September’s Start Gives Investors Whiplash

September’s Start Gives Investors Whiplash

The markets closed last week in a bullish mood on the news that (stop me if you’ve heard this one before) the US and China will be back at the negotiating table in October. You don’t say! Oh but this time we have schedules and a list of attendees so it is totally different.

h/t @StockCats

The past three days of bullishness have been in sharp contrast to the chaos of August during which global stock markets lost around $3 trillion in market cap thanks to the ongoing trade wars and more data pointing to global slowing. As of Friday’s close, over the past year, the S&P 500 is up 3.7%, the Nasdaq 2.5%, Dow Jones Industrial Average up 3.4%, the NYSE Composite Index up 0.17% and the Russell 2000 is down -12.1%. During August 2,930 acted as a resistance level for the S&P 500 multiple times, but the index managed to break through that level last week, which is typically a bullish signal.

As the markets have taken an immediate about-face on the reignited hopes for progress in the trade wars, we’ve seen a profound flip-flop in equity performance which gave many a portfolio whiplash.

  • Those stocks with the lowest P/E ratios that were pummeled in August are up an average of 5.3% since last Tuesday’s close.
  • The stocks that held up best in August are barely breakeven over the final three trading days last week while those that were soundly beaten down in August are up the most so far in September.
  • Stocks with the most international revenue exposure are materially outperforming those with primarily domestic revenue exposure.

While corporate buybacks have been a major source of support for share prices in recent years, corporate insiders have been big sellers in 2019 selling an average of $600 million worth of stock every trading day in August, per TrimTabs Investment Research. Insider selling has totaled over $10 billion in five out of the first eight months of 2019. The only other time we’ve seen so much insider selling was in 2006 and 2007.

Bonds

August saw an additional $3 trillion of bonds drop into negative territory. We are now up to $17 trillion in negative-yielding bonds globally, with $1 trillion of that corporate bonds – talk about weak growth expectations! We also saw the yield on the 30-year Treasury bond drop below the dividend yield for the S&P 500 recently. The last time that happened was in 2008.

The yield on the 10-year Treasury dipped below the 2-year multiple times during the trading day in August but closed for the first time inverted on August 26th. August 27th the spread between the 10-year Treasury yield and the 2-year rate fell to negative 5 basis points, its lowest level since 2007. Overall the yield on the 10-year Treasury note fell 52 basis points during the month of August – that’s a big deal. The last time we saw a fall of that magnitude in such a short period of time was in 2011 when fears of a double-dip recession were on the table. Currently, the real yield on US 10-year is sitting in negative territory which says a lot about the bond market’s expectations for growth in the coming years. Keep that in mind as you look at the PE multiple for the S&P 500 after having two consecutive quarters of contracting EPS.

A growing number of countries have their 10-year dropping into negative territory:

  • Switzerland first in January 2015
  • Japan in February 2016
  • Germany and Netherlands in the Summer of 2016
  • Finland and Denmark in the Fall of 2016
  • Ireland, Latvia, Slovakia, Belgium, Sweden, Austria, France all negative

The US is now the only nation in the developed world with any sovereign rate above 2% (h/t @Charlie Bilello). My bets are that we are the outlier that won’t stay an outlier indefinitely.

Recently the Italian 10-year bond dropped to new all-time lows as Cinque Stelle (5 Star) movement managed to team up with the center-left Democratic Party of former Prime Minister Matteo Renzi. Don’t expect this new odd-couple coalition to last long as these two parties have basically nothing in common save for their loathing of Matteo Salvini and the League, but for now, the markets have been pacified. These two parties detest one another and were trading insults via Twitter up until about a month ago. This marriage of convenience is unlikely to last long.

The European Central Bank meets on September 12th, giving them one week head start versus the Federal Reserve’s Open Market Committee meeting, which is September 17th & 18th, kicking off the next round of the central bank race to the bottom. The ECB needs to pull out some serious moves to prop up Eurozone banks, which are near all-time lows relative to the broader market. We’ll next hear from the eternally-pushing-on-a-string Bank of Japan on September 19th.

Currency

Dollar Strength continues to be a problem across the globe. The US Trade Weighted Broad Dollar Index recently reached new all-time highs, something I have warned about in prior Context & Perspective pieces as being highly likely. It’s happened and this is big – really big when you consider the sheer volume of dollar-denominated debt coming due in the next few years and that this recent move is likely setting the stage for significant further moves to the upside.

In the context of the ongoing trade war with China, the renminbi dropped 3.7% against the dollar in August, putting it on track for the biggest monthly drop in more than a quarter of a century as Beijing is likely hunkering down for a protracted trade war with the US, despite what the sporadically hopefully headlines may say.

Make no mistake, this is about a lot more than just terms of trade. This is about China reestablishing itself as a major player on the world stage if not the dominant one. For much of the past two millennia, China and India together accounted for at least half of global GDP. The past few centuries of western dominance have been a historical aberration.

As the uncertainty around Brexit continues to worsen (more on this later), the British pound last week dropped to its lowest level against the dollar in 35 years, apart from a brief plunge in 2016 likely for technical reasons.

Domestic Economy

The US economy continues to flash warning signs, but there remain some areas of strength.

The Good:

  • Consumer Spending rose +0.4% month-over-month in July, beating expectations for an increase of +0.3%.
  • Average hourly earnings for August increased by 0.4% month-over-month and 3.2% year-over-year, each beat expectations by 0.1%.
  • ADP private nonfarm payrolls increased by 195,000 in August versus expectations for 148,000.
  • Unemployment rates for black and Hispanic workers hit record lows.
  • The prime-age (25-54) employment-population ratio hit a new high for this business cycle, still below the peak of both the prior and 1990s expansion peaks, but still an improvement.
  • While employment growth is slowing, jobs continue to grow faster than the population.
  • Despite the weakest ISM Manufacturing report in years, the ISM Non-Manufacturing report painted a much rosier picture of at least the service sector. While expectations were for an increase to 54.0 from 53.7 in July, the actual reading came in well above at 56.4. In contrast to the ISM Manufacturing report, New Orders were much stronger than the prior month and only slightly below the year-ago level.
  • The Citi Economic Surprise Index (CESI) has continued to recover, moving above zero (meaning more surprises to the upside than down) for the first time in 140 days after having been in negative territory for a record 357 days.

The Bad:

  • Nonfarm payrolls increased by only 130,000 versus consensus estimates for 163,000 and only 96,000 of those jobs came from the private sector – the slowest pace since February. Both July and June job figures have been revised lower, which is basically what we have been seeing in 2019. A long string of revisions to the downside means there is a material shift in the labor market. Total nonfarm payroll employment increased by 130,000 in August.
  • Job growth has averaged 158,000 per month in 2019, below the average monthly gain of 223,000 in 2018.
  • University of Michigan Consumer Confidence survey total contradicted the Conference Board’s findings with its main index falling the most since 2012 in August, dropping to the lowest level since President Trump took office. Concerns over tariffs were spontaneously mentioned by 1/3 of the respondents. The most concerning data from the survey where Household Expectations for personal finances one year from now experienced the biggest one month drop since 1978, falling 14 points.
  • Consumer spending doesn’t look so great when you look at the drop in the Personal Savings rate from 8.0% in June to 7.7% in July, which means that 75% of the increase in spending was at the cost of savings. Net income only rose 0.1% in nominal terms in July versus expectations for a 0.3% increase – not at all consistent with the narrative of a strong labor market.
  • The Chicago Fed’s Midwest state economy survey found that the number of firms cutting jobs rose to 21% in August from just 6% in July while those hiring dropped to 25% from 36%.
  • The Quinnipiac University poll found that for the first time since President Trump took office, more Americans believe the economy is getting worse (37%) than believe it is improving (31%).
  • Camper van sales dropped 23% year-over-year in July. This has historically been a pretty accurate leading indicator of future consumer spending.
  • The Duncan Leading Indicator (by Wallace Duncan of the Dallas Fed in 1977) has turned negative year-over-year for the first time since 2010. A Morgan Stanley study found that when this indicator has turned negative, a recession began on average four quarters later, with only one false positive out of seven going back to the late 1960s.
  • While expectations were for the ISM Manufacturing Index to increase from 51.2 to 51.3 in August, the reading came in at 49.1 (below 50 indicates contraction), the fifth consecutive monthly decline in the index and the first time the index has dropped into contraction in three years. Even worse, the only sub-index not in contraction was supplier deliveries. New Orders (the most forward-looking of all sub-indices) hasn’t been this weak since April 2009.
  • Durable Goods New Orders and Sales are improving but remain in contraction territory while Inventories are rising at around a 5% annual pace – that’s a problem.
  • US Producer Prices experienced their first decline in 18 months.
  • The Atlanta Fed’s GDPNow estimate for the third quarter has fallen to 1.5%.

