ASX 200: Iron ore tailwinds continue

The ASX continues to enjoy a massive tailwind, with iron ore spot prices holding above $120/tonne. Prices are expected to moderate, with Brazilian exports recovering. Clyde Russell at Mining.com comments:

“Even if Brazil’s exports do remain slightly below normal, it may be the case that the iron ore forward curve is currently too optimistic. The Singapore Exchange front-month contract closed at $121.24 a tonne on Wednesday, while the six-month contract was at $100.52 and the 12-month at $89.52. This shows traders do expect prices to moderate…”

Iron Ore

The Materials index continues to climb, with rising troughs on the Trend Index signaling buying pressure.

ASX 200 Materials

REITs continue their strong up-trend, in expectation of lower interest rates. The equity (dividend) yield on VAP/ASX 300 REITs has fallen to 4.3%.

ASX 200 REITs

Financials are testing resistance at 6450 but face headwinds from declining house prices and construction work.

ASX 200 Financials

The ASX 200 is headed for a test of its 2007 high at 6830, with a rising Trend index indicating buying pressure. Penetration of the rising trendline on the index chart is not likely but would warn of a correction to test support at 6000.

ASX 200

We continue to maintain a high level of cash in our Australian Growth portfolio.

Rate cuts and buybacks – the emperor’s new clothes

The interest rate outlook is softening, with Fed chairman Jerome Powell hinting at rate cuts in his Wednesday testimony to Congress:

“Our baseline outlook is for economic growth to remain solid, labor markets to remain strong and inflation to move back over time.”
but…. “Uncertainties about the outlook have increased in recent months. In particular, economic momentum appears to have slowed in some major foreign economies and that weakness could affect the US economy.”

Stephen Bartholomeusz at The Sydney Morning Herald comments:

“Perhaps the most disturbing aspect of the Fed shifting into an easing cycle before there is strong evidence to warrant it, is economies already stuck in high debt and low growth environments will be forced even deeper into the kind of policies that in Japan have produced more than 30 years of economic winter with no apparent escape route.”

If the Fed moves too early they could further damage global growth, with long-term consequences for US stocks. But markets are salivating at the anticipated sugar hit from lower rates. Stocks surged in response to Powell’s speech, with the S&P 500 breaking resistance at 3000. A rising Trend Index indicates buying pressure.

S&P 500

The argument for higher stock prices is that lower interest rates may stave off a recession. The chart below shows how recessions (gray bars) are normally preceded by rising interest rates (green) followed by sharp cuts when employment growth (blue) starts to fall.

Fed Funds Rate & Payroll Growth

Rate cuts themselves are not a recession warning, unless accompanied by declining employment growth. Otherwise, as in 1998 when there was minimal impact on employment, the economy may recover. Falling employment growth is, I believe, the most reliable recession warning. So far, the decline in growth has been modest but should be monitored closely.

Falling employment is why recessions tend to lag an inverted yield curve (negative 10-year minus 3-month Treasury yield spread) by up to 18 months. The negative yield curve is a reliable warning of recessions only because it reflects the Fed response to rising inflation and then falling employment.

Yield Spread

Valuations

A forward Price-Earnings ratio of 19.08 at the end of June 2019 warned that stocks are highly priced relative to forecast earnings. The forward PE  jumped to 19.55 by Friday — an even stronger warning.

S&P 500 Forward Price-Earnings Ratio

June 2019 trailing Price-Earnings ratio at 21.52 warned that stock prices are dangerously high when compared to the 1929 and 1987 peaks preceding major crashes. That has now jumped to 22.04.

S&P 500 Price-Earnings (based on highest trailing earnings)

The only factor that could support such a high earnings multiple is unusually strong earnings growth.

But real corporate earnings are declining. Corporate profits, before tax and adjusted for inflation, are below 2006 levels and falling. There are still exceptional stocks that show real growth but they are counter-balanced by negative real growth in other stocks.

Corporate Profits before tax adjusted for Inflation

Impossible, you may argue, given rising earnings for the S&P 500.

S&P 500 Earnings

There are three key differences that contribute to earnings per share growth for the S&P 500:

  1. Inflation;
  2. Taxes; and
  3. Stock Buybacks.

Inflation is fairly steady at 2.0%.

GDP Implicit Price Deflator & Core CPI

Quarterly tax rates declined from 25% in Q3 2017 to 13.22% in Q4 2018 (source: S&P Dow Jones Indices).

S&P 500 Quarterly Tax Rates

Stock buybacks are climbing. The buyback yield for the S&P 500 rose to 3.83% in Q4 2018 (source: S&P Dow Jones Indices).

