiment have reverted back to levels of more extreme complacency, the fundamental and economic backdrop has deteriorated further.

The first chart shows the monthly buy/sell signals stretched back to 1995 (25 Years). As shown, these monthly ‘buy’ and ‘sell’ indications are fairly rare over that stretch. What is interesting is that since 2015 there have been two-major sell signals, both of which were arrested by Central Bank interventions.”

With these “buy signals” in place, and the market pushing higher on conclusions of “trade deals” and the election of the conservative party in the U.K. (which clears the way for Brexit), the markets rallied further toward our target of 3300.

Over the last couple of weeks, we have slowly been increasing the equity allocation in portfolios toward being fully exposed.

This is because, as we have been discussing on RIAPRO (Try FREE for 30-days), the Fed’s “QE-NOT QE” was being interpreted by the markets as QE. The chart below shows the increase in the Fed’s balance sheet as compared to the rally in the market.

The recent market surge, which started coincident with the Fed’s restart of “QE, Not QE,” is very reminiscent of the surge in asset prices we saw at the end of 1999 as the Fed flooded the system with liquidity in advance of the potential “Y2K” issues.

As noted in our RIAPRO Daily Market Commentary:

“Today’s ‘Chart of the Day’ shows the surge in the NASDAQ index, which occurred during the last few months of 1999. Most people attribute the massive gain to the feverish pitch in the dot com bubble. We believe the real culprit was the Fed which added substantial amounts of repo liquidity to the banking sector due to concerns of Y2K and the potential for mass computer malfunctioning. Those repo funds gravitated to the financial markets.

For more, please read the following WSJ article from 1999- Federal Reserve Clears Loan Facility Linked To Y2K Computer Problems.

“The graph below shows the 10x surge in repo during late 1999 and its quick removal shortly after the New Year. Note the recent surge, on the right side of the graph, dwarfs the 1999 experience and that is before an expected $500 billion spike in repo financing over the next week or two.”

Unlike 1999, we have our doubts as to how quickly the graph normalizes, as the Fed continues to underestimate the scope of the growing overnight funding issues.

To quote Yogi Berra “it’s deja vu, all over again.”

Overly Extended, Bullish & Valued

While we have been adding exposure in recent weeks to participate with the rise in the markets, the issues of technical price deviations, valuations, and subsequent risk has not been forgotten. By the majority of measures that we track from momentum, to price, and deviation, the market’s sharp advance has pushed the totality of those indicators back to overbought.

These overbought conditions, combined with the more extreme deviation from the 200-dma, and the longer-term bullish trend, have led to short-term corrections.

The deviations from the longer-term bullish trend are shown below, along with the more extreme levels of complacency by investors.

Historically, when all of the indicators are suggesting the market has likely encompassed the majority of its price advance, a correction to reverse those conditions is often not far away.

For these reasons, and others, this is why the exposure we have added has been only partial holdings, that we will build into opportunistically, and have a “value tilt” to them. Currently, there are the early signs of a rotation from momentum to value in the market, which gives “value” a bit of a “defensive” posture currently.

We still remain fully weighted in our fixed income portfolios, which consist of high quality holdings and a bit shorter-duration, with a slight overweight in cash.

How To Add Exposure

Adding exposure at these levels can be a challenge, unless you just don’t care about the “risk of loss.” Since we manage money for clients who are near, or in, retirement, we care about the risk very much. So, the answer to how to add exposure at this stage of the bull cycle is the same as the answer to that age-old question:

“How do you pick up a porcupine? Carefully.”

Here are the guidelines we are following:

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
  1. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move.This could be disastrous if the market reverses sharply in the short term. Again, move slowly.
  1. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tend to lead when markets fall. Like “weeds choking a garden,” pull them.
  1. Add to sectors, or positions, that are performing with, or outperforming, the broader market.
  1. Move “stop loss” levels up to current breakout levels for each position. Managing a portfolio without “stop loss” levels is like driving with your eyes closed.
  2. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.
  1. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

Buying Because I Have To. You Don’t.

“So, if you believe the market is overbought, why are you buying?”

There is a difference between views of long-term fundamentally driven potential outcomes, and short-term opportunities in the markets.

Let me be VERY clear about something.

As a portfolio manager, we buy “opportunity” because we have to. If we don’t, we suffer career risk, plain and simple.

However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the market.

Think about it this way.

The markets have returned more than 300% since the 2009 lows in the longest bull market on record. Yes, it is still just one bull market. 

