I am fond off quoting Jesse Livermore’s maxim “You don’t argue with the tape” but Livermore was a keen student of market conditions and based his decisions on far more than just price action in the market.
We are witnessing a spectacular stock market rally, driven by retail investors and hedge funds piling into the market while institutional investors are sitting on the sidelines.
The Nasdaq 100 broke through resistance at 10,000, new highs signaling a fresh primary advance. Bearish divergence on Twiggs Money Flow index may warn of selling pressure but it is hard to argue with the tape. Only a fall below 9500 would signal another decline and that seems unlikely at present.
Even retail sales (ex food) have recovered sharply, from -15.3% in April to -1.4% in May (annual % gain).
Light vehicle sales are more sluggish but June sales of 13.05 million are still a sizable bounce.
So why are many old investment hands acting with such caution?
We know that the efforts to contain the COVID19 outbreak are struggling, with over 60,000 new cases per day, but the economy still seems in good shape.
Source JHU CSSE
Let’s look at where the money is coming from.
Treasury debt has expanded by more than $3 trillion in the last four months (March 9 – July 9) as the government does everything in its power to cushion the economy from an unprecedented shutdown. Rescuing airlines, bailing out Boeing, emergency business loans, job preservation schemes, and supporting Fed purchases of a wide variety of financial assets to keep the plumbing of financial markets open. Every way they can, government has been flooding the market with money and some of that has found its way to the stock market. Whether through boosting stock purchases, enabling companies to raise debt or boosting consumer spending to buoy up sales, the market is flying on borrowed money.
Steep up-trends like this typically end in a blow-off. A trend is self-reinforcing if rising prices attract more investors who in turn bid up prices even further. A steady influx of new investors is required to sustain the trend, else it dies.
Similar self-reinforcing cycles are evident in nature, where they expand violently outward at an exponential rate until they run out of fuel. The fuel driving the event may differ, from dry tinder in a forest fire, warm ocean temperatures in a hurricane, consumable vegetation in a locust plague, …..or exposed population in a virus outbreak. The cycle expands, feeding on itself, until the fuel is exhausted.
A stock market blow-off is no different. The up-trend will continue for as long as rising prices are able to attract new investors. It will stop when the source of new money dries up. In this case, when Treasury tries to slow the unsustainable growth in federal debt. Then it becomes a case of devil-take-the-hindmost as a preponderance of sellers attempt to offload their stocks on a rapidly shrinking pool of buyers.
The view is often promoted that low GDP growth over the past decade is caused by low interest rates and balance sheet expansion (QE) by central banks. That is putting the cart before the horse. Central banks have tried to stimulate their economies, with massive QE and low interest rates, because of low GDP growth. Not the other way around.
The real cause of low GDP growth is low job growth, as the chart below illustrates.
[click here for full screen image]
Offshoring jobs means offshoring growth.
The last time that the US had employment growth above 5.0% is 1984 which also the last time that we saw real GDP growth at 7.5%. Since then, job growth has progressively weakened — and GDP with it.
In the last decade, employment growth peaked at 2.27% and GDP at 3.98% in Q1 of 2015.
We now expect job growth to fall to -20% in April, four times the -5% trough in 2009, and a sharp GDP contraction.
How long the recession/depression will continue is uncertain. But, in the long-term, it is unlikely that the US can achieve +5% real GDP growth unless employment growth recovers close to +3.0%.
Initial jobless claims in the US for the 6 weeks to April 25th exceed 30 million.
That will take unemployment above 20%, with total jobs falling to levels last seen in 1997, and more job losses still to come.
Employment is the key to economic recovery. While unemployment is high, consumer spending will stay low and the economy will struggle. Companies may receive bailouts and the Fed will keep financial markets awash with liquidity but that does not help falling sales.
Be prepared. April employment numbers are going to be ugly. Expect some turbulence.
I have read The Panic of 1907 (by Robert Bruner & Sean Carr) four or five times — I read it at every market crash.