S&P 500 Buyback Yield

The 2017 Tax Cuts and Jobs Act caused a surge in repatriation of offshore cash holdings — estimated at almost $3 trillion — by multinationals. And a corresponding increase in stock buybacks.

S&P 500 Buybacks, Dividends & Earnings

In summary, the 2018 surge in S&P 500 earnings is largely attributable to tax cuts and Q1 2019 is boosted by a surge in stock buybacks in the preceding quarter.

Buybacks plus dividends exceed current earnings and are unsustainable in the long run. When the buyback rate falls, and without further tax cuts, earnings growth is going to be hard to find. Like the emperor’s new clothes.

It’s a good time to be cautious.

“Only when the tide goes out do you discover who’s been swimming naked”.

~ Warren Buffett

ASX tailwinds v. headwinds

The ASX continues to enjoy a massive external tailwind, with iron ore spot prices holding at $120/tonne.

Iron Ore

Headwinds stem mainly from domestic sources. Low employment and disposable income growth have slowed consumption, especially of durables such as housing and motor vehicles. Construction work done in the private engineering sector (mainly mining and energy related) continues to decline after a dramatic fall in 2013-2015. Public sector spending is also tailing off as the NBN roll-out winds down.

Australia: Construction Work Done

Private sector building still shows some resilience but is expected to fall as approvals for new residential construction decline (source: ABS).

Australia: Building Approvals

My concern is that the headwinds will outlast the tailwind, in which case all three construction sectors could fall to 2006 levels.

The ASX 200 continues to advance, headed for a test of its 2007 high at 6830. A declining Trend index would warn of rising selling pressure, while penetration of the rising trendline on the index chart would signal a correction to test support at 6000.

ASX 200

We continue to maintain a high level of cash in our Australian Growth portfolio.

ASX: Iron ore at $120

The ASX is still enjoying a massive tailwind from iron ore prices, with  spot prices close to $120/tonne.

Iron Ore

My concern is how long this tailwind will last. But the ASX 200 advances unperturbed, heading for a test of its 2007 high at 6830. Penetration of the rising trendline is unlikely but would warn of a correction to test support at 6000.

ASX 200

I continue to maintain a high level of cash in my Australian Growth portfolio because of long-term headwinds.

Still cautious

Inflationary pressures are easing, with average hourly earnings growth declining to 3.35% in June, for Production and Non-Supervisory Employees, and 3.14% for Total Private sector.

Average Wage Rates

But this warns that economic growth is slowing. Annual growth in hours worked has slowed to 1.25%, suggesting a similar decline in GDP growth for the second quarter.

Real GDP and Hours Worked

Jobs growth held steady at 1.5% for the 12 months ended June 2019, after a decline from 2.0% in January.

Payroll Growth

Further decline in jobs growth is likely in the months ahead and a fall below 1.0% would warn that recession is imminent.

The Case Shiller index warns that growth in housing prices is slowing.

Case Shiller Index

Growth in construction expenditure (adjusted for inflation) has stalled.

Construction Expenditure/CPI

Retail sales growth is faltering.

Retail Sales

Units of light vehicle sales has stalled.

Light Vehicle Sales

And capital goods orders (adjusted for inflation) are faltering.

Manufacturers Orders for Capital Goods

One of the few bright spots is corporate bond spreads — the difference between lowest investment grade (Baa) and equivalent Treasury yields — still low at 2.3%, indicating that credit risk is benign.

Corporate Bond spreads

The S&P 500 broke through 2950 and is testing 3000. The 3000 level is an important watershed, double the 2000 and 2007 highs at 1500 (1552 and 1576 to be exact), and I expect strong resistance.

S&P 500

A rising Trend Index indicates buying pressure but this seems to be mainly stock repurchases and institutional buying. Retail money, as indicated by investment flows into ETFs, favors fixed income over equities despite the low yields.

ETF Flows source: ETF.com

It’s still a good time to be cautious.

The prevailing wisdom is that markets are always right. I take the opposite position. I assume that markets are always wrong……I watch out for telltale signs that a trend may be exhausted. Then I disengage from the herd and look for a different investment thesis. Or, if I think the trend has been carried to excess, I may probe going against it. Most of the time we are punished if we go against the trend. Only at an inflection point are we rewarded.

~ George Soros

S&P 500: Plan B

The S&P 500 is testing its all-time high at 2950. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure. Respect of resistance is likely and would signal retracement to test support at 2750.

S&P 500

The 10-Year Treasury yield has fallen to 2.0%, indicating that the Fed is expected to cut interest rates in the second half of 2019.