Assuming that you were astute enough to buy the “cherry picked” low, and didn’t spend the bulk of the bull market rally simply getting back to even, you would have accumulated years of excess returns towards meeting your retirement goals. 

If you went to cash now, the odds are EXTREMELY high that in the years ahead you will far outpace investors who remain invested. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs the decline will destroy most, if not all, of the returns accumulated over the last decade. (That isn’t a theoretical assumption. It’s historical fact.)

While we may indeed be shifting exposure and taking on some additional risk, we do so very cautiously.

Cracks In The Bull Market Armor

While we did increase our exposure to the markets, as the bullish trend does currently persist, there is growing evidence of “cracks” appearing.

With the Fed flooding the system with liquidity to fund short-term repurchase operations, this is not normal and suggests that something has “broken” in the system. 

Given the current rally is built on substantially weaker fundamental and economic underpinnings, weaker earnings growth, and an exhausted consumer, increases in equity risk could very well be reversed in short order. This due to the following reasons:

  1. We are in the latter stages of the bull market.
  2. Economic data continues to remain weak
  3. Earnings are beating continually reduced estimates
  4. Volume is weak
  5. Longer-term technical underpinnings are weakening and extremely stretched.
  6. Complacency is extremely high
  7. Share buybacks are slowing

It is worth remembering that markets have a very nasty habit of sucking individuals into them when prices become detached from fundamentals. Such is the case currently and has generally not had a positive outcome.

What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case, technically, to warrant taking on some equity risk on a very short-term basis. We will see what happens over the next couple of weeks. 

However, the longer-term dynamics are turning more bearish. When those negative price dynamics are combined with the fundamental and economic backdrop, the “risk” of having excessive exposure to the markets greatly outweighs the potential “reward. “

Remember, investing is not a competition, it is a game of long-term survival. 

The Myth Of The “Great Cash Hoard” Of 2019

Tell me if you heard this one lately:

“There’s a trillion dollars in cash sitting on the sidelines just waiting to come into the market.” 

No.

Well, here it is directly from the Wall Street Journal:

“Assets in money-market funds have grown by $1 trillion over the last three years to their highest level in around a decade, according to Lipper data. A variety of factors are fueling the flows, from higher money-market rates to concerns over the health of the 10-year economic expansion and an aging bull market.

Yet some analysts say the heap of cash shows that investors haven’t grown excessively exuberant despite markets’ double-digit gains this year, and have plenty of money available to buy when lower prices prevail.”

See…there is just tons of “cash on the sidelines” waiting to flow into the market.

Except there isn’t.

The Myth Of Cash On The Sidelines

Despite 10-years of a bull market advance, one of the prevailing myths that seeming will not die is that of “cash on the sidelines.” To wit:

“’Cash always makes me feel good, both having it and seeing it on the sidelines,’ said Michael Farr, president of the money-management firm Farr, Miller & Washington.

Stop it.

This is the age-old excuse why the current “bull market” rally is set to continue into the indefinite future. The ongoing belief is that at any moment investors are suddenly going to empty bank accounts and pour it into the markets. However, the reality is if they haven’t done it by now, following 4-consecutive rounds of Q.E. in the U.S., a 330% advance in the markets, and ongoing global Q.E., exactly what is it going to take?

But here is the other problem.

For every buyer there MUST be someone willing to sell. As noted by Clifford Asness:

“There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

Every transaction in the market requires both a buyer and a seller with the only differentiating factor being at what PRICE the transaction occurs. Since this is required for there to be equilibrium in the markets, there can be no “sidelines.” 

Think of this dynamic like a football game. Each team must field 11 players despite having over 50 players on the team. If a player comes off the sidelines to replace a player on the field, the player being replaced will join the ranks of the 40 or so other players on the sidelines. At all times there will only be 11 players per team on the field. This holds equally true if teams expand to 100 or even 1000 players.

Furthermore, despite this very salient point, a look at the stock-to-cash ratios (cash as a percentage of investment portfolios) also suggest there is very little available buying power for investors currently. As we noted just recently with charts from Sentiment Trader:

As asset prices have escalated, so have individual’s appetite to chase risk. The herding into equities suggests that investors have thrown caution to the wind.

With cash levels at the lowest level since 1997, and equity allocations near the highest levels since 1999 and 2007, it suggests investors are now functionally “all in.” 

With net exposure to equity risk by individuals at historically high levels, it suggests two things:

  1. There is little buying left from individuals to push markets marginally higher, and;
  2. The stock/cash ratio, shown below, is at levels normally coincident with more important market peaks.

But it isn’t just individual investors that are “all in,” but professionals as well.