The crash occurred more than 100 years ago and is one of many banking crises that beset the United States in the 19th and early 20th century. What made 1907 stand out is that the financial system was saved by the leadership of a private individual, John Pierpont Morgan, head of the banking firm that later became known as J.P. Morgan & Co. Without the 70-year old Morgan’s force of will, the entire financial system would have imploded.
John Pierpont Morgan – source: Wikipedia
The crisis led to formation of the Federal Reserve Bank in 1913. The US had not had a central bank since President Andrew Jackson withdrew the charter for the second Bank of the United States in 1837. Bank clearing houses prior to 1913 were private arrangements created by syndicates of banks and were poorly-equipped to deal with the challenges of a banking crisis.
The lessons of 1907 are still relevant today. The authors of the book suggest that “financial crises result from a convergence of forces, a ‘perfect storm’ at work in financial markets.”
They identify seven elements that converged to create a perfect storm in 1907:
- Complex Financial Architecture makes it “difficult to know what is going on and establishes linkages that enable contagion of the crisis to spread.”
- Buoyant Growth. “Economic expansion creates rising demands for capital and liquidity and ….excessive mistakes that eventually must be corrected.”
- Inadequate Safety Buffers. “In the late stages of an economic expansion, borrowers and creditors overreach in their use of debt, lowering the margin of safety in the financial system.”
- Adverse Leadership. “Prominent people in the public and private spheres implement policies that raise uncertainty, which impairs confidence and elevates risk.”
- Real Economic Shock. “Unexpected events hit the economy and financial system, causing a sudden reversal in the outlook of investors and depositors.”
- Undue Fear, Greed and other Behavioral Aberrations. “….a shift from optimism to pessimism that creates a self-reinforcing downward spiral. The more bad news, the more behavior (erupts) that generates bad news.”
- Failure of Collective Action. “The best-intended responses by people on the scene prove inadequate to the challenge of the crisis.”
Compare these seven elements to the current crisis in March 2020:
Complex Financial Systems
The global financial system is far more complex than the gold-based financial system of 1907. Regulation has not kept pace with the growth in complexity, with many products designed to avoid regulation and lower costs. The ability to build firebreaks to stop the spread of contagion in unregulated or lightly regulated areas of the financial system is severely limited. And that is where the fires tend to start.
In 1907 the fire started with poorly regulated trust companies that dominated the financial landscape: making loans, receiving deposits, and operating as an effective shadow-banking system. A run on trust companies threatened to engulf the entire financial system.
In 2020 it started with hedge funds leveraged to the hilt through repo markets but soon threatened to spread to other unregulated (or lightly regulated) areas of our shadow banking system:
- Leveraged hedge funds
- Risk parity funds
- International banks lending and taking deposits in the unregulated $6.5 trillion Eurodollar market (these banks are offshore and outside the Fed’s jurisdiction).
- Money market funds
- Muni funds
- Commercial paper markets
- Leveraged credit
- Bond ETFs
Many of these offer the attraction of low costs and higher returns, often enhanced through leverage, but what investors are blind to (or choose to ignore) are the risks from lack of proper supervision and the lack of liquidity when money is tight.
Maturity mis-match is often used to boost returns. Short-term investors are channeled into long-term securities such as Treasuries, corporate bonds, munis or credit instruments, with the promise of easy sale or redemption when they require their funds. But this tends to fail when there is a liquidity squeeze, forcing a sell-off in the underlying securities and steeply falling prices.
We all welcome strong economic growth but should beware of the attendant risks, especially when financial markets are administered more stimulants than a Russian weightlifter for purely political ends.
Excessive use of Debt
Corporate borrowings are far higher today and rising debt has warned of a coming recession for some time.
Public debt is growing even faster, with US federal debt at 98.6% of GDP.
In the early 1900s, President Teddy Roosevelt led a populist drive to break the big money corporations through Anti-Trust prosecutions. This cast a shadow of uncertainty that fueled the sudden reversal in investor sentiment.
In 2020, we have another populist in the White House. Frequent changes in direction, spats with allies, imposition of trade tariffs, impeachment efforts by Congress, and a heavy-handed approach to trade negotiations have all elevated the level of uncertainty.
