S&P 500: Treasuries warn of a bear market

10-Year Treasury yields plunged Friday, to close at 2.45%, warning of a decline to test primary support at 2.0%.

10-Year Treasury Yields

The yield curve is now likely to turn negative. The 10-Year/2-Year yield differential has already fallen to 0.13%. Below zero signals a negative yield curve, a reliable predictor of oncoming recession within the next 12 to 18 months.

10-Year minus 2-Year Treasury Yields

The S&P 500 retreated Friday and is likely to breach its new support level at 2800. Follow-through below 2600 would warn of a bear market.

S&P 500

Gold: Short candles signal weakness

The Dollar is expected to continue ranging between 95 and 97.50 over the next few months.

Dollar Index

Spot Gold bounced off intermediate support at $1280/ounce but short candles over the past three weeks warn of selling pressure. Breach of $1280 would warn of another test of primary support at $1180.

Spot Gold in USD

ASX 200: Financials & Materials test support

Financials are testing their new support level at 5900/6000. Falling housing prices are likely to drag the index lower. Penetration of the rising trendline at 5800 would warn of another test of primary support at 5300.

ASX 200 Financials

Materials are also testing their new support level at 12500/12600 but respect is far more likely, given the tailwind from iron ore prices.

ASX 200 Materials

The ASX 200 is consolidating at 6200 but continuation to test resistance at 6300/6350 is likely. Expect stubborn resistance, followed by a correction.

ASX 200

I remain cautious on Australian stocks and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

Buybacks, interest rates and declining growth

The Fed did a sharp about-turn on interest rates this week: a majority of FOMC members now expect no rate increases this year. Long-term treasury yields are falling, with the 10-Year breaking support at 2.55/2.60 percent. Expect a test of 2.0%.

10-Year Treasury Yields

While the initial reaction of stocks was typically bullish, the S&P 500 Volatility Index (21-day) turned up above 1.0%, indicating risk remains elevated.

S&P 500

The reason for the Fed reversal — anticipated lower growth rates — is also likely to weigh on the market.

Stocks are already over-priced, with an S&P 500 earnings multiple of 21.26, well above the October 1929 and 1987 peaks. With earnings growth expected to soften, there is little to justify current prices.

S&P 500 Price-earnings (PEmax)

The current rally is largely driven by stock buybacks ($286 billion YTD) which dwarf the paltry inflow from ETF investors into US equities ($18 billion YTD). We are also now entering the 4 to 6-week blackout period, prior to earnings releases, when stock repurchases are expected to dip.

Why do corporations continue to repurchase stock at high prices? Warren Buffett recently reminded investors that buybacks at above a stock’s intrinsic (fair) value erode shareholder wealth. If we look at the S&P 500 in the period 2004 to 2008, it is clear that corporations get carried away with stock buybacks during a boom and only cease when the market crashes. They support their stock price in the good times, then abandon it when the market falls.

S&P 500 Buybacks
source: S&P Dow Jones Indices

Shareholders would benefit if corporations did the exact opposite: refrain from buying stock during the boom, when valuations are high, and then pile into the stock when the market crashes and prices are low. Why doesn’t that happen?

The culprit is typically low interest rates. It is hard for management to resist when stock returns are more than double the cost of debt. Buybacks are an easy way of boosting stock performance (and executive bonuses).

Treasury Yields: 3-Month & 5-Year

Corporations are using every available cent to buy back stock. Dividends plus buybacks [purple line below] exceed reported earnings [green] in most quarters over the last five years.

S&P 500 Buybacks & Dividends compared to Earnings

That means that capital expenditure and acquisitions were funded either with new stock issues or, more likely, with debt.

Corporate debt has been growing as a percentage of GDP since the 1980s. The pace of debt growth slowed since 2017 (shown by a down-turn in the debt/GDP ratio) but continues to increase in nominal terms.

Corporate Debt/GDP

Low interest rates mean that stock buybacks are likely to continue — unless there is a fall in earnings. If earnings fall, buybacks shrink. Declining earnings mean there is less available cash flow to buy back stock and corporations become far more circumspect about using debt.

S&P forecasts that earnings will rise through 2019.

