Something more than Harvey and Irma have Goldman Sach’s CEO “unnerved” about the current stock market?

Something more than Harvey and Irma have Goldman Sach’s CEO “unnerved” about the current stock market?

As we witnessed over the weekend, the Caribean and Florida took a beating from Hurricane Irma, and its impact is going to be a major source of weakness in the economy for the current quarter. Paired with the impact of Hurricane Harvey, we’re looking at one-two punch to the GDP gut and we expect existing GDP forecasts for 3Q 2017 will be revised sharply lower in the coming days. That’s enough to rattle the market, but there are other reasons investors should be increasingly cautious. Last week, when speaking at a conference in Germany, Goldman Sachs (GS) CEO Lloyd Blankfein shared that he was “unnerved” by things going on in the stock market. As we’ve been analyzing the economic data and watching the political landscape in Washington, we here at Tematica have been talking about a growing sense of unease in the market over the last several months. Yet, the market has at least thus far managed to shrug these mounting concerns off its proverbial shoulders.

In today’s increasing frenetic society, short attention span filled society sometimes it takes a “voice from on high” to catch people’s attention and wake them up. All it took was a short comment from Blankfein during the question and answer session of his presentation at a conference in Germany:

“Things have been going up for too long,” he told attendees at a Handelsblatt business conference in Frankfurt. “When yields on corporate bonds are lower than dividends on stocks? That unnerves me.”

 

We certainly share Mr. Blankfein’s concerns and have been hammering the points home weekly in our Monday Morning Kickoff report and the Cocktail Investing Podcast.  To fully understand the source of Mr. Blankfein’s current unease let’s explore his statement:

 

#1: “Things have been going up for too long.”

While there have been modest pullbacks in the market, like the ones in late 2014 and the second half of 2015, a longer view shows the major averages have moved sharply higher over the last five years, with the S&P 500 in the upper range of its long-term upward trend. Before factoring in dividends, the S&P 500, a key benchmark of institutional investors, is up more than 70% since September 2012.

More recently, the S&P 500 has gone more than 300 trading days without a 5% or more pullback, the longest such streak since July 19, 1929. For those wondering, the record still sits at 369 trading days per Dow Jones data. Historically speaking periods of suppressed volatility tend to be followed by periods of heightened volatility, as market volatility reverts back to its mean. Given the extended period of low volatility, the probability of entering a period of heightened volatility moves higher.

As the stock market has moved higher, so too has its valuation. As we write this, the S&P 500 is trading at 18.7x expected 2017 earnings versus the 5 and 10 year average multiples of 15.5x and 14.1x, respectively. In 2015 and 2016, we saw earnings expectation revised lower during each year until annual EPS growth was nil. With economic data that is once again leading the Atlanta Fed to reduces it GDP forecast, we’re seeing downward earnings revisions to EPS expectations in the back half of 2017. We at Tematica classify that as “unnerving.”

 

#2: The Current “Recovery” is Now Over 100 Months

If we look back to when the stock market bottomed out during the Great Recession, the timeframe for the current “recovery” has been over 100 months. By comparison, the average economic expansion over the 1945-2009 period spanned 58.4 months. In other words, the current expansion is rather long in the tooth and a variety of data points ranging from slowing growth in employment to peak housing and auto to a flattening yield curve support this assessment. While the length of expansion has likely been affected by the Fed’s aggressive monetary policy, the bottom line is at some point

While the length of expansion has likely been affected by the Fed’s aggressive monetary policy, the bottom line is at some point it will come to an end. As the Fed looks to unwind its balance sheet and gets interest rates closer to normalized levels, we’re reminded that the Fed has a track record of boosting interest rates as the economy heads into a recession. Let’s not forget that every new presidential administration coming in after a two-termer going all the way back to 1900 has experienced a recession within the first twelve months. Yep, we color that as “unnerving.”

 

#3: The Market’s Post-Election Euphoria Has Worn Off

Coming into 2017 there was a wave of euphoria surrounding newly elected President Trump with high hopes concerning what his administration would accomplish. Over the last few months, a number of executive orders have been administered, but we have yet to see any progress on tax reform or infrastructure spending. The risk is that expectations for these initiatives are once again getting pushed out with tax reform that was slated for August now being expected (don’t hold your breath) near the end of 2017. The risk is the underlying economic assumptions that powered revenue and EPS expectations in the second half need to be reset, which will mean those lofty valuations are even loftier.