The Ugly:

  • US Freight rates have fallen 20% from the June 2018 high. Even more dire warning comes from freight orders, which dropped 69% in June from June 2018.

Europe

That nation that has been the region’s strongest economy is struggling as the fallout from the US-China trade war expands around the world.

  • The German unemployment rate rose for the fourth consecutive month.
  • German retail sales took a bigger battering than expected in July, falling 2.2% from June to reveal the biggest drop this year in the latest indication that Europe’s largest economy may well slide into recession. Since February, monthly retail sales figures have either declined or been flat, with the exception of the 3% gain in June.
  • A recent survey revealed that employers are posting fewer jobs, intensifying fears that the downturn in the country’s manufacturing industry has spread into the wider economy.
  • Manufacturing orders came in weaker than expected, declining -5.6% versus expectations for -4.2%.
  • Construction activity has contracted at the fastest rate since June 2014.
  • Germany’s export-dependent economy shrank 0.1% in the second quarter while the central bank warned this month that a recession is likely.

The rest of Europe continues to weaken.

  • Italian industrial orders fell -0.9% in June, making for a -4.8% year-over-year contraction
  • French consumer spending is up all of +0.1% year-over-year.
  • Spain’s flash CPI has fallen from 0.5% year-over-year in July to 0.3% in August year-over-year.
  • Switzerland’s year-over-year-GDP growth has fallen to 0.2% versus expectations for 0.9% – treading water here.
  • Brexit has turned into an utter mess as Prime Minister Boris Johnson has lost his majority in Parliament. Novels could and likely will be written on this mind-boggling drama in what was once one of the most stable democracies in the world. Rather than put you through that, as they say, a picture is worth a thousand words.

The challenge for anyone negotiating terms for Brexit with the Eurozone basically comes down to this.

Talk about a Sisyphean effort

Understanding this impossible reality, here is what to expect in the coming weeks.

For those who may not be convinced that this is a material problem, this is an estimate of the impact of a hard Brexit on the Eurozone alone.

Bottom Line

Around 70% of the world’s major economies have their Purchasing Managers Index in contraction territory (below 50) – that is a lot of slowing going on. Much of the world is drowning in debt with excess productive capacity – a highly deflationary combination.

We are witnessing a major turning point in the global economy and geopolitical landscape. The past 60 post-WWII years have primarily consisted of US economic and military dominance, increasing levels of globalization and relatively low levels of geopolitical tension.

Today we are seeing a shift away from an optimistic world of highly interconnected global supply chains towards one driven by xenophobia and nationalism. We are seeing rising economic and political tensions between not only traditional rivals but also between long-term allies. In the coming decades, the US economy will no longer be the singular global economic and military powerhouse, which will have a material impact on the world’s geopolitical balance of power.

The big question facing investors is whether the US and much of the rest of the world are heading into a recession. Many leading indicators that have proven themselves reliable in the past indicate that this is highly likely but today really is different.

Never before in modern history have we had these levels and types of central bank influence. Never before have we had such a long expansion period. Never before have we had this much debt, particularly at the corporate level. Never before have we had such profound demographic headwinds. On top of all that, we have a directional shift away from globalization that is forcibly dismantling international supply chains that were decades in the making with no clarity on future trade rules.

Will central bankers be able to engineer a way to extend this expansion? No one who is intellectually honest can answer that question with a high level of confidence as we are in completely uncharted territory. This means investors need to be agile and put on portfolio protection while it remains relatively cheap thanks to historically low volatility levels.

I’ll leave you with a more upbeat note, my favorite headline of the week.

Turning Heads I Win, Tails You Lose Inside Out

Turning Heads I Win, Tails You Lose Inside Out

For much of the current expansion, cycle investors have been forced taught to believe in a Heads-I-Win-Tales-You-Lose investing environment in which good economic news was good for equities and bad economic news was also good for equities. Good news obviously indicates a positive environment, but bad news meant further central bank intervention, which would inevitably raise asset prices.

Those who didn’t buy-the-dip were severely punished. Many fund managers who dared to take fundamentals into consideration and were wary, or put on portfolio protection, saw their clients take their money and go elsewhere. An entire generation of market participants learned that it’s easy to make money, just buy the dip. That mode just may be changing as the past two weeks the major indices have taken some solid hits. Keep in mind that while the headlines keep talking up the equity markets, the total return in the S&P 500 has been less than 5% while the long bond has returned over 18%. Austria’s century bond has nearly doubled in price since it was first offered less than two years ago!

Earnings Season Summary

So far, we’ve heard from just under 2,000 companies with the unofficial close to earnings season coming next week as Wal Mart (WMT) reports on the 15th. The EPS beat rate has fallen precipitously over the past week down to 57.2%, which if it holds, will be the lowest beat rate since the March quarter of 2014. Conversely, the top line beat rate has risen over the past week to 57.4% which is slightly better than last quarter, but if it holds will be (excepting last quarter) the weakest in the past 10 quarters. The difference between the percent of companies raising guidance versus percentage lowering is down to -1.8% and has now been negative for the past four quarters and is below the long-term average.

With 456 of the 505 S&P 500 components having reported, the blended EPS growth estimate is now -0.72% year-over-year, with six of the eleven sectors experiencing declining EPS. This follows a -0.21% decline in EPS in Q1, giving us (if this holds) an earnings recession. The last time we experienced such a streak was the second quarter of 2016.

The Fed Disappoints

Last week Jerome Powell and the rest of his gang over at the Federal Reserve cut interest rates despite an economy (1) the President is calling the best ever, (2) an unemployment rate near the lowest level since the 1960s, at a (3) time when financial conditions are the loosest we’ve seen in over 16 years and (4) for the first time since the 1930s, the Fed stopped a tightening cycle at 2.5%. We have (5) never seen the Fed cut when conditions were this loose. They were looking to get some inflation going, Lord knows the growing piles of debt everywhere would love that, but instead, the dollar strengthened, and the yield curve flattened. Oops. That is not what the Fed wanted to see.

The President was not pleased. “What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world,” he said in a tweet. “As usual, Powell let us down.”

The dollar’s jump higher post-announcement means that the Fed in effect tightened policy by 20 basis points. Oops2. The takeaway here is that the market was not impressed. It expected more, it priced in more and it wants more. Now the question is, will the Fed give in and give the market what it wants? Keep in mind that both the European Central Bank and the Bank of England are turning decisively more dovish, which effectively strengthens the dollar even further.

Looking at past Fed commentary, the track record isn’t exactly inspirational for getting the all-important timing right.

