Playing the long game

Chart for the Week

GDP growth is slowing, while US corporate profits (before tax) are also declining as a percentage of GDP.

Corporate profits Before Tax/GDP

Yet the S&P 500 and other major indices are rising, lifted by Fed liquidity injections in the repo market. The red line shows total assets on the Fed’s balance sheet.

S&P 500 and Fed Assets

The Long Game

We play the long game — reducing exposure to equities when market risks are high and staying on the defensive until normality is restored — even if this means sitting on cash while equities rise. The only alternative, unless you trust your ability to accurately identify exact market tops and bottoms, is to hang on to your positions no matter what happens. But there are few individuals who can withstand the stress and make rational decisions during a major market draw-down.

Updates for Market Analysis Subscribers

Best wishes for the New Year. It promises to be an eventful one.

What is causing the current S&P 500 rise and how is it likely to end?

In November 2007, six months after the inverted yield curve (3M-10Y) recovered to a positive slope, bellwether transport stock Fedex broke primary support at 100 to warn of an economic slow-down.

Today, two months after rate cuts restored an inverted yield curve to positive, Fedex again broke primary support, this time at 150. Their CEO observed that the stock market might be booming but the “industrial economy does not reflect any growth at all.”


Real GDP growth is slowing, with our latest estimate, based on weekly hours worked, projecting GDP growth of 1.5% for the calendar year.

Real GDP and Weekly Hours Worked

While real corporate profits are declining.

Corporate Profits Before Tax adjusted for Inflation

What is keeping stocks afloat?

First, a flood of new money from the Fed. They expanded their balance sheet by $375 billion since September 2019 and are expected to double that to $750 billion — bringing total Fed holdings to $4.5 trillion by mid-January — to head off an expected liquidity crisis in repo and FX swap markets. The red line below shows expansion of the Fed’s balance sheet, the blue is the S&P 500 index.

S&P 500 and Fed Assets

Second, ultra-low bond yields have starved investment markets of yield, boosting earnings multiples. P/E of historic earnings rose to 22.01 at the end of the September quarter and is projected to reach 22.82 in the December quarter (based on current S&P earnings estimates).

S&P 500 P/E (maximum of previous earnings)

That is significantly higher than the peak earnings multiples achieved before previous crashes — 18.86 of October 1929 and 18.69 in October 1987 — and is only surpassed by the massive spike of the Dotcom bubble.

How could this end?

First, if the Fed withdraws (or makes any move to withdraw) the $750 billion temporary liquidity injection, intended to tide financial markets over the calendar year-end, I expect that the market would crash within minutes. They are unlikely to be that stupid but we should recognize that the funding is permanent, not temporary.

Second, if bond yields rise, P/E multiples are likely to fall. 10-Year breakout above 2.0% would signal an extended rise in yields.

10-Year Treasury Yields

China has slowed its accumulation of US Dollar reserves, allowing the Yuan to strengthen against the Dollar (or at least weaken at a slower rate). Reduced Treasury purchases are causing yields to rise. The chart below shows in recent months how Treasury yields have tracked the Yuan/US Dollar (CNYUSD) exchange rate.


Accumulation of USD foreign exchange reserves (by China) is likely to be a central tenet of US trade deal negotiations — as they were with Japan in the 1985 Plaza Accord. Expect upward pressure on Treasury yields as growth in Chinese holdings slows and possibly even declines.

Third, and most importantly, are actual earnings. With 98.6% of S&P 500 companies having reported, earnings for the September quarter are 6.5% below the same quarter last year. Poor Fedex results and low economic growth warn of further poor earnings ahead.

We maintain our view that stocks are over-priced and that investors need to exercise caution. We are over-weight cash and under-weight equities and will hold this position until normal P/E multiples are restored.

Gold, Treasuries and China’s Yuan

China’s Yuan retreated against the Dollar, encountering resistance at 14.35 US cents as the seemingly endless trade talks hit another rough patch. Breach of recent support 14.15 would warn of another test of primary support at 14 cents.

Chinese Yuan CNY/USD

Chinese purchases have weakened 10-Year Treasury yields in the last two weeks. A Yuan at 14 cents is likely to result in 10-year yields testing support at 1.50%. The disconnect between long-term and short-term rates in the US is growing, with long-term rates increasingly dictated by actions at the PBOC.

10-Year Treasury Yields

Declining yields strengthen demand for Gold as it lowers the opportunity cost. Expect continued support at $1450/ounce and a possible test of the descending trendline at $1500. Breach of support is unlikely unless Treasury yields again test resistance at 2.0%.

Gold (USD/ounce)

Silver is similarly testing support at $17.00/ounce but we are unlikely to see a follow-through unless Treasury yields strengthen.

Silver (USD/ounce)

Australia’s All Ordinaries Gold Index continues in a downward trend channel, headed for secondary support at 6000. Declining Trend Index peaks warn of strong selling pressure. Respect of 6000 would signal that the primary up-trend is intact, while breach and a test of primary support at 5400 would warn of trend weakness.

All Ordinaries Gold Index


Gold remains in a long-term up-trend. A correction may offer an attractive entry point but we first need to confirm that the up-trend is intact before increasing exposure to gold stocks.