 

#4: Precious Metals Are Gaining Strength

Since August 1, Gold, Silver and the Utilities sector have significantly outperformed financials and consumer discretionary stocks – never a positive sign. The KBW index of regional banks has fallen below is 50-day, 100-day and 200-day moving averages and is down over 18% from its March 1st

 

#5: The Breadth of Current Rally Isn’t Looking So Hot

The median Dow stock is down more than 4% from its 52-week high and the median S&P 500 stock has dropped nearly 7.5%. Only 44% of Nasdaq members are trading above their 50-day moving average.

 

#6: Another Contra-Indicator Has Reared its Head — Individual Investor Confidence

TD Ameritrade’s (AMTD) Investor Movement Index (IMX) has continued its month-over-month rise. For those unfamiliar with this, it’s a behavior-based index created by TD Ameritrade that aggregates Main Street investor positions and activity to measure what investors are actually doing and how they are positioned in the markets. The higher the reading, the more bullish retail investors are. In August, the IMX hit 7.45, up from 7.09 in July, to hit an all-time high.

Why is that unnerving you ask?

While TD Ameritrade opted to put a rosy spin on the data, saying, “Our clients’ decision to continue buying reflects the resiliency of the markets.” Institutional investors, however, see this continued surge higher as a warning sign. Here’s why: Historically speaking, retail investors have been late to the stock market party. Not fashionably late, but really late, which means they tend to enter at or near the point at which things start to go seriously awry.

Complicating things a bit further, over the last month CNNMoney’s Fear & Greed Index has slumped from a Neutral reading (52) to Fear (38). Taking stock (pun intended) of these two indicators together at face value sends a mixed message on investor sentiment. Not a hardcore piece of data like the monthly ISM data, but one institutional investors and Wall Street traders are likely to consider as they roll up their sleeves and revisit the last few weeks of data.

 

How to Know What’s Next

These are just some of the points that could be unnerving Blankfein. Generally speaking, the stock market abhors uncertainty and anyone of those points on their own would be a cause for concern. Taken together they are reasons to be cautious as we move deeper into September, which is historically one of the most tumultuous months for stocks.

Whether you’re a subscriber to Tematica Investing or not, we would recommend you subscribe to both our Monday Morning Kickoff and Cocktail Investing Podcast to get our latest thoughts on the economy, the stock market as well as thematic signals that power our 17 investing themes.

 

Currency Wars – It's On!

Currency Wars – It's On!

2015-01-26 Currency WarLast Wednesday the European Central Bank (ECB) announced that it is launching its own quantitative easing program that was double what had been rumored, at an impressive €1.2 trillion. ECB Chairman Mario Draghi was able to pull off a program of this size by having some 80% of the bond-buying executed by national central banks. The agreement is that Germany will only buy German government bonds, France will only buy French bonds and so on. This was key to getting the program approved because if Spain or Italy goes off the rails, the German Bundesbank’s balance sheet won’t be immediately devastated. This is the main driver behind the rally in German bonds beyond the periphery bonds, which is also driving the rally in US bonds, as the markets can’t indefinitely maintain such a large spread between the only perceived risk-free rates left!

Despite all the rhetoric concerning how the economy is so very ship shape and all is going well on at least this side of the Atlantic, last year the best performing sectors were defensive ones: utilities and healthcare. This year with the crash in oil prices, the energy sector is forced to significantly delay capital expenditures and will by necessity put downward pressure on wages. Gasoline and diesel prices across the US have now fallen for a record 16 straight weeks. For the rest of the economy, the threat of global slowing and deflation may make many businesses hesitant to invest aggressively in expansions.

Central bankers across the globe have been on the frontlines of the newest form of international altercations, currency wars, which is driving yields into truly bizarre territory. Two weeks ago the Swiss National Bank removed the three-year currency cap on the franc and cut key rates having told the market just a month earlier that there were in fact no plans to remove the cap, sending markets into a veritable tizzy. India cut its key rate by 25 basis points and Bank of Korea lowered its outlook. Last week the Bank of Canada surprised everyone by lowering its main interest rate by a quarter percentage point for the first time since 2009. In Japan, Bank of Japan Governor Kuroda cut the nation’s core inflation forecast to 1% from 1.7%. Earlier last week the International Monetary Fund cut its forecast for inflation in advanced nations almost in half.   The result of these moves has left the Swiss 10-year yield in negative territory, the German 10-year at 0.52%, the French 10-year at 0.70% and the Japanese 10-year at 0.23% given that expected rates of inflation are all above these levels in their respective nations, 10-years in much of the develop world are now in negative real yield territory.   The currency war is on!