Importantly, while investors are holding very little ‘cash,’ they have taken on a tremendous amount of ‘risk’ to chase the market. It is worth noting the current levels versus previous market peaks.”

Even Ned Davis noted that investors remain more invested in riskier assets than has historically been the case.

“Cash is low, meaning households are fairly fully invested.” 

So, Where Is All This Cash Then?

The Wall Street Journal was correct in their statement that money market cash levels have indeed been climbing. The chart from the Office Of Financial Research shows this:

There are a few things we need to consider about money market funds.

  1. Just because I have money in a money market account, doesn’t mean I am saving it for investing purposes. It could be an emergency savings account, a down payment for a house, or a vacation fund on which I want to earn a higher rate of interest. 
  2. Also, money markets are used by corporations to store cash for payroll, capital expenditures, operations, and a variety of other uses not related to investing in the stock market. 
  3. Foreign entities also store cash in the U.S. for transactions processed in the United States which they may not want to immediately repatriate back into their country of origin.

The list goes on, but you get the idea.

If you take a look at the chart above, you will notice that the bulk of the money is in Government Money Market funds. These particular types of money market funds generally have much higher account minimums (from $100,000 to $1 million) which suggests that these funds are predominately not retail investors. (Those would be the smaller balances of prime retail funds.)

So, where is all that cash likely coming from?

Hoarding Cash

You are already most likely aware that Warren Buffett is hoarding $128 billion in cash, and that Apple is sitting on a cash trove of $100 billion, with Microsoft holding $136.6 billion, and Alphabet amassing $121 billion.

Yes, some of that cash has been used for share buybacks, but much of it is sitting there waiting for acquisitions, R&D, capital expenditures, etc. However, that cash is primarily sitting in short-term and longer-term dated treasuries, AND, you guessed it, money market funds.

However, as noted above, there is also a flood of money coming into U.S. Dollar denominated assets for better yield and safety than what is available elsewhere in the world.  

At RIAPRO.NET we regularly track the U.S. Dollar for our subscribers. (You can access these reports with a FREE 30-day Trial.)

  • Despite much of the rhetoric to the contrary, the dollar remains in a strongly rising uptrend. Given a “strong dollar” erodes corporate profits on exports (which makes up 40% of corporate profits overall) a strong dollar combined with tariffs isn’t great for corporate bottom lines. Watch earnings carefully during this quarter.
  • Furthermore, the dollar bounced off support of the 200-dma and the bottom of the uptrend. If the dollar rallies back to the top of its trend, which is likely, this will take the wind out of the emerging market, international, and oil plays.
  • The “sell” signal is also turning up. If it triggers a “buy” the dollar will likely accelerate pretty quickly.

Much of the bulls rallying cry has been based on the dollar weakening with the onset of QE, but as shown above, that has yet to be the case. However, US Dollar positioning has been surging as of late as money has been flowing into US Dollar denominated assets. Importantly, it is worth watching positioning in the dollar as a reversal of dollar-longs are usually reflective of short- to intermediate-term market peaks.

As shown above, and below, such net-long positions have generally marked both a short to intermediate-term peak in the dollar. The bad news is that a stronger dollar will trip up the bulls, and commodities, sooner rather than later.

However, as it relates to foreign positioning, it is worth noting that EURO-DOLLAR positioning has been surging over the last 2-years. This surge corresponds with the surge in dollar-denominated money market assets.

What are Euro-dollars? The term Eurodollar refers to U.S. dollar-denominated deposits at foreign banks, or at the overseas branches, of American banks. Net-long Eurodollar positioning is at an all-time record as foreign banks are cramming money into dollar-denominated assets to get away from negative interest rates abroad.

Importantly, when positioning in the Eurodollar becomes NET-LONG, as it is currently, such has been associated with short- to intermediate corrections in the markets, including outright bear markets. 

What could cause such a reversal? A pick up of economic growth, a reversal of negative rates, a realization of over-valuation in domestic markets, which starts the decline in asset prices. Then, the virtual spiral begins of assets flowing out, lowers asset prices, leading to more asset outflows.

While the bulls are certainly hoping the “cash hoard” will flow into U.S. equities, the reality may be quite different.

That’s how the bear markets begin.

Slowly at first. Then all of a sudden.

Fundamentally Speaking: Earning Season’s Good, Bad & Ugly

With the third quarter of 2019 reporting season mostly behind us, we can take a look at what happened with earnings to see what’s real, what’s not, and what it will mean for the markets going forward.

The Good

As always is the case, the majority of companies beat their quarterly estimates, as noted by Bespoke Investment Group.