Stretching credulity

Fed Chairman, Jay Powell says the US economy is strong.

But they have cut interest rates three times this year.

And it’s all hands to the pump below decks. The Fed expanded their balance sheet by $288 billion since September and broad money (MZM plus time deposits) growth has almost doubled to $1.4 trillion this year.

Fed Assets and Broad Money Growth

Donald Trump says that a Phase 1 trade deal has been settled with China.

But the two parties can’t seem to agree on whether China’s agricultural purchases are part of the deal (China is reluctant to commit to a $ amount).

Nor can they recall whether rolling back tariffs was part of the deal. China would like to think so but Trump is now threatening to increase tariffs if a deal isn’t signed.

Fundamentals show that activity is contracting. Industrial production is falling.

Fed Assets and Broad Money Growth

Freight shipments are contracting.

Cass Freight Shipments

And retail sales growth is declining.

Advance Retail Sales

Yet Dow Jones Industrials just broke 28,000 for the first time, while Trend Index troughs above zero show long-term buying pressure.

Dow Jones Industrial Average

Paul Tudor Jones

“Explosive” is the right word.

Martin North: Mortgage stress highest ever in Australia

Martin North at DFA does monthly household surveys to assess the granularity of property data in Australia. What he finds is that one-third of households (about 1 million) are in mortgage stress. In Sydney, the problem is concentrated in the Western suburbs and inner city units.

Many Western and outer fringe households bought in at high prices and have experienced price falls of 30% or more. They are locked in because of little or no remaining equity and cannot refinance to get the benefit of lower rates. They have run down savings and run up credit cards in the hope that the situation would improve but there has been little movement in these areas and banks are starting to foreclose.

Inner city units have suffered similar price falls but also face the problem of poor construction standards which makes resale difficult.

Martin is skeptical of high auction clearance rates and recovery in prices, pointing out that this is largely restricted to the Eastern suburbs where households enjoy much lower mortgage exposure relative to property values.

Hat tip to Macrobusiness where I found the video.


Ultra-low interest rates may lead to a ‘debt trap’

The highly-regarded Stephen Bartholomeusz warns that central bank policies may lead to a ‘debt trap’:

“….With the world apparently re-starting the use of unconventional monetary policies even before central banks have extricated themselves from the legacies of a decade of those policies, there is a real risk that the impacts and the threats posed by their side effects will swell and that the world will be caught within what the BIS has previously described as a “debt trap’’ with no exit.

The other disturbing aspect of the [BIS] report is that it repeatedly says it is too early to assess the longer-term implications of the policies the central banks have employed.

Central bankers respond to the latest data – they respond to short-term signals – but the side-effects of their post-crisis policies have already been building for a decade and will continue to build while they maintain ultra-low or negative policy rates and keep buying bonds and other fixed interest securities to depress longer-term interest rates and suppress risk premia.

How those side-effects are unwound and how the banks extricate themselves from their policies and the legacies of those policies won’t be known until they try, but the potential for another crisis has been increased by the big surge in global leverage and the elevated asset prices the policies have encouraged.

Negative rates and quantitative easing and variations on those themes might, as the BIS report says, be useful additions to central bankers’ toolboxes but the past decade has shown they aren’t by themselves a panacea for economic ills and they bring with them potentially unpleasant side effects the longer they are in place.”

Debt traps occur when the interest rate needed to service the government debt is greater than the growth rate of GDP, according to former Fed governor Robert Heller:

“…In such a situation, debt service obligations grow more rapidly than the economy; eventually, the accumulated debt can no longer be serviced properly. In other words, the dynamics of the situation become unsustainable and a death spiral ensues.”

So far, central banks have responded by driving interest rates to record lows but unintended consequences are emerging, with low interest rates leading to low GDP growth. A feedback loop is emerging:

    • Low interest rates

Australia: 10-Year Bond Yield

    • Low bank interest margins

Australia: Bank Net Interest Margins

    • Low credit growth

Australia: Credit & Broad Money Growth

    • Low inflation

Australia: Underlying Inflation

    • And low economic growth

Australia: GDP Growth

We are venturing where angels fear to tread: central banks trialing new policies without empirical evidence as to their long-term consequences.

Monetary policy should be administered judiciously, intervening only when the financial system is in dire straits, outside the realm of the regular business cycle. Instead monetary policy is treated as a panacea, the constant drip-feed building a long-term dependence on further stimulus.

The problem with ‘traps’ is that they are difficult to escape.

“If you find yourself in a hole, the first thing to do is stop digging.”

~ Will Rogers

[NOTE: I should clarify that Australia has relatively low fiscal debt and is not in any immediate danger of a debt trap. But the ‘lucky country’ would suffer severely from fallout if the US or China were caught in a debt trap.]

Robert Shiller’s warning

Nobel prize-winning economist Robert Shiller warns that cracks are once again surfacing in the US housing market.

“We have had a strong housing market for pretty much all the time since 2012. Just after the financial crisis, the housing market didn’t recover, maybe because banking was in disarray and people were still expecting declines after the event. After 2012, it started going up at more than 10 per cent a year nationwide in the US, and has been slowing down since.”