The great San Francisco earthquake and fire of 1906 created an economic shock that was felt across the Atlantic. The earthquake ruptured gas mains, setting off fires, while fractured water mains hampered firefighting. Over 80% of the city was destroyed. Much of the insurance was carried in London and Europe and led to a sell-off of securities in order to meet claims. The Bank of England became increasingly concerned about the outflow of gold from the UK and hiked its benchmark interest rate from 3.5% to 6.0%. London was then the hub of global financial markets and money became tight.
In 2020 we have the coronavirus impact on global manufacturing, services and financial systems: the mother of all demand and supply shocks.
Undue Fear and Greed
Collapse of highly leveraged ventures in 1907 — with an attempted short squeeze on United Copper shares by connected corporations, banks and broking houses — stirred fears that a leading Trust company was going to fail. The panic soon spread and started a run on a number of trust companies.
A spike in the repo rate in September last year revealed that hedge funds had used repo to leverage their relatively meager capital into a rumored $650 billion exposure to US Treasuries. The Fed had to dive in with liquidity to settle the repo markets, lifeblood of short-term funding by primary dealers. But financial markets were on edge and concerns about funding difficulties in the unregulated $6.5 trillion offshore Eurodollar market and leveraged credit in the US started to grow. But the coronavirus outbreak in Europe and North America was the eventual spark that set off the conflagration.
Failure of Collective Action
Tust companies failed to organize an effective defense in 1907 against a run on their largest member, The Knickerbocker Trust Company, fueling a panic that threatened to engulf other trusts. Responding to appeals for help, J.P. Morgan intervened and marshaled the banking industry and surviving trusts to mount an effective defense.
Today that role falls to the Federal Reserve. Chairman Jay Powell moved quickly and purposefully to flood financial markets with liquidity, but the Fed was forced to reach far outside their normal ambit — increasing dollar swap lines with foreign central banks (to supply liquidity to international banks operating in the Eurodollar market) and providing liquidity to money market funds, muni funds, commercial paper markets, bond funds, hedge funds (through repo markets) and more. In effect, the Fed had to bail out the shadow banking system.
One thing that strikes me about financial crises is that each one is different, but some things never change:
- artificially low interest rates;
- rampant speculation;
- excessive use of debt;
- unregulated and highly leveraged shadow-banking with hidden linkages through the financial system;
- financial engineering (the latest examples are leveraged credit and covenant-lite loans, hedge funds running leveraged arbitrage, risk parity funds with targeted volatility, and management using stock buybacks to enhance earnings per share, support prices and boost their stock-based compensation);
- misuse of fiscal stimulus (to fund corporate tax cuts while running a $1.4 trillion fiscal deficit);
- misuse of monetary policy (cutting interest rates when unemployment was at record lows);
- yield curve inversion; and
- misallocation of investment (to fund unproductive assets)
Jim Grant (Grant’s Interest Rate Observer) sums up the problem:
“The Fed has intervened at ever-closer intervals to suppress the symptoms of misallocation of resources and the mis-pricing of credit. These radical interventions have become ever-more drastic and the ‘doctor-feel-goods’ of our central banks have worked to destroy the pricing mechanism in credit.
….[credit and equity markets] have become administered government-set indicators, rather than sensitive- and information-rich prices… and we are paying the price for that through the misallocation of resources…..
Is there no salutary role for recessions and bear markets? …..they separate the sound from the unsound, they separate the well-financed from the over-leveraged and if we never have these episodes of economic pain, we will be much the worse for it.”
We haven’t learned much at all in the last 100 years.
Commodity prices warn that the global economy is still in a slump.
The Dow Jones – UBS Commodity Index remains at one-third of its 2007 peak, with no sign of recovery.
The fall in crude prices hasn’t been as severe, but Brent Crude is again weakening and looks set for another test of $50/barrel.
Shipping rates for dry bulk goods, such as iron ore and coal, have fallen, with the Baltic Dry Index close to long-term support at 500.
Supply interruptions to iron ore production in Brazil have cushioned Australian producers from a sharp down-turn in iron ore prices. But coal exporters are feeling the pinch.
Recovery of Brazilian production over the next two years is expected to add downward pressure to iron ore prices.