But, we think the odds favor a continuation of positive growth, and we still do not yet see enough evidence to persuade us that we have entered, or are about to enter, a recession.” Alan Greenspan, July 1990

“The staff forecast prepared for this meeting suggested that, after a period of slow growth associated in part with an inventory correction, the economic expansion would gradually regain strength over the next two years and move toward a rate near the staff’s current estimate of the growth of the economy’s potential output.” FOMC Minutes March 20, 2001

“At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems to likely be contained.” Ben Bernanke, March 2007

“Would I say there will never, ever be another financial crisis? You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.” Janet Yellen, June 2017 (This one is going to be a real doozy)

This time around Fed Chairman Powell told us that what we are getting is a “mid-cycle policy adjustment.” Wait, what? We are now (1) in the longest expansion in history with (2) the lowest unemployment rate in over 50 years as (3) corporate leverage levels reaching record levels at a (4) time when more of it is rated at just above junk than ever before in history. This is mid-cycle? I’m pretty sure this one will be added to the above list as some serious Fed facepalming. Now I think these folks are incredibly bright, but they are just tasked with an impossible job and live in a world in which their peers believe they can and ought to finesse the economy. So far that theory hasn’t turned out all that well for anyone who doesn’t already have a good-sized pile of assets.

Domestic Economy (in summary because it is August after all)

  • We are 3-year lows for the US ISM manufacturing and services PMIs.
  • We are seeing a shrinking workweek, contracting manufacturing hours and factory overtime is at an 8-year low.
  • Just saw a contraction in the American consumer’s gasoline consumption.
  • American households just cut their credit card balances, something that happens only about 10% of the time during an expansion. Keep in mind that Q2 consumer spending was primarily debt-fueled when looking towards Q3 GDP.
  • The Organization for Economic Co-operation and Development (OECD) Leading Economic Indicator for the US fell to a 10-year low in June, having declined for 18 consecutive months. A streak of this nature has in the past always been indicative of a recession. Interestingly that same indicator for China just hit a 9-month high.
  • The Haver Analytics adjusted New York Fed recession risk model has risen from 50% in early January to a 10-year high of 80%.

Global Economy

  • The IMF has cut world GDP forecasts for the fourth consecutive time.
  • We have 11 countries so far in 2019 experiencing at least one quarter of shrinking GDP and 17 central banks are in cutting mode with Peru the latest to cut, the Royal Bank of Australia hinting at further cuts and Mexico and Brazil likely next in line.
  • Some 30% of the world’s GDP is experiencing inverted yield curves.
  • Over half the world’s bond market is trading below the Fed funds rate.
  • Despite the sanctions on Iran and OPEC output cuts, WTI oil prices have fallen over 20% in the past year.

Europe

  • The Eurozone manufacturing PMI for July fell to 46.5, down from 47.6 in June and is now at the lowest level since the Greek debt crisis back in 2012 as employment declined to a six-year low with a decline in exports. Spain came in at 48.2, 48.5 for Italy and 49.7 for France.
  • Germany, long the economic anchor for the Eurozone and the world’s fourth-largest economy, has negative yields all the way out 30 years and about 40% of Europe’s investment-grade bonds have negative yields. The nation’s exports declined 8% year-over-year and imports fell 4.4% in June as global demand continues to weaken.
  • France had its industrial production contract -2.3% in June versus expectations for -1.6%.
  • Italy’s government is back in crisis mode as the two coalition ruling parties look to be calling it quits. Personally, I think Salvini (head of the League) has been waiting for an opportune time to dump his Five Star partners and their recent vote against European Infrastructure gave him that chance. The nation is likely heading back to the polls again at a time when Europe is facing a potential hard Brexit, so we’ve got that going for us.
  • The UK economy just saw real GDP in Q2 contract 0.2% quarter-over-quarter. Domestic demand contracted -3%. Capex fell -0.5% and has now been in contraction for five of the past six quarters. Manufacturing output also contracted -2.3% in the worst quarter since the Great Financial Crisis.

Asia

  • South Korean exports, a barometer for global trade, fell 11% year-over-year in July. The trade war between South Korea and Japan continues over Japan’s reparations for its brutal policy of “comfort women” during WWII.
  • The trade war with China has entered the second year and this past week it looks unlikely that we will get anything sorted out with China before the 2020 election. The day after Fed’s rate decision Trump announced that the US would be imposing 10% tariffs on $300 billion of Chinese goods starting September 1st. In response, China devalued its currency and word is getting out that the nation is preparing itself for a prolonged economic war with the US. The rising tension in Hong Kong are only making the battle between the US and China potentially even more volatile and risky. Investors need to keep a sharp eye on what is happening there.
  • Auto sales in China contracted 5.3% year-over-year in July for the 13th contraction in the past 14 months.
  • Tensions are rising between India and Pakistan thanks to India’s PM Modi’s decision to revoke Kashmir’s autonomy.

US Dollar

When we look at how far the dollar has strengthened is have effectively contracted the global monetary base by more than 6% year-over-year. This type of contraction preceded the five most recent recessions. While the headlines have been all about moves in the equity and bond markets, hardly anyone has been paying attention to what has been happening with the dollar, which looks to be poised the breakout to new all-time highs.

Reaching for new all-time highs?

A strengthening dollar is a phenomenally deflationary force, something that would hit the European and Japanese banks hard. So far we are seeing the dollar strengthen significantly against Asian and emerging market currencies, against the New Zealand Kiwi and the Korean Won, against the Canadian dollar and the Pound Sterling (Brexit isn’t helping) and China has lowered its peg to the dollar in retaliation against new tariffs in the ongoing trade war. There is a mountain of US Dollar-denominated debt out there, which is basically a short position on the greenback and as the world’s reserve currency and the currency that utterly dominates global trade. As the USD strengthens it creates an enormous headwind to global growth.

The deflationary power of a strengthening US dollar strength in the midst of slowing global trade and trade wars just may overpower anything central banks try. This would turn the heads-I-win-tales-you-lose buy-the-dip strategy inside out and severely rattle the markets.

The bottom line is investors need to be watching the moves in the dollar closely, look for those companies with strong balance sheets and cash flows and consider increasing liquidity. The next few months (at least) are likely to be a bumpy ride.

In the Midst of Rising Unknowns, Focus on What We Do Know

In the Midst of Rising Unknowns, Focus on What We Do Know

As someone famous (or infamous depending on your leanings) once said, “there are known knowns….there are known unknowns…but there are also unknown unknowns.”

We’ve got a whole lot of the second two going around these days and that is not good for growth. Life and investing requires dealing with uncertainty to be sure, but holy cow these days investors and businesses are facing a whole other level of who-the-hell-knows and that is a headwind to growth.

  • The bumbling battle over Brexit
  • China’s earnings recession
  • Slowing in Europe
  • Yield curve inversions
  • Record levels of frustration with Capital Hill
  • The Cost of Corporate Uncertainty
  • The battle over the GDP pie
  • Beware Reversion to the Mean

Brexit

The United Kingdom, in or out? The mess that has become of Brexit is wholly unprecedented in modern history. As of March 29th, the day the UK was set to leave the EU, Brexit has never been more uncertain nor has the leadership of the UK in the coming months. This graphic pretty much sums it up.

Many Brits are unhappy with the state of their nation’s economy and are blaming those folks over in Brussels, as are many others in the western world – part of our Middle Class Squeeze investment theme.

China

Its economy is slowing, but just how bad it is and just how dire the debt situation in the nation is difficult to divine given the intentional opacity of the nation’s leadership. The ongoing trade negotiations with America run as hot and cold as Katy Perry depending on the day and when you last checked your Twitter feed.

Most recently China’s industrial profits fell 14% year-over-year in the January and February meaning we are witnessing an earnings recession in the world’s second largest economy.

Europe

Last week the markets ended in the red, driven in part by weaker than expected German manufacturing PMI from Markit with both output and new orders falling significantly – new orders were the weakest in February since the Financial Crisis.