10-Year Treasury yield

Stocks are still running on hope of a deal in the US-China trade dispute. Xi Jinping and Donald Trump will meet this weekend to discuss the way forward. Chinese preconditions for a trade agreement are likely to include the US lifting its ban on the sale of technology to telecommunications giant Huawei and removal of US tariffs on Chinese imports, according to The Wall St Journal. The US is unlikely to accede and chances of a deal are slim to nonexistent.

Trump doesn’t seem concerned: “My Plan B with China is to take in billions and billions of dollars a month and we’ll do less and less business with them……My plan B’s maybe my plan A.” (Bloomberg)

Plan B is the likely outcome, with a moderate impact on US corporate earnings and Fed rate cuts to keep the market on track. Risks rise while the potential upside declines. It’s a good time to be cautious.

We must recognize that as the dominant power in the world we have a special responsibility. In addition to protecting our national interests, we must take the leadership in protecting the common interests of humanity……There is no other country that can take the place of the United States in the foreseeable future. If the United States fails to provide the right kind of leadership our civilization may destroy itself. That is the unpleasant reality that confronts us.

~ George Soros: The Age of Fallibility

ASX 200 plain sailing at present

Iron ore tailwinds show no signs of abating, with spot prices close to $110/tonne.

Iron Ore

It’s all plain sailing, with the ASX 200 advancing towards its 2007 high at 6830. Penetration of the rising trendline is unlikely but would warn of a correction to test support at 6000.

ASX 200

I continue to maintain a high level of cash in my Australian Growth portfolio because of long-term headwinds.

A good time to be cautious

Markets are buoyant with the S&P 500 headed for another test of its all-time high at 2950. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure but the overall technical outlook looks promising.

S&P 500

So why should it not be a good time to invest in stocks?

First, the yield curve warns of a recession in the next 6 to 18 months. The 10-year Treasury yield is below the yield on 3-month T-bills, indicating a negative yield curve. This is our most reliable recession signal, with 100% accuracy since the early 1960s.

Yield Differential

Annual jobs growth has declined since January. Further declines in the next few months would further strengthen the recession warning.

Annual Growth in Total Payrolls

Small cap stocks in the Russell 2000 lag well behind the S&P 500, indicating that investors are de-risking.

Russell 2000 ETF

Cyclical sectors like Automobiles & Components also offer an early warning, anticipating slower consumer spending on durables such as housing, clothing and automobiles.

S&P 500 Automobiles & Parts

Lastly, the historic Price-Earnings ratio is above 20 (PE and PEmax are equal at present), indicating stocks are over-priced.

S&P 500 historic PE ratio based on highest prior earnings

It’s a good time to be cautious.

S&P 500 hesitancy

This week’s doji on the S&P 500 signals hesitancy. Reversal below the mid-point of the previous week’s candle would complete a bearish doji star reversal. Breach of support at 2750 would further strengthen the bear signal, warning of a test of 2400.

S&P 500

Small caps are a lot weaker, with the Russell 2000 (iShares ETF) testing support at 145. Breach would warn of a test of primary support.

Russell 2000 Small Caps

ASX 200: Materials rocket but Financials fade

Last week I wrote that I had zero confidence in the ASX 200 breakout but you can’t argue with the tape. The ASX 200 retracement respected its new support level at 6350 and commenced a fresh advance. Money Flow completed a trough high above zero, signaling strong buying pressure.

ASX 200

Iron ore is a big contributor, rocketing to $106/tonne.

Iron Ore

Materials followed suit, breaking resistance at 13,500 suggesting a fresh advance.

ASX 200 Materials

The housing rally in response to the recent RBA rate cut has fizzled out, with CoreLogic reporting lower auction clearance rates last weekend:

The combined capital city final auction clearance rate came in at 48.3 per cent last week, which was lower than the 58 per cent the previous week. The lower clearance rate was across a lower volume of auctions over what was the Queen’s birthday long weekend, which saw 805 homes taken to auction, down on the 1,661 auctions the prior week.

The Financials advance has also lost impetus, with lower peaks on the Money Flow Index warning of increased selling pressure. Reversal below 6000 would warn of another correction.

ASX 200 Financials

The market is discounting the potential impact of a US-China trade war on Australia, relying on a large Chinese injection of fiscal stimulus to steady the ship. They may be right but Chinese officials have been talking this down for the past few months.

We hold 46% of our Australian Growth portfolio in cash and fixed income securities because of high uncertainty from (1) the US-China trade war; and (2) declining house prices and their potential impact on under-capitalised banks — leveraged at nearly 20 times common equity (CET1).