Those negative real yields reflect that most European countries are in or nearly in a recession. Italy for example is in a recession for the third time in six years, suffering from a 9% drop in output since 2008, and with unemployment increasing steadily from 7.8% in 2009 to 13.4% in November 2014. The ECB is expected to inject a massive monetary stimulus in an attempt to bolster the economies of these beleaguered nations, but the root of the problem isn’t monetary, thus the solution cannot solely be monetary. For example, in the January 10th edition of the Economist, Rwanda, which was in a bloody civil war just 20 years ago, is now cited to be a better place to do business than Italy! (Remember how we earlier mentioned that it is easier to start a business in Italy than in the U.S.?) No amount of monetary stimulus can fix those structural problems.

So we have defensive sectors outperforming and a material decline in trading volume, which tells you that investors are nervous.   Which brings us to the recent turn around in the yellow metal. Gold has traditionally had an inverse relationship with the dollar. For example, over the past four years the SPDR Gold Shares ETF (GLD) has had a -0.45 correlation with the Amex Dollar Index (DXY). From December 15th through yesterday, that correlation had completely reversed to be 0.75.   In 2015 so far, the correlation has been a mind-boggling 0.84! That’s a nearly perfect positive correlation. With central bankers around the world under pressure to manipulate their currency so as to inflate asset prices rather than having elected politicians deal with the very real structural problems, we believe it is no surprise to see gold once again showing strength. It has long been viewed as one of the only reliable stores of value and as long as the currency wars wage, will likely show continued strength, albeit with bumps along the way.

Not out of the woods yet with the economy

Not out of the woods yet with the economy

The Economy

While the domestic economy is strengthening a bit, the recent unemployment numbers greatly overstate the improvement as most of the gains simply came from people leaving the workforce rather than actual employment gains.  At Meritas, we mostly ignore the unemployment numbers and look simply at Civilian Employment as a Percentage of the Population.  This number remained unchanged from December and has only increased 0.2% from January of 2011 and is currently 58.5% after having bottomed out at 58.2% Dec of 2009.  We are only up 0.3% since the bottom of the employment market!  Employment numbers alone don’t tell the whole story – we have to also look at income levels.  Real household income, meaning income adjusted for inflation, was $55,962 in January 2000.  At the end of the recession it had fallen to $53,638.  It is now $50,876.  In twelve years it has fallen over 9%.  On top of that households are saddled with unprecedented levels of debt.  For decades the average household income to debt ratio was about 65%.  It peaked at 140% in 2007 and is now just below 120%.  Falling incomes and the need to reduce debt don’t make for much of an economic tailwind.

As for Commodities

The price for commodities is really a function of two things:  the supply vs. demand for the commodity and the strength of the dollar.  Most commodities, with the exception of natural gas and crude oil are over-bought today, we believe on the false assumption that the European situation is going to be well controlled and that we are economically out of the woods.  The Baltic Dry Index, which is a measure of commodity shipping costs, advanced from a 25 year low for the first time since Dec 12th, after falling rates boosted the number of dry-bulk owners dropping anchor and refusing to hire.  Rates are near or below cash break-even for every vessel class, so we are starting to see more ships anchoring and refusing to trade.  The index is down 62.8% YTD and 38.1% Year-over-Year.  We just saw how little pricing power there is in the market as P&G was forced to roll back prices after an 8% increase cost them 7% of market share.

Gold is trading more as a currency than a commodity these days.  It is a hedge against the loose monetary policy arising from pressures caused by too much debt.  Gold isn’t really going up so much as fiat currencies are being devalued.  Speculators have increased their holdings of gold for four consecutive weeks. Possibly in response to the European sovereign debt crisis and indications from the Fed to expect continued loose monetary policy.  During the last reporting period net purchases were over 33k, brining the net long position to 188k contracts.  Non -commercial energy product accounts failed to increase their holdings of oil after the Fed conference, selling 4,500 contracts on a net basis, reducing the net long positions to just over 300k positions.  This is just 0.1 Standard Deviation below the one-year average.  Copper is clearly driven by what happens in China and there are a lot of concerns about what could happen there this year.  The IMF reported that China’s growth would be cut in half from a projected 8.2% in 2012 if Europe’s debt crisis worsens.  In defense against this, China will likely continue to ease up on their monetary policy, which will push the Shanghai Stock market index up and provide a tailwind to copper.

Food commodities down YoY

  • Corn down 4.5% up 0.2% YTD
  • Coffee down 13.9% down 5.3% YTD
  • Sugar down 25.9% up 3.9% YTD

Metals

  • Aluminum down 12.0% up 10.8% YTD
  • Copper down 15.7%% up 12.4% YTD
  • Gold up 27.4% up 9.6%
  • Silver up 15% up 19.9%

Energy

    • Brent up 14.1% up 6.1% YTD
    • Gasoline up 19%% up 7.9% YTD
    • Natural Gas up 19% up 7.9% YTD
    • Natural Gas down 41.1% down 15%

The Fall of Sacred Cows

As global events unfold, the underlying premises which have guided market participants’ reactions to bureaucratic actions are being put to the test and are coming up short. This is going to get a wee bit technical, but bear with me and it will all come together after a few paragraphs.