Markit German Manufacturing PMI

It wasn’t just the Germans though as the French Markit Composite Index (Manufacturing and Services) dropped into contraction territory as well in February, coming in at 48.7 versus expectations for 50.7, (anything below 50 is in contraction). The French PMI output index is also in contraction territory.

This led to the largest one-day decline in the Citi Eurozone Economic Surprise Index in years, (hat tip TheDailyShot).

Yield Curve Inversion

This pushed the yield on the German 10-year Bund into negative territory for the first time since 2016 while in the US Treasury market, the 10-year to 3-month and 10-year to 1-year spreads went negative – an inverted yield curve which has been a fairly reliable predictor of US recessions. The 10-year 3-month inverted for the first time in 3,030 days – that is the longest period going back over 50 years. The Australian yield curve has also inverted at the short end.

No Love for Capital Hill

Americans’ view of their government is the worst on record – another manifestation of our Middle-Class Squeeze Investment theme. Gallup has been asking Americans what they felt was the most important problem facing the country since 1939 and has regularly compiled mentions of the government since 1964. Prior to 2001, the highest percentage mentioning government was 26% during the Watergate scandal. The current measure of 35% is the highest on record.

Few issues have every reached this level of importance to the American public: in October of 2001 46% mentioned terrorism; in February of 2007 38% mentioned the situation in Iraq, in November 2008 58% mentioned the economy and in September 2011 39% mentioned unemployment/jobs.

While America appears to be more and more polarized politically, the one thing that many agree upon, regardless of political leanings – government is the greatest problem.

It isn’t just the US that is having a tiff with its leaders. Last weekend over 1 million (yes, you read that right) people protested in London calling for a new Brexit referendum – likely the biggest demonstration in the UK’s history and then there are all the firey protests in France.

The Cost of Corporate Uncertainty

When companies face elevated levels of uncertainty, they scale back and defer growth plans and may choose to shore up the balance sheet and reduce overhead rather than invest in opportunities for growth. So how are companies feeling?

A recent Duke CFO Global Business Outlook Survey found that nearly have of the CFOs in the US believe that the nation will be in a recession by the end of this year and 82% believe a recession will have begun before the end of 2020.

It isn’t just in the US as CFOs across the world believe their country will be in a recession by the end of this year – 86% in Canada, 67% in Europe, 54% in Asia and 42% in Latin America.

All that uncertainty is hitting the bottom line. Global earnings revision ratio has plunged while returns have managed to hold up so far.

It isn’t just the CFO that is getting nervous as CEOs are quiting at the highest rates since the financial crisis – getting out at the top?


The GDP Pie

To sum it up, lots of unknowns of both the known and unknown variety and folks are seriously displeased with their political leaders.

So what do we actually know?

We know that US corporate profits after tax as a percent of GDP (say that five times fast) are at seriously elevated levels today, (nearly 40% above the 70+ year average) and have been since the end of the financial crisis. No wonder so many people are angry about the 1%ers.

Corporate profits have never before in modern history been able to command such a high portion of GDP. This is unlikely to continue both because of competition, which tends to push those numbers down and public-policy. If the corporate sector is going to command a bigger piece of GDP, that means either households or the government is going to have to settle for a smaller portion.

It isn’t just the corporate sector that has taken a bigger piece of the GDP pie. Federal government spending to GDP reached an all-time high of 25% in the aftermath of the financial crisis and has remained well above historical norms since then.

Given the level of dissatisfaction we discussed earlier concerning Capital Hill, it is highly unlikely that we will see a reduction in government deficit spending. When was the last time a politician said, “So you aren’t satisfied with what we are doing for you? Great, then we’ll just do less.”

That leaves the households with a smaller portion of the economic pie – evidence of which we can see in all the talk around how wage growth remains well below historical norms.

Reversion to the Mean

Given the current political climate, it is unlikely that government spending as a percent of GDP is going to decline in any material way, which leaves the battle between the corporate and household sector. Again, given the current political climate (hello congresswoman AOC) it is unlikely that the corporate sector is going to be able to maintain its current outsized share of GDP – the headlines abound with forces that are working to reduce corporate profit margins and as we’ve mentioned earlier, global earnings are being revised downward significantly. If the corporate sector’s portion of GDP falls to just its long-term average (recall today it is 40% above and has been above that average for about a decade), it would mean a significant decline in earnings.

The prices investors are willing to pay for those earnings are also well above historical norms.

Today the Cyclically Adjusted PE Ratio (CAPE) is 82% above the long-term mean and 93% above the long-term median. What is the likelihood that this premium pricing will continue indefinitely? My bets are it won’t.

The bottom line is that the level of both corporate profits and what investors are willing to pay for those profits are well outside historical norms. If just one of those factors moves towards their longer-term average, we will see a decline in prices. If both adjust towards historical norms, the fall will be quite profound.

Germany′s aging population desperate for more nurses 

Germany′s aging population desperate for more nurses 

We’ve talked quite a bit over the last several quarters about the nursing shortage in the US that has fueled the sharp climb in AMN Healthcare shares. Now we are hearing the same in Germany, with the root cause serving as a confirming signal for our Aging of the Population investing theme and its global implications.

Germany faces a massive lack of medical care personnel, which means many hospitals are overburdened. Nurses complain that they are too short-staffed to properly tend to their patients. Currently, roughly 1 million people work in the country’s nursing industry. It is projected that 3 million nurses will be needed by 2060, given Germany’s aging population. In late 2015, there were 2.9 million individuals in need of care — by 2030, this figure is expected to rise to 4.1 million.

Source: Germany′s aging population desperate for more nurses | Germany| News and in-depth reporting from Berlin and beyond | DW | 01.08.2018

Manufacturing Goes Bipolar but Yellen is Feeling Good

Manufacturing Goes Bipolar but Yellen is Feeling Good

The recent US manufacturing data has gone biopolar while over in Europe and even Japan, manufacturing is more solidly strenghtening. Then there is Fed Chair Janet Yellen’s recent assurances… this week is shaping up to be full of entertainment outside of yesterday’s fireworks!

ISM Manufacturing data for June indicated solid growth in most areas but was also considerably better than expectations (57.8 versus expectations for 55.3, up from 54.9 in May, a 3-year high) at a time when most economic data is coming in at or weaker than expectations.


source: tradingeconomics.com

  • New orders rose to 63.5 from 59.5
  • Backlogs gain 2 points to hit 57
  • Supply deliveries rose by near 4 percent to reach 57
  • Employment hit 3-month high at 57.2 from 53.5
  • But…. The prices paid index fell to a 7-month low of 55 from 60.5 in May, 68.5 in April and 70.5 in March. Ehh? Production and demand rising but prices are dropping month after month after month?

To further emphasize that this month’s ISM manufacturing report might not be all that telling is the U.S. Census Bureau Construction Spending report which was flat for May versus expectations for a gain of 0.3 percent month-over-month. Given that this one measures what was spent rather than sentiment, we tend to give it more weight. Most of the components saw a month-over-month drop in spending, including manufacturing (down -1.7 percent), residential (down -0.6 percent), commercial (down -0.7 percent), highway and street (down -1.0 percent), lodging (down -0.3 percent), communication (down 1.9 percent), transportation (down -1.2 percent). Overall total private construction dropped 0.6 percent month-over-month while public construction rose 2.1 percent. Other than that all good – sheesh!

Bear in mind that the last time ISM manufacturing came in around 58 was August 2014, after which the annualized GDP growth rate slowed to 2.3 percent. The time before that was early 2011 which preceded a slump to 1.9 percent growth for GDP.

On the other hand, the Markit manufacturing survey told a very different story, one that was more consistent with what we saw in the Construction Spending report, falling to a six-month low of 52 from 52.7 in May. We like to confirming data points and sorry Mr. ISM, your cheese is standing alone this month.