The only positive appears to be container shipping rates. The Harpex Index rose steeply in 2019, reflecting increased demand for container shipping of finished goods.
Somewhat surprising, since this coincided with US-China trade tensions and tariff increases. The answer may lie with importers on both sides of the Pacific attempting to front-run the imposition of tariffs and build inventories in case of supply interruptions and to allow time to adapt their supply chain. Expect the index to retreat in the early part of 2020.
It looks like low global growth will continue.
Bob Doll from Nuveen Investments is more bullish on stocks than I am but sets out his thoughts on what could cause the current run to end:
“Stock valuations are starting to look full, and technical factors are beginning to appear stretched. As stock prices have risen since last summer, bond yields have crept higher. Should this trend persist, it could eventually cause a headwind for stocks. Credit spreads are signaling some risks, as non-energy high yield corporate bond spreads have dropped to multi-decade lows.
As such, we think stocks may be due for a near-term correction or consolidation phase. Nevertheless, we expect any such phase to be mild and brief as long as monetary conditions remain accommodative and economic and earnings growth holds up. In other words, although we see some near-term risks, we don’t think this current bull market is ending.
That raises the question of what might eventually cause the current cycle to end. We see three possibilities. First, recession prospects could increase significantly. We see little chance of that happening any time soon, given solid economic fundamentals. Second, a political disruption like a resurgence in trade protectionism could occur. We also don’t think that is likely to happen, especially in an election year. Third, bond yields and interest rates could move higher as economic conditions improve, creating problems for stocks. This one seems like a higher probability, and we’ll keep an eye on it.”
The upsurge in retail sales and housing starts may have strengthened Bob’s view of the economy but manufacturing is in a slump and slowing employment growth could hurt consumption. The inverted yield curve is a long-term indicator and I don’t yet see any indicators confirming an imminent collapse.
I rate economic risk as medium at present.
US-China trade risks have eased but I continue to rate political disruption as a risk. This could come from any of a number of sources. US-Iran is not over, the Iranians are simply biding their time. Putin’s attempted constitutional coup in Russia. China-Taiwan. Libya. North Korea. Brexit is not yet over. Huawei and 5G are likely to disrupt relations between China, the US and European allies, with China threatening German automakers. Europe also continues to wrestle with fallout from the euro monetary union, a system that is likely to eventually fail despite widespread political support. Impeachment of Trump may not succeed because of the Republican majority in the senate but could produce even more erratic behavior with an eye on the upcoming election. Who can we bomb next to win more votes?
Bonds & Interest Rates
I don’t see inflation as a major threat — oil prices are low and wages growth is slowing — and the Fed is unlikely to raise interest rates ahead of the November election. Bond yields may rise if China buys less Treasuries, allowing the Yuan to strengthen against the Dollar, but the Fed is likely to plug any hole in demand by further expanding its balance sheet.
Market Risk: Irrational Exuberance
The market is running on more stimulants than a Russian weight-lifter. Unemployment is near record lows but Treasury is still running trillion dollar deficits.
While the Fed is cutting interest rates.
And again expanding its balance sheet. More than twelve years after the GFC. The blue line reflects total assets on the Fed’s balance sheet, mainly Treasuries and MBS, while the orange line (right-hand scale) shows how shrinking excess reserves on deposit at the Fed have helped to create a $2 trillion surge in liquidity in financial markets since 2009. Even when the Fed was supposedly tightening, with a shrinking balance sheet, in 2018 to 2019.
The triple boost has lifted stock valuations to precarious highs. The chart below compares stock market capitalization to profits after tax over the past 60 years.
Ratios above 15 flag that stocks are over-priced and likely to correct. Peaks in 1987 and 2007, shortly before the GFC, are typical of an over-heated market. The Dotcom bubble reflected “irrational exuberance” — a phrase coined by then Fed Chairman Alan Greenspan — and I believe we are entering a second such era.
Recovery of the economy under President Trump is no economic miracle, it is simply the triumph of monetary and fiscal stimulus over rational judgement. Trump knows that he has to keep the party going until November to win the upcoming election, so expect further excess. Whether he succeeds or not is unsure but one thing is certain: the longer the party goes on, the bigger the hangover.