S&P 500 Earnings

But forecasts can change. Expected year-on-year earnings growth for the March 2019 quarter has been revised down to 3.5%. Forecasts for June and September remain at 12.0% and 11.4% (YoY growth) respectively.

S&P 500 Year-on-Year Earnings Growth Forecast

If nominal GDP continues to grow at around 5% (5.34% in Q4 2018) and the S&P 500 buyback yield increases to 3.0% (2.93% at Q3 2019 according to Yardeni Research) then earnings growth, by my calculation* should fall to around 8.2%.

*1.05/0.97 -1.

With an expected dividend yield of 2%, investors in the S&P 500 can expect a return of just over 10% p.a. (dividend yield plus growth).

But the Fed now expects growth rates to fall by about 1.1% in 2019 and 1.2% in 2020, which should bring investor returns down to around 9% p.a. Not a lot to get excited about.

I knew something was wrong somewhere, but I couldn’t spot it exactly. But if something was coming and I didn’t know where from, I couldn’t be on my guard against it. That being the case I’d better be out of the market.
~ Jesse Livermore

“Stocks rebound but sentiment soft”

From Bob Doll at Nuveen Investments. His weekly top themes:

1. We think the odds of a U.S. recession are low, but we also believe growth will remain soft for a couple of quarters. U.S. growth may bottom in the first half of 2019 following a relatively disappointing fourth quarter and the recent government shutdown. We expect growth will improve in the second half of the year.

Agreed, though growth is likely to remain soft for an extended period. The Philadelphia Fed Leading Index is easing but remains healthy at above 1.0% (December 2018).

Leading Index

2. Inflation remains low, but upward pressure is mounting. With unemployment under 4% and average hourly earnings rising to an annual 3.6% level, we may start to see prices rise. So far, better productivity growth has kept the lid on prices, but this trend bears watching.

Agreed. Average hourly earnings are rising and inflation may follow.

Hourly Earnings Growth

3. Trade issues remain a wildcard. The U.S./China trade dispute appears to be making progress, but the timeline is slipping and significant disagreement remains over tariff levels and intellectual property protections.

This is the dominant issue facing global markets. Call me skeptical but I don’t see a happy resolution. There is too much at stake for both parties. Expect a drawn out conflict over the next two decades.

4. We do not expect Brexit to cause widespread market issues. We think the risk of a hard Brexit is low, since no one wants to see that outcome. Some sort of soft separation or even a Brexit vote redo appears more likely.

Agreed. Hard Brexit is unlikely. Soft separation is likely, while no Brexit is most unlikely.

5. The health care sector may remain under pressure due to political rhetoric. Health care stocks in general, and managed care companies in particular, have struggled in light of talk about ending private health care coverage. We think Congress lacks the votes to enact such legislation. But this issue, as well as drug pricing policies, are likely to remain at the center of the political dialogue through the 2020 elections.

Health care is a political football and may take longer to resolve than the trade war with China.

6. Downward earnings revisions may present the largest risk for stocks. As recently as September 30, expectations for first quarter earnings growth were +7%. That slipped to +4% by January 1 and has since fallen to -3%.

A sharp fall in earnings would most likely spring from a steep rise in interest rates if the Fed had to combat rising inflation. That doesn’t seem imminent despite rising average hourly earnings. The Fed is maintaining money supply growth at close to 5.0%, around the same level as nominal GDP, keeping a lid on inflationary pressures.

Money Supply & Nominal GDP growth

7. Equity returns may be modest over the next decade compared to the last. Since the bull market began 10 years ago, U.S. stocks have appreciated over 400%. It’s nearly impossible to imagine that pace will be met again, but we feel confident that stocks will outperform Treasuries and cash over the next 10 years.

Expect modest returns on stocks, low interest rates, and low returns on bonds and cash.

Theresa May: How to herd cats

Theresa May

Theresa May has a task of Herculean proportions: to negotiate a Brexit deal that will gain approval from a divided British parliament and an obstinate EU. Securing a deal would make herding cats look easy.

But Mohamed El Erian argues in Bloomberg that the British prime minister is close to a deal with which everyone is “equally unhappy”. And it is “possible that May has managed to corner both her internal position and the EU, opening a wider window for the government to secure support for her deal in the coming weeks. To understand this, consider how the bargaining positions are changing not just because of the pending March 28 deadline but also, and more importantly, because of the European elections scheduled for May 23-26.