Last week the European sovereign debt crises push central banks across the world, (the Fed, the ECB, Bank of England, Bank of Japan, Bank of Canada, and Swiss National Bank) to move in concert to cut the rate on U.S. dollar liquidity swaps by 50 basis points. Now European banks can borrow dollars at a slightly lower rate and phew, all is saved! Really? Interbank lending has so utterly frozen up that on Friday we saw in an ECB data release showing that banks had borrowed more than 8.6 billion Euros overnight from the Central bank and usage of the ECB’s deposit facility rose to over 300 billion Euros this past week. This shows that banks, much like in 2008, have become increasingly wary of lending to each other and prefer the essentially non-existent rates on their reserves. Think about that, banks are afraid of lending to each other, even overnight! This move by central banks simply addresses the symptom, liquidity, and does nothing to resolve the real problem of insolvency.

Yet we keep being assured that those wondrous politicians will work it out. So then does anyone have an explanation for why aggregate central bank purchasing of gold bullion was a record 148.3 tons in Q3, with purchases in 2011 on track to be the biggest year since Bretton Woods failed over 40 years ago? What do they know? (Sarcastic tone intended.)

I believe it is clear that the half-point easing of rates by the central banks last week only buys a little more time and underscores just how fragile the global banking system has become. Bank nationalizations and a rather dour recession are likely in Europe’s near future.

Yet the stock market rallies! Remember that from late 2007 to early 2009 there were four such swap extensions or expansions which initiated, in aggregate, a total of about 3,000 point rallies in the Dow, yet over the entire period the Dow fell 50%. By the time the market bottomed in March 2009, the recession was coming to an end. The European recession is just getting started and the combination of drastic austerity measures and credit contraction is likely to ensure that this one is going to sting something awful!

So why the market joy? There are two facets to understanding major macroeconomic events: the data and the interpretation of the data. The data is simple and quantifiable. The interpretation is entirely different in that it requires a set of base premises through which one determines the meaning of the data. For example, I walk outside in the morning and the ground is wet. If I live in Seattle, I will likely surmise it rained or there was a heavy fog the night before. If I’m in Vegas, I’m more likely to start hunting for a broken sprinkler head. Thus the fact, wet ground, is interpreted through my internal paradigm.

The markets these days are driven in large part by the beliefs of the participants. The fundamental data is abundant and torpid, but the interpretation is far more capricious. The data is evolving in such a way as to contradict some previously unquestioned beliefs. In the face of such unnerving events, it is not surprising to see that these beliefs are hard to shake and beliefs are struggling to catch up with the evolving fundamentals. As the data degrades sufficiently, these underlying beliefs can rapidly and violently change a situation from bizarrely benign to an overnight crisis.

One such premise is the belief that since a default on the debt of the larger developed nations would be incredibly painful, bureaucrats will never allow it to happen. This belief hinges on a seemingly unquestioned belief that bureaucrats are essentially omnipotent; if they will it, it will be so.

If we look at the larger picture of global debt, it is clear that we have reached the largest accumulation of peacetime debts in history, so there is no playbook to help anticipate what will happen next. With wartime debt, the victor gets the spoils, facilitating debt pay-downs, and the loser is mired in defeat and default. The total global credit market has grown at an over 11% annual compound growth rate since 2002, while GDP has only grown at about 4%. There is currently no nation in the world with a sufficient pool of disposable capital at hand to stave off a major crisis in the global debt super cycle. Hard defaults are likely unavoidable, despite the bureaucrat sound bites. It is absolutely astonishing to see central banks attempt to assure that markets that all will be well as heavily indebted nations will most certainly provide money, that they themselves don’t have, to bail each other out. What sort of logic makes this math possible?

Let’s look at a few specifics. The ECB has been purchasing Greek Bonds since May 2010 and now owns 40% of all outstanding Greek debt. During this time the Greek 10-year has risen from as low as 6.34% to almost 32%. If this level of purchasing couldn’t contain the debt of a nation as small as Greece, why would anyone believe that larger economies will be more successful? Just because this time, they really mean it? The IMF claims that it has around $385 billion available to provide aid to member nations. Italy, the seventh largest contribution to the IMF, needs around $800 billion!

Bottom Line: We are watching the apoplectic fits that are characteristic of a bear market with the additional volatility one would expect as sacred cows of bureaucratic belief fall before our very eyes.