Also contradicting the ISM, June auto sales declined 0.9 percent month over month, dropping to 16.5 million units at an annual rate and making for the fifth decline in the past six months. The first half of the year has seen sales drop at a 20 percent annual rate. A drop of this magnitude occurred last in 2010 when markets were fretting about the likelihood of a double-dip and the Fed was moving towards loser policies.

We’d point out that this lack of pricing power isn’t just here, as the Eurozone and Japan are experiencing the same phenomenon, with Japan experiencing a 43-year high for labor shortage without much in the way of upward pricing pressures.

In contrast, the Markit Nikkei Japan Manufacturing PMI continued to improve in June, extending the current sequence of expansion to ten months with gains in both production and new orders.

IHS Markit Spain Manufacturing PMI revealed that Spanish manufacturing completed a strong second quarter with growth of output, new orders and employment remaining elevated. June saw further sharp rises in output and new orders with the rate of job creation at near-record highs. Purchasing activity increased at the fastest pace so far in 2017.

IHS Markit Italy Manufacturing PMI saw sharp and accelerated increases in output and new orders in June with output picking up on the back of robust export orders. Even employment rose amid a rebound in business sentiment.

IHS Markit France Manufacturing PMI saw new orders increase at a sharper pace in June with output growth moderating. The index rose to 54.8 from 53.8 in May and was only just shy of April’s six-year high.

IHS Markit/BME Germany Manufacturing PMI rose to a 74-month high with the fastest growth in new orders since March 2011 as input prince inflation slowed to a 7-month low. The 12-month outlook for production remained strongly positive.

Back in the U.S., on top of the contradictory manufacturing data, there is the ECRI leading indicator which has fallen now for three consecutive weeks, with a decline in six of the past seven and now sits at its lowest point since December 9th, 2016.

Mr. Market seems utterly unimpressed with continued trend for economic data to disappoint relative to expectations as the CBOE VIX net speculative shorts is now at the highest level ever – so apparently there is nothing of concern here.

Fed Chairperson Janet Yellen seems to agree, “Would I say there will never, ever be another financial crisis? You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.”

Really? That’s quite a statement, but then…

“But, we think the odds favor a continuation of positive growth, and we still do not yet see enough evidence to persuade us that we have entered, or are about to enter, a recession.” Alan Greenspan, July 1990

“At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems to likely be contained.” Ben Bernanke, March 2007

via GIPHY

America First? When it comes to GDP we get the bronze!

America First? When it comes to GDP we get the bronze!

Yesterday we talked about how the American economy, despite all the euphoric headlines since the election, didn’t deliver much of a performance in the fourth quarter and in fact we saw the weakest full-year GDP growth rate since 2011 which was well below the U.K.’s 2016 growth rate of 2 percent. Today we learned that the Eurozone as well kicked our economic tuckus in 2016.

GDP grows 0.6% in final quarter of 2016, beating expectations and taking annual figure to 1.8%

Yep, that hurt. So much for America being the “cleanest shirt in the economic laundry.” Despite headwinds ranging from the accelerating Greek drama to the mountain of Italian non-performing loans that led to the nationalisation of Banca Monte dei Paschi di Siena, Brexit, failed Constitutional reforms leading to the resignation of Prime Minister Renzi in Italy …. the list goes on, they beat us.

 

Last week talks between the U.S. and Mexico hit a serious bump after a President Trump Tweet led Mexico’s President Peña Nieto to cancel their upcoming meeting, while the administration has been threatening a 20 percent tax on imports from Mexico, which would put serious upward price pressure on, (among other things) fruits, vegetables and auto parts. Today Peter Navarro, Trump’s top trade advisor, accused Germany of currency exploitation. According to the FT, “In a departure from past US policy, Mr Navarro also called Germany one of the main hurdles to a US trade deal with the EU and declared talks with the bloc over a Transatlantic Trade and Investment Partnership dead.”

While last week’s meeting with the British Prime Minister Theresa May ended with some serious hand-holding, over the weekend the President’s sudden implementation of an immigration ban left, “our closest ally flailing after the UK government was openly contradicted by US diplomats over which British nationals were covered by the measure.”

After Trump’s election victory, the Bank of Japan was initially more optimistic about more favourable economic conditions amid expectations for stronger American growth. That enthusiasm has been fading as yesterday, ahead of a two-day policy meeting, officials are less optimistic about the impact on Japan’s economy. According to the Wall Street Journal, “We now realise that we know very little about him.”

Trump’s team has been poking our allies in some uncomfortable ways, making many around the globe nervous, and yet the VIX (a measure of implied volatility) is pretty much yawning.

The 90 percent of the America economy that is not represented by either inventory build or state and local government spending managed to grow at a whopping 0.6 percent annual rate in the fourth quarter.

Amidst all this, the Fed keeps talking about further rate hikes

Under Armour (UA) just released its fourth quarter and full year results and was yet one more citing currency headwinds.

Upon the announcement of Trump’s immigration ban on Friday, the markets started to fall. Monday the S&P 500 fell 60 basis points and is now down 0.76 percent from its most recent closing high last Wednesday. Bespoke compiled headlines over the past few days that reveal concerns the Trump hope trade is starting to fade.

Is this an inflection point? Too soon to tell, but we can say that having an administration with no political history who has pretty much tossed out the rule book is likely to cause heightened volatility, which is not reflected in market pricing. Erecting trade barriers and surprising the market, let alone allies, is likely to induce more caution in the C suite.

This morning we also saw that compensation costs in 2016 rose 2.2 percent, significantly faster than GDP of 1.6 percent, which makes another Fed hike more likely. We’ll be hearing from the Federal Reserve on Wednesday and will be looking to see if the tone from the FOMC meeting is more dovish than we heard in Fed Chair Janet Yellen’s testimony on January 19th. We will also hear from over 100 companies this week on their earnings, putting the relative complacency in the markets to a test.

Source: Eurozone’s economic recovery picks up speed

China isn't the only country slowing

China isn't the only country slowing

Slow-TurtleChina isn’t the only country slowing, as we are sure you’ve all been hearing, the global economy is slowing to a level that ought to make everyone pay attention. Earlier this month the International Monetary Fund (IMF) cut forecasts for 2015 yet again, projecting 3.1% versus its prediction in July for 3.3% and its April prediction for 3.5%.  This means that this year, despite the unprecedented level of monetary stimulus injected all over the world by government desperate to get things moving… the world economy will grow at its slowest pace since the global financial crisis.

Last week, Citibank cut its global growth forecast for 2016 for the fifth consecutive month, predicting 2.8% versus the previous forecast of 2.9%. Keep in mind that Citibank’s chief economist William Buiter has stated previously that global growth below 3% coupled with a significant output gap effectively represents a global recession. Now that’s just one person’s opinion, but it conveys the importance of these numbers.

If we take a brief tour around the globe, we’ll see that the Eurozone in 2014 finally posted positive growth of 0.9%, after having contracted in 2012 and 2013. The first quarter’s growth rate came in at 0.5% with the second quarter slowing slightly to 0.4%, giving the economy about 1.2% growth year-over-year.

In mid-November, we’ll get the first estimate for the third quarter, which so far is likely to be at around the same pace as the second. On Friday, we got some good news when the Eurozone Markit Composite PMI (Purchasing Manager’s Index) came in at 54 (above 50 is expansionary). The data for services came in nicely at 54.2 with manufacturing unchanged from the prior month at 52. So there is some growth in the region, though from a historical perspective it is still relatively weak. So let’s dig into the details.

If we dig a bit deeper, we see that the Eurozone’s largest economy, Germany, is suffering from the slowing in China and Russia, two major export partners with its 2nd quarter GDP coming in at 0.4%. Consumer confidence has been falling since the first quarter, but it still maintains an enviable unemployment rate of less than 5%, with a youth unemployment rate of 7%, which bodes well for the nation’s productivity in the future.