William McChesney Martin Jr., the longest-serving Fed Chairman (1951 to 1970), famously described the role of the Fed as “to take away the punch bowl just as the party gets going.” Unfortunately Jerome Powell seems to have been sufficiently cowed by Trump’s threats (to replace him) and failed to follow that precedent. We are all likely to suffer the consequences.
I have read several commentators proclaiming that the crisis is over and the stock market and US economy are back on track for solid growth. Let’s examine some of the evidence.
The Yield Curve (Bearish)
While the US yield curve has uninverted in the past and yet a recession has still come along, the uninversion seen in recent months coming after such a shallow and short-lived inversion provides confidence that the inversion seen last year gave a false signal…. (Shane Oliver at AMP)
Yield curve inversions seldom last long. For one simple reason: the Fed fires up the printing press to reduce short-term interest rates and boost the economy. The yield curve uninverted before the last three recessions and this time looks no different.
Consumer Confidence (Bullish)
Retail sales kicked up in December, a sign of growing consumer confidence.
Auto sales are still flat but housing starts have also jumped.
Economic Activity (Bearish)
When it comes to economic activity, Cass freight shipments are falling.
Rail freight indicators also point to declining activity levels.
Leading employment indicators, such as temporary jobs and job openings, warn that labor market growth is slowing.
But overall payroll growth, albeit subdued is still stable, with the 3-month TMO of non-farm payroll growth respecting the 0.5% amber warning level.
Last week we compared market cap to profits before tax. This week, we compare to profits after tax. Recent levels above 20 have only previously been exceeded, in the past 60 years, during the Dotcom bubble.
Dallas Fed president Robert Kaplan conceded that expansion of the Fed balance sheet is helping to lift asset prices.
Commenting on the Fed’s massive liquidity response to the repo crisis, Kaplan said that “my own view is it’s having some effect on risk assets……It’s a derivative of QE when we buy bills and we inject more liquidity; it affects all risk assets. This is why I say growth in the balance sheet is not free. There is a cost to it. And we need to be very disciplined about it and sensitive to it.”
This is a clear warning to investors to stay on the defensive. We maintain our view that stocks are over-valued and will remain under-weight equities (over-weight cash) until normal earnings multiples are restored.
Warren Buffett is not infallible but the level of cash on Berkshire’s balance sheet seems to indicate a similar view regarding stock valuations.
Chart for the Week
GDP growth is slowing, while US corporate profits (before tax) are also declining as a percentage of 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.
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
- S&P 500: Stocks lift but jobs and profits a red flag
- ASX 200 breakout
- Australia: Bearish apart from mining
- Gold bearish on imminent phase 1 deal
Best wishes for the New Year. It promises to be an eventful one.
The S&P 500 has advanced steadily since breaking resistance at 3000.
Lifted by Fed liquidity injections in the repo market.
Optimism over improved global trade has spread, with the DJ Euro Stoxx 600 breaking resistance at 400.
South Korea’s KOSPI completed a double-bottom reversal to signal an up-trend.
And India’s Nifty Index broke resistance at 12,000.
Commodity prices remain low but rising Trend Index troughs on the DJ-UBS Commodity Index suggest that a bottom is forming.
Crude spiked up with rising US-Iran tensions but is expected to re-test support at 50 as supply threats fade.
Fedex recovered above primary support at 150, but the outlook for economic activity remains bearish.
Falling US wages growth warns of slowing job creation.
Declining employment growth highlights similar weakness.
Initial jobless claims, while not alarming, are now starting to rise.
Growth in weekly hours worked has slowed, with real GDP expected to follow.
While GDP growth is slowing, corporate profits (before tax) are also declining as a percentage of GDP.
Market Capitalization of equities has spiked to a ratio of 20 times Corporate Profits (before tax), an extreme only previously seen in the Dotcom bubble.
The market can remain irrational for longer than you or I can stay solvent, but this is a clear warning to investors to stay on the defensive.
We maintain our view that stocks are over-valued and will remain under-weight equities (over-weight cash) until normal earnings multiples are restored.