More than the March 28 deadline, the European elections could well constitute a binding practical constraint on both the UK and EU, thereby significantly raising the probability of forcing the clarity and sufficient unity and cooperation needed for a workable proposal…..

With many European officials likely to oppose UK participation in the elections, the prospects of a disorderly hard Brexit essentially imposing itself will prove very threatening to British politicians on both sides of the argument. In other words, a May-proposed deal that includes some further EU concessions will certainly still not be optimal for them but will be better than being widely blamed for the alternative. And Brussels would go ahead, also fearing the alternative.

Here’s how this likely, though not yet overwhelmingly probable scenario would proceed: The May government would get agreement from parliament on a short-term extension to the March 28 deadline. This would be accepted by Brussels and allow for negotiations on some further concessions. Parliament would consider the revised deal and, after lots of noise and jockeying, agree to it before the European elections in which the UK would not participate.”

With an extension beyond April out of the question, parliament faces a clear choice: accept Theresa May’s deal or face a no-deal, hard Brexit. Securing approval of a negotiated deal would be a massive win for May, Britain and the EU.

Hat tip to Greg McKenna.

Dollar retreats but Gold flat

The Dollar retreated from resistance at 97.50 and is likely to test support at 95.50.

Dollar Index

Spot Gold, however, continues to test short-term support at $1300/ounce. Breach is likely and would warn of another test of primary support at $1180.

Spot Gold in USD

ASX 200 approaching resistance

A sign of increased risk aversion is the stellar performance of the A-REIT index. AREITs are trading at substantial premiums to net asset value as investors bid up stocks with stable cash flows.

ASX 200: Real Estate

Financials are retracing to test their new support level at 5900/6000. Calls from the RBNZ for the big four to increase their capital haven’t helped.

ASX 200 Financials

Materials are also retracing but continue their up-trend. Though the iron ore windfall is unlikely to last.

ASX 200 Materials

The ASX 200 is heading for a test of resistance at 6300/6350. Expect stubborn resistance, leading to a correction.

ASX 200

I remain cautious on Australian stocks and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

S&P 500: Beware the buyback blackout

We are now entering the blackout period when US corporates normally refrain from buying back stock, in the four to six-week period prior to their next earnings release. There is no outright ban on buybacks during that period but discretionary repurchases are restricted.

Zerohedge illustrates the extent to which stock buybacks are currently driving the market:

S&P 500 buybacks

Buybacks dwarf the $18 billion year-to-date inflow from ETF investors into US equities. The blackout period is likely to cause weakness.

10-Year Treasury yields also breached support at 2.60%, warning of a further decline in long-term interest rates. A sign of increased risk aversion.

10-Year Treasury Yields

Volatility on the S&P 500 has declined close to 1% but an upsurge in the next few weeks would warn of elevated risk. Breach of 2600 would indicate another test of primary support at 2350/2400.

S&P 500 & Twiggs Volatility

We extend our sympathies to the victims of the shooting in Christchurch and their families. Our hope is that this atrocity will draw people together in support of each other rather than divide them.

It has often been said that power corrupts. But it is perhaps equally important to realize that weakness, too, corrupts. Power corrupts the few, while weakness corrupts the many. Hatred, malice, rudeness, intolerance, and suspicion are the faults of weakness. The resentment of the weak does not spring from any injustice done to them but from their sense of inadequacy and impotence….
~ Eric Hoffer

China slowdown

Consumer durable sales are falling sharply:

And from Trivium China:

Premier Li Keqiang reiterated that big stimulus isn’t coming:

“An indiscriminate approach may work in the short run but may lead to future problems.”
“Thus, it’s not a viable option.”
“Our choice is to energize market players.”

….It’s a decidedly different tack than the credit-fueled stimulus of yesteryear, and the practical outcomes of this new policy response are two-fold:

  • Given that it’s a new strategy, the transmission channels from policy to actual economic growth support are not well understood.
  • The one thing we do know – this approach will take longer to impact the economy than the credit-driven responses of previous cycles.

The bottom line: It will take China’s deceleration longer to bottom out than markets and businesses currently expect.

China’s stated intention is to avoid big stimulus, so a policy reversal, if we see it, would signal that the slowdown is far worse than expected.