France, the Eurozone’s second largest economy, on the other hand experienced no growth in the second quarter, versus expectations for a 0.2% increase with an unemployment rate of just under 11% and a youth unemployment rate of nearly 25%.

Italy, the Eurozone’s third biggest economy experienced just 0.2% growth versus 0.3% expected. Unemployment has remained stubbornly high at nearly 12% with youth unemployment over 40%, which is a devastating number for the future of the country.  However, Prime Minister Matteo Renzi has made a lot of progress in reforming the government, so despite those rather dour numbers, consumer confidence is higher today than it has been over the past 12 years! Directions are important – we can’t just look at the numbers in isolation.

So things aren’t great in Europe, but they aren’t horrible either… however, significant growth seems perpetually illusive with rising concerns that the slowing in China and the emerging markets could be a tipping point for the area, which is likely why the head of the European Central Bank, Mario Draghi, hinted last Thursday that the ECB (Europe’s version of the Fed) is willing and ready to inject more quantitative easing into Europe’s economy. More QE, the now omnipresent heroin of the stock market was promised and equity indices all over soared!

So what about China? How bad it is there? Truth is, no one really knows. The country is based on an ideology that requires opacity at all levels of government, so accurate data or even an honest attempt at accurate data is something we are unlikely to ever get from official sources.

Those sources recently reported that China’s growth in Q2 was 6.9%, close enough to the official target of 7.0%, but being below, it provides a wee bit of cover for some stimulus. And wouldn’t you just know it! The People’s Bank of China, essentially their Fed, just lowered lending rates…a coincidence we’re sure!

Taking a step back, China has cut their 1-year interest rate 6 times since November of 2014, lowering the rate from 5.6% to 4.35%… but we’re sure everyone there is quite calm! The Required Deposit Reserve Ratio for Major Banks has been lowered 4 times since February, from 19.50% to 17.50%. This ratio determines how much leverage banks can have, which translates into loans. The lower the ratio, the greater the leverage which means more loans… more of nothing to see here folks? We don’t think so.

Here are a few more interesting data points:

  • China’s export trade has fallen -8.8% year to date.
  • China import trade is down 17.6% year to date.
  • Railway freight volume is down 17.34% year over year.
  • China hot rolled steel price index is down 35.5% year to date
  • Fixed asset investment is up 10.3% sounds great? (averaged +23% 2009-2014)
  • Retail sales are up 10.9%, the slowest growth in 11 years
  • China Containerized Freight Index, which reflects the contractual and spot market rates to ship containers from China to 14 destinations around the world, has just hit its lowest level in history, now 30% below where it was in February and 25% below where it was at its inception 17 years ago.

You get the point. It is slowing and we suspect it is slowing a lot more than the official GDP numbers would indicate.

Why should those of us outside China care? Because China has been a major supporter of global growth since the financial crisis. When all hell broke loose in 2007 & 2008, China put its infrastructure spending into high gear. That meant that those economies that supply commodities had a backup buyer for their exports when everyone else was crashing, which put a vital floor under the global economy.

But China couldn’t keep it up indefinitely, and we are seeing the consequences of that nation’s shift from a primarily export driven, massive infrastructure-building economy to a more domestic demand-driven economy with a lot less infrastructure spending.

China has been Germany’s fourth-largest export partner, with Russia not that far behind. Falling oil prices and sanctions have crippled Russia’s economy, so it also isn’t buying much from Germany. If Germany sells less, it’ll buy less from other nations… and keep in mind that all those Eurozone countries are just barely eking out positive growth, so small changes will have an impact.

Onto those emerging economies, many of which were benefiting from China’s infrastructure spend as they are primarily commodity exporters. If we look at what has happened to commodity prices over the past twelve months, you can get an appreciation for just how painful this has been for many of these countries. Keep in mind that 45% of global GDP comes from commodity export nations – commodity prices crater and these nations can buy less stuff from other nations – more headwinds to growth.

In fact, 2015 will be the fifth consecutive year that average growth in emerging economies has declined. This is a serious drag on the advanced economies, which on the other end of the spectrum, will likely post their best growth since 2010 – albeit growth that isn’t all that spectacular.

Japan… well it’s still stuck between barely growing and contracting, regardless of how much the Bank of Japan tries to kick start the economy. Japan’s industrial output unexpectedly fell in September, raising concerns that the nation may be slipping back into another recession. Production declined 0.5% in August following a 0.8% decline in July versus economists’ expectations for a 1% gain. Inventories rose 0.4% in August over July, and expanded in five of eight months this year, which is a hindrance to future growth as with rising stockpiles of unsold goods, companies are less likely to expand output in the future.

As for Latin America, Argentina is still a mess and Brazil is in a recession, with many of the other countries doing alright. Chile is expected to be around 2.5% for 2015. Colombia 2.8%… like we said, ok, not great.

In the US, things aren’t awful, but not exactly robust, which is why I had been predicting for months that the Fed would not hike rates in September.

  • For example, the Industrial production index came in with another decline of -0.4% in September versus expectations of -0.2%, which makes it the 5th decline out of 8 reported figures in 2015.
  • Capacity utilization, which measures to what degree the economy is taking advantage of its ability to make stuff, was expected to drop from 78% to 77.8%. Instead, it fell further to 77.6%, for the 7th decline out of 8 readings in 2015. This means the U.S. continues to use less and less of its capacity to make stuff – hardly shocking given the wide misses in manufacturing data reported by regional Federal Reserve banks for August.
  • September retail sales came in below expectations, rising a seasonally adjusted 0.1% from August versus expectations for 0.2%. The good news is the increase came from a 1.8% month-over-month increase in auto sales. Overall retail sales, when we exclude autos and gasoline, have not grown since January.
  • U.S. producer prices in September posted their biggest decline in eight months, at a drop of -0.5%, as energy costs fell for the third month in a row. This means that the Producer Price Index is now down 1.1% year-over-year as of the end of September.
  • U.S. total business sales also declined in September, down -0.58% month-over-month and down -3.09% year-over-year as of August.

Going forward, I still remain very skeptical that the Fed will raise rates. The fact that China is continuing to loosen its monetary policy and comments out of the ECB concerning it likely embarking on further easing only add to our skepticism as the moves by China and the ECB will already put upward pressure on the dollar, harming U.S. exports. A rate hike would only exacerbate the dollar strengthening against other currencies.

Fed tightening has been a trigger in nine of the last eleven recessions, so you can see yet another reason for the Fed to be cautious.

The tough thing now is that with a Fed that can’t seem to make up its mind, investors are left wondering what to do, so they end up selling the good and the bad when they get nervous. This will make for increased volatility, but that also means more opportunities for those that keep focused on the goal and don’t get distracted by shorter-term market dramatics.

Risk On?

Risk On?

This morning I spoke with Matt Ray on America’s Morning News about the recent market action. Are we back to risk on? Here is a bit more detail on our discussion.

Equity markets have rebounded to an impressive extent after the recent correction, with the S&P500 less than 5% away from its all time highs, last seen in late May, while the VIX, the measure of volatility has closed in on a two-month low after having spiked up in August.

So were all those machinations between the summer and today much ado about nothing?  To answer that, we need to understand what drives returns.  The answer, like most things in life, is it’s complicated. Over the long-term, investment returns are based on fundamentals – ideally finding a company with an excellent management team that has products or services that are in high demand for a growing demographic with shares at an attractive price. But, in the short to medium-term, returns are all about risk – are investors seeking risk or withdrawing from it?

Today, the answer to the question of affinity for risk relies more and more upon bureaucrats, which makes the investor’s job an awful lot like a fortune-telling gazing into her crystal ball.

Fig-2-1-Fortune-teller

 

Who the hell knows what insanity will get blurted out next… particularly if Donald Trump has access to a mic or a twitter feed!