Shiller says that a worrying pattern emerging in house prices is reminiscent of the property market in the run-up to the Great Recession.

The bursting of the US housing bubble in 2006-07 was a key trigger of the financial crisis…… “I have seen this happen before, we’re like back in 2005 again when the rate of increase in home prices was slowing down a lot but still going up.

Case Shiller Index

Growth in the Case Shiller National Home Price Index is clearly weakening but we need to be careful of confirmation bias where we “cherry-pick” negative news to reinforce a bearish outlook. I would take the present situation as an “amber” warning and only a drop below zero (when house prices fall) as a red flag.

Shiller has an enviable reputation for predicting recessions, having warned of the Dotcom bubble in tech stocks and the housing bubble ahead of the 2008 global financial crisis. He is correct that narratives (beliefs) can become self-fulfilling prophecies. If the dominant view is that the economy will contract, then it probably will — as corporations stop investing in new capacity and banks restrict lending. Geo-political tensions — US/China, UK/EU Brexit, and Iran/Saudi Arabia — combined with massive uncertainty in global trade and oil markets, could quickly snowball into a full-blown recession.

Predicting recessions with payroll and unemployment data

Recessions are notoriously difficult to measure (even the NBER occasionally gets it wrong) and an official declaration of a recession may be lagged by more than 6 months. Economist Claudia Sahm devised the Sahm Rule, using changes in unemployment levels, as a more timely predictor of recessions.

Sahm rule: US Data

But the signal repeatedly lags the official start date of recessions by several months, limiting its usefulness for investment purposes.

In previous articles I observed that payroll growth is a good predictor of recessions. But payroll growth has been declining for decades; so it has been difficult to devise a one-size-fits-all-recessions rule. Until I turned to using momentum.

Twiggs Momentum is my own variation on the standard momentum formula and I applied this to monthly payroll data to arrive at a 3-month TMO.

Sweden: Sahm rule

The orange band on the above chart reflects the amber warning range, between 0.5% and 0.3%, where recession is likely. If TMO crosses below the red line at 0.3%, risk of recession increases to very high.

When the TMO falls below 0.5%, a recession is likely, but there is one false reading at 0.49% in 1986. So I treat 0.5% as an amber warning level.

There are no false signals below 0.3% in the last 50 years. So I treat the 0.3% level as a red warning — that recession risk is very high.

Some of the signals (e.g. 1975) are late but the TMO has a far better record, than the Sahm Rule, at giving timely warning of recessions.

The August 2019 TMO reading is an amber warning of 0.5%.

Tectonic shift threatening the global reserve currency system

As Mark Carney observed at Jackson Hole: the global reserve currency system is broken — it has been since Nixon defaulted on gold backing for the Dollar in 1973 — and there is no fix. We have to find a replacement along the lines of Carney’s suggestion. On Macrovoices, two experts on the EuroDollar system, Jeffrey Snider and Luke Gromen discuss the massive tectonic shift facing the global financial system.

This is a complex topic but it is important that we grasp the implications before a tsunami appears on the horizon.

Interest spreads hold sway over the global economy

An inverted yield curve is a reliable predictor of recessions but it also warns of falling bank profits. When the spread between long-term Treasury yields and short-term rates is  below zero, net interest margins are squeezed.

Yield Differential (10y - 3m)

In a normal market, with a steep yield curve, net interest margins are wide as bank’s funding maturity is a lot shorter than their loan book. In other words, they borrow short and lend long. Few bank deposits have maturities longer than 3 to 6 months, while loans and leases have much longer maturities and command higher interest rates.

When the yield curve inverts, however, the spread between long and short-term rates disappears and interest margins are squeezed. Not only is that bad for banks, it’s bad for the entire economy.

When their interest margins are squeezed, banks become risk averse and lending growth slows. That is understandable. When interest margins are barely covering operating expenses, banks cannot afford credit write-downs and become highly selective in their lending.

Slowing credit growth has a domino-effect on business investment and consumer spending on durables (mainly housing and automobiles). If there is a sharp fall in credit growth, a recession is normally not far behind1.

Bank Loans & Leases

Right now, the Fed is under pressure to cut interest rates to support the US economy. While this would lower short-term rates and and may flatten the yield curve, cutting interest rates off a low base opens a whole new world of pain.

Quartz this week published a revealing commentary on the damage that negative interest rates in developed economies are doing to bank net interest margins :

The problem for commercial banks is that government bond and mortgage interest rates keep going lower, but it isn’t as easy to cut deposit rates — the rate at which banks themselves borrow from customers — at the same pace. After all, it’s tough to convince people to keep deposits in an account that returns less than they put in (even though this already happens, invisibly, through inflation).

Bank Net Interest Margins in Developed Countries

Ultra-low interest rates are likely to squeeze bank margins in a similar way to the inverted yield curve. And with a similar impact on credit growth and the economy.

If I was Trump I would be pleading with the Fed not to cut interest rates.

1. The NBER declared a recession in 1966 when the S&P 500 fell 22% but later changed their mind and airbrushed it out of history.