The Fed has now become a primary source of uncertainty, (contrary to what they claim is their intent) while politicians and bureaucrats muddy the waters in countless ways, such as when Hillary Clinton took to twitter to bash biotech pricing.  I understand her outrage, but in today’s world of instant communication via social media, a few words can have an enormous impact and countless unintended consequences.

We’ve seen high profile investors like David Einhorn with Greenlight, John Paulson, and Michael Novogratz of the flagship Fortress macro fund, (which is now liquidating) struggling to live up to their reputations as fundamentals are easily overwhelmed by bureaucrat commentary and the market’s tendency to try to read central bank tea leaves.

So where are we today?  The S&P 500 is again closing in on its all-time high, but if we look a bit deeper we see that 63% of the stocks in the S&P 500 are still below their 200-day moving average and credit spreads remain elevated. When I see lack of breadth like this, meaning that indices are moving up based on a small group of stocks, and we see credit spreads still indicating that investors aren’t running towards risk, I remain cautious.

If we look at history to get an idea of probabilities, the S&P 500 has found itself below its 200-day moving average with more than 50% of the stocks within it also under their 200-day -moving average 24% of the time.  Annualized returns when the market has been in this position have been 9.7%, which sounds pretty good, except the maximum interim loss during those times has been 50%! (Hat tip to John Hussman for his data) So you may get decent returns, but there’s a good chance you’ll lose your lunch in the process.

If we look at the economic fundamentals, we have more cause for concern:

  • Total US business sales are down 3.09% year-over-year
  • US capacity utilization is also down year-over-year, (we are using less of our ability to make stuff than we did last year)
  • Industrial production contracting in 8 of the last 9 months
  • The producer price index is down 1.1% year-over-year, not exactly a sign of impending inflation)
  • Retails sales fell yet again in September
  • The Federal Reserves GDPNow currently estimates 3Q GDP to be 0.9%, (not exactly an overheating economy)
  • This morning we also learned that China’s GDP growth rate slowed to 6.9%, which is the weakest since the Great Recession. That will hurt Germany (major exporter to China) which is already suffering from Russia’s slowdown (big exporter to them as well) as it tries to keep the rest of the Eurozone afloat.  Mario Renzi is doing his best to get Italy turned around, but give the man a break!

If we look at earnings so far with 58 companies having reported, it isn’t exactly inspiring either

  • The percentage of companies beating on earnings is above the average, which sounds pretty good until…
  • The percentage of companies beating on revenues is below average
  • This means that earnings beats are coming from cost-cutting and financial engineering with things like share-buybacks – no indicative of long-term growth
  • As far as valuations, today the forward price-to-earnings ratio is 16, which above the 5-year and 10-year average of 14.1, which means that despite the dour fundamentals, stocks are still rather pricey.
  • Within the S&P 500, nine companies have offered weak December quarter outlooks compared to only one that has raised expectations

With fundamentals not giving us much to go on, in the short-to-near term it is all about that risk, which means investors need to be focused on how will the major indices behave as they approach their 200-day moving averages?  If they blow right past the 200-day AND if we see credit spreads (the different between the risky stuff and the safer stuff) get narrower, then it is back to game on, likely through the rest of the year, regardless of what is happening under the covers.

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Market Update

Market Update

To say the markets have been volatile lately would be the understatement of 2015!  This year started out with the major U.S. indices trading in the narrowest range in history, something like Hitch’s (Will Smith) dance instructions for Albert (Kevin James) in the 2005 movie Hitch, if you haven’t seen it you owe to yourself to click here.

The chart below shows how stable the S&P 500 was for the first half of the year, gentle moving back and forth across its 50-day moving average.

SP500 FirstHalf

Well that all changed… a bit like Albert’s dance moves once he was out on his date with Allegra Cole, and the market started gyrating wildly in ways that would have left Hitch shaking his head.

This chart shows the movement of the S&P 500 starting with the third quarter and ending Wednesday, October 14th.  Rather than oscillating gently around its 50-day moving average as was the case during the first half of the year, the index plunged below both its 50-day (yellow line) and 200-day (red line) with the 50-day moving well below the 200-day moving average.

SP500 3Q

This indicated a material turn in the market’s direction.  Recently we’ve seen the markets get all dog-with-waggy-tail about the dour jobs report earlier this month as we return to a bad-news-is-good-news market sentiment. That made a Fed rate hike later this year even less likely which is like giving a triple espresso to your toddler to wash down his Halloween spoils! Early last week the index moved back up above its 50-day moving average, and last week the S&P 500 gave its strongest performance of the year, but that move now appears to possibly have been a failed rally.  Market breadth, meaning the number of stocks moving up versus down, continues to have more moving down, which has us concerned that this upward trend is not sustainable.

If we take a bigger step back, we see that the last time the 50-day moving average dropped below the 200-day, was back in August 2011 during the fun times of the government shut-down showdown.  That time it took nearly six months for the 50-day to move back above the 200-day with the index declining 19.4% from the April 29th peak to the September 30th 2011 trough.

SP500 4year

Thus one of the broadest indices for the U.S. has moved below both its 50-day and 200-day moving averages with its 50-day moving average having moved below its 200-day, indicating the index is in a downtrend.  The Russell 2000, which is the standard index for small cap stocks finds itself in the same state of affairs, as does the Nasdaq, the primary technology index – in other words most of the indices are feeling rather peckish.

 

We also like to look at which sectors are leading the markets as that gives us an indication of market sentiment.  Market movement is all about attitudes towards risk. When investors are risk-seeking, the market moves up. When they are risk-averse, it tends to go down.  By looking at which sectors are strong and which are weak, we can get a feel for the general attitude towards risk in the markets.

 

There are two primary classifications for sectors, cyclical and defensive.  Defensive sectors are those in which companies tend to not suffer large changes in demand for their products or services during tough economic times.   This includes things like basic consumer staples and utilities; people tend to keep buying toilet paper and taking showers even when things aren’t going so well… thankfully. Cyclical sectors are those that enjoy increasing demand during good times, but suffer when families and businesses have to tighten their belts.  Companies in the defensive sectors tend to outperform cyclical sectors in downturns and vice versa as investor attitudes towards risk and growth shift.

 

Healthcare has traditionally been considered a defensive sector, but that has changed in recent years. Since January 1st, 2011 the sector has outperformed every other by a hefty margin, which is not typical defensive sector behavior.  This shift is driven by some enormous changes; first, the Affordable Care act significantly increases the demand for healthcare services. Second, aging populations in much of the developed world and China also serve to increase demand. Finally, the percentage of the healthcare sector that is represented by the high-growth biotech sub-industry has grown from a sub-10% weighting in 2001 to nearly 22% today. Conversely, Pharma’s weighting has fallen from more than 70% at year-end 2001 to 42% today, according to Sam Stovall, a U.S. equity strategist at S&P Capital IQ. So despite its defensive heritage, today the sector behaves a bit more cyclically than in years past.

Sectors FirstHalf

As you can see in the previous chart, for the first half of 2015, the Healthcare (cyclical now) and Consumer Discretionary (cyclical) sectors led by a significant margin, up 10.72% and 7.35% respectively while the Utilities (defensive), Energy (cyclical) and Real Estate (cyclical) sectors lagging the most, down -9.38%, -4.11% and -2.39% respectively.

However, starting July 1st, we see sector leadership shifted with the Utilities (defensive) sector now the strongest performer up nearly 6%, with Real Estate (cyclical) coming in second at 1.7% for the 3+ months while the former leader, Healthcare (cyclical) is now down -10.1%. Financials have also dropped precipitously, down 7.52% and with all the concerns over slowing growth in China, (and with that weaker demand for raw materials) we aren’t surprised to see the materials sector has also dropped to nearly 10% down.

Sectors Sept on

What this tells us is that investors are becoming more risk-averse. The pullback in healthcare is most evident in the iShares Nasdaq Biotechnology ETF which has just experienced a dramatic pullback, down over 20% from its all-time high.

IBB

In fact, year-to-date returns have been negative across most every asset class with commodities and emerging markets getting hit hardest, while Japan and Europe have outperformed the U.S., albeit modestly.

Asset Performance

Putting it all together, investors have been pulling away from many of those equity sectors and indices that are riskier and moving towards those areas that are viewed as more defensive.  In fact, the quarter ending September 30th delivered the worst quarterly stock-market performance since 2011 with the S&P500 falling 6.9% and investors pulling a net of $46 billion out of U.S. stock funds in July and August, according to the Investment Company Institute.  Being busy little data beavers, we like to see confirmation of our hypothesis from a variety of sources, so let’s also take a look at bonds.

 

The next charts show that bonds experienced a similar trend to equities, with a “risk on” environment prevailing in the first half of the year and “risk off” bonds performing better in the third quarter.  For example, in the first half, the more “secure” types of bonds, such as domestic investment grade corporate bonds in the iShares iBoxx Investment Grade Corporate Bond fund (LQD) were lagging behind higher risk corporate high-yield bonds/ aka junk bonds like those in the SPDR Barclays High Yield Bond fund (JNK). Even emerging market bonds (high risk) like those in the Vanguard Emerging Market Government Bond ETF (VWOB) and WisdomTree Emerging Markets Corporate Bond (EMCB) were able to outperform longer-dated U.S. Treasury bonds like those in iShares Barclays 20+ Year Treasury bond fund (TLT), but towards the end of the second half things started to shift.

Bonds First Half

From July first through October 14th, we have seen a substantial reversal of bond sector performance from the first half.  For instance, the first half’s worst performer, iShares 20+ Year Treasury bond ETF (TLT) outperformed all other bond funds on the chart in the third quarter’s “risk off” environment.  Similarly, lower risk domestic corporate bonds such as those in SPDR Barclays High Yield Bond fund (LQD) significantly outperformed riskier domestic high yield bonds, such as those in SPDR Barclays High Yield Bond fund (JNK) and emerging market corporate bonds such as those in WisdomTree Emerging Market Corporate Bond fund (EMCB) and Vanguard Emerging Market Government Bond Index fund (VWOB).

Bonds Second Half

So far we’ve seen consistent behavior from the various U.S. equity indices and sectors and we have confirmation from bonds that investor sentiment has shifted away from risk.  So let’s look around the rest of the world.

 

Across the globe, markets have all experienced pullbacks, with China’s Shanghai A shares index fell briefly into the red for the year after having risen nearly 60% between January and June and are now up just a little over 3%. France and Italy have performed the strongest year-to-date with their indices up 9.42% and 12.87% respectively.  Way to go Italy as it looks like Prime Minister Matteo Renzi’s reforms are being well received by the markets! Germany and Japan managed to be slightly in the green, up 3.07% and 3.95% respectively. With the China’s weakening economy affecting Germany and Japan’s worsening domestic economy, we are on the lookout for more talk of stimulus measures in those areas, which could be a nice tailwind for stock prices.

 

Finally, the strong dollar, which has been getting a lot of air time over the past year, hasn’t done much either way lately.  The next chart shows how it has mostly been sideways since around April of this year, and in fact the AMEX Dollar Index is down -2% since early April and down -0.56% over the past three months.  But don’t think that means we are out of the woods just yet as we are already getting warnings from a variety of companies across a wide swath of industries that their earnings (earnings season is just kicking off) will be weaker than expected in part due to the strong dollar.

 

You’ll notice on the next chart that the dollar hit a trough the day the markets had a major correction, on August 24th and again the day the Fed announced that it would not be raising rates.  Pardon a brief little pat on the back as I’ve been calling that one since May.  With the data we were seeing, a rate hike looked nigh impossible, despite the proclamations by many on Wall Street that it was a fait accompli.

DXY past year

Germany and Greece: An Impossible Relationship?

Germany and Greece: An Impossible Relationship?

This morning the markets in Europe rose giddily on the belief that the problems with Greece were resolved, despite the bureaucrats insistence that they were in fact, not at all. By late afternoon in Europe, it had become clear that there was no resolution, but the talks continued. I swear I’ve had breakups that seemed an awful lot like this!

Most people have at some point in their lives been in a relationship, be it romantic or platonic, with another person who has a different view  of “The Way Things Ought to Be.” This can be over something as mundane as how frequently one ought to exercise to how much and how loudly one ought to laugh or perhaps just how much fun is appropriate in one’s life or the really volatile one, just how wild one ought to get into the wee hours!  Having a material discrepancy over “The Way Things Ought to Be” can be highly destructive to the relationship, leaving both parties fuming at each other in an indignant, self-righteous huff.

Germany and Greece: An Impossible Relationship?

A giant banner protesting Greece's austerity measures hangs near the Parthenon on Acropolis hill in Athens early May 4, 2010. A group of demonstrators from Greece's communist party, KKE, staged the protest atop the Acropolis as Athens braced for a 48-hour nationwide strike by civil servants which would also include the shutdown of travel services.    REUTERS/Pascal Rossignol  (GREECE - Tags: EMPLOYMENT BUSINESS POLITICS CIVIL UNREST)

 

 

 

 

 

 

 

These two are the sovereign equivalent of that couple that seems rather fascinated by each other, perhaps some seriously passionate sparks on occasion, but are eventually at each other’s throats, utterly baffled as to how the other cannot see just how clearly WRONG they are! Each is convinced that if they just lay down the law and point out precisely what the other ought to be doing instead of what they are doing followed by an ultimatum, the indisputable “rightness” of their position will become clear and they’ll get their way… because that’s so often how human nature works!

Deep in German culture is a profound belief, darn near religious, that inflation can never be used to manage debt.  For Greece, that’s a bit like arguing ouzo is best used as a floor cleaner! The nation has been wracking up debt then discarding it in a variety of ways, often via inflation for over two centuries. Carmen Reinhard and Kenneth Rogoff, in their book “This Time Is Different,” determined that between 1800 and 2008, Greece spent 50.6% of the time in default or restructuring!

Germany on the other hand derives great joy and satisfaction from strictly following the rules – tell that to a nation so tied up in bureaucratic red tape that trying to resolve the proper way to handle something there goes a bit like this.

A Greek entrepreneur goes to a public agency and asks, “What do I need to be able to do this thing X?” 
Answer: “A, b, c, d, maybe e, probably f, not sure though about g.”

Hmmm, OK… so our entrepreneur goes to another agency and asks the same question.
Answer: “E, f, not sure about a, definitely not c but definitely g and we’ve never heard of b.”

Exasperated our entrepreneur seeks the advice of a prominent attorney, thinking they’ll be able to properly chart the course, only to discover that they’ve got no idea either.  There are so many laws sitting on top of contradictory laws and regulation upon regulation that there is no clear answer.  Ta da!  Welcome to graft.  If there is no one clear answer on the books, you just have to buy a temporary one from whomever is in charge that day.

In the end our entrepreneur gives up, forgets trying to build a business and gets a job as a public employee!

So here’s the  problem now.  Germany thinks that if it strong arms Greece out of the eurozone, the rest of the eurozone trouble-makers will get scared straight, fall back in line and Germany can relax that everyone will from now on start playing by the rules. So far what Germany is pushing will not allow Greece’s economy the room it needs, culturally and financially, to change – “Dear Eurozone: I love you but you are just no good for me.”

What if Greece gets the boot, defaults, starts all over again and after a while its economy is more robust than Italy’s or Spain’s?  That’d be a bit like having one’s ex show up to a friend’s party with their gorgeous and very successful new significant other; more than just a little bit awkward.

Can’t you just see the love?