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%.

S&P 500: Treasuries reflect flight to safety

10-Year Treasury yields plunged below 2.0% on Donald Trump’s announcement of further tariffs (10% on $300bn) on China. The fall reflects rising demand for Treasuries as a safe haven in these turbulent times.

10-Year Treasury Yield

The spread between 10-Year and 3-Month Treasuries recovered above zero. This is a bearish sign: recession normally follows the recovery and not the initial inversion.

10-Year 3-Month Treasury Spread

The S&P 500 retreated below 3000 on Trump’s announcement, strengthening the bearish divergence signal on Twiggs Money Flow which warns of a correction. A test of support at 2750 is likely.

S&P 500

The Russell 2000 ETF (IWM) is expected to test primary support at 145. Small cap stocks have lagged the S&P 500 this year, highlighting risk aversion.

Russell 2000 Small Caps Index

Dow Jones Euro Stoxx 600, reflecting large cap stocks in the European Union, is similarly headed for a test of primary support at 365. Strong bearish divergence on the Trend Index warns of a reversal.

DJ Euro Stoxx 600

Falling commodity prices reflect market concerns for the global economy. A Nymex Light Crude breach of $51/barrel would signal a primary down-trend. Declining peaks on the Trend Index warn of selling pressure.

Nymex Light Crude

The DJ-UBS Commodity Index is similarly headed for a test of support at 75. Breach would signal a primary down-trend. A peak near zero on the Trend Index warns of strong selling pressure.

DJ-UBS Commodity Index

Dr Copper, often used as a barometer of the global economy, has breached primary support at 5800, signaling a decline. Again, a Trend Index peak below zero warns of strong selling pressure.

Copper

Employment stats for July have improved slightly, with Average Hourly Wages growth easing to 3.3% (Total Private).

Average Hourly Wage

And annual payroll growth ticked up to 1.5%

Employment Growth & FFR

But weekly hours worked are declining, warning that real GDP will decline further, after printing 2.3% for the second quarter.

Real GDP & Weekly Hours Worked

I have warned my clients to cut exposure to the market. It’s a good time to be cautious.

“Price is what you pay; value is what you get.”

~ Benjamin Graham

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

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

Australia needs to break the downward spiral

Ross Gittins, Economics Editor at The Sydney Morning Herald, sums up Australia’s predicament:

“The problem is, the economy seems to be running out of puff because it’s caught in a vicious circle: private consumption and business investment can’t grow strongly because there’s no growth in real wages, but real wages will stay weak until stronger growth in consumption and investment gets them moving.

Policy has to break this cycle. But, as [RBA governor] Lowe now warns in every speech he gives, monetary policy (lower interest rates) isn’t still powerful enough to break it unaided. Rates are too close to zero, households are too heavily indebted, and it’s already clear that the cost of borrowing can’t be the reason business investment is a lot weaker than it should be.

That leaves the budget as the only other instrument available. The first stage of the tax cuts will help, but won’t be nearly enough…..”

Cutting already-low interest rates is unlikely to cure faltering consumption and business investment. Low wage growth and a deteriorating jobs market are root causes of the downward spiral and not much will change until these are addressed.

Low unemployment is misleading. Underemployment is growing. Trained barristers working as baristas may be an urban legend but there is an element of truth. The chart below shows underemployment in Australia as a percentage of total employment.

Australia: Underemployment % of Total Employment

How to halt the spiral

Tax cuts are an expensive sugar hit. The benefit does not last and may be frittered away in paying down personal debt or purchasing imported items like flat-screen TVs and smart phones. Tax cuts are also expensive because government is left with debt on its balance sheet and no assets to show for it.

Infrastructure spending can also be wasteful — like school halls and bridges to nowhere — but if chosen wisely can create productive assets that boost employment and build a healthy portfolio of income-producing assets to offset the debt incurred.

The RBA has already done as much as it can — and more than it should. Further rate cuts, or God forbid, quantitative easing, are not going to get us out of the present hole. What they will do is further distort price signals, leading to even greater malinvestment and damage to the long-term economy.

What the country needs is a long-term infrastructure plan with bipartisan support. Infrastructure should be a national priority. There is too much at stake for leadership to take a short-term focus, with an eye on the next election, rather than consensus-building around a long-term strategy with buy-in from both sides of the house.

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.

If earnings undershoot, stocks will fall

Annual employment growth is falling while average hourly earnings growth remains high. This is typical. Ahead of the last two recessions (gray bars below), average hourly earnings growth (green) held steady while employment growth (blue) declined.

Employment Growth & Average Hourly Wage Rate

If annual employment growth (blue line on the above chart) falls below 1.0% then a Fed rate cut is almost guaranteed. Not something to celebrate though, as the gray bars and further job losses illustrate.

Declining growth in hours worked points to lower GDP growth in the second quarter.

Real GDP & Hours Worked

From Bob Doll at Nuveen:

“China is taking a tough stance toward the U.S. on trade. Chinese officials appear open to ongoing negotiations, but a recently released statement denies the country’s role in intellectual property theft, blames the U.S. for negotiation breakdowns and calls out the damage done to the American economy as a result of the dispute. All of this suggests that trade issues will persist for some time.”

The CCP is upset that they are now being called out for bad behavior when this should have been addressed years ago. Conflict can no longer be avoided and is likely to last for a generation or more.

“On Monday, US President Trump told reporters that he would impose tariffs on an additional USD 300 billion of Chinese goods if Xi Jinping doesn’t meet with him in Japan.” ~ Trivium China, June 12, 2019

Trump is doing his best to kill any chance of a trade deal. He is making it impossible for Xi to turn up for a G20 meeting. Kow-towing to Trump would totally undermine Xi’s standing in China.

Xi wants a trade deal that is a handful of empty promises, so the CCP can continue on their present course. The US wants an enforceable undertaking, so that the CPP is forced to change course. Chances of both achieving what they want are negligible.

Both sides need to guard against economic war (time to call it what it is) slipping into a full-scale conflict. All it takes is a spark that sets off tit-for-tat escalation where neither side will back down.

Proxies such as North Korea, Syria and Pakistan are especially dangerous as they are capable of dragging great powers into direct confrontation (think Serbia before WWI, Korea after WWII).

Wannabe great powers like Russia will also do their best to foment conflict between their larger rivals. Stalin achieved this with the Korean War in the 1950s and Vladimir Putin is more than capable of attempting the same. The world is a dangerous place.

Upside potential for stocks is declining while downside risks are growing. Investors are flowing out of equities and into Treasuries despite minimal yield (10-year yield is negative after inflation and tax).

Stocks are being supported by buybacks but that can only continue for as long as cash flows (from earnings) hold up. Buybacks plus dividends for the S&P 500 exceeded reported earnings by more than $100 billion in Q4 2018.

S&P 500 Buybacks, Dividends & Reported Earnings

That is unsustainable. If earnings undershoot, stocks will fall.

S&P 500: Short-term versus long run

The market is excited at the prospect of Fed rate cuts (in response to the US-CCP trade war), with the S&P 500 headed for another test of its earlier high at 2950. A Trend Index trough above zero indicates short-term buying pressure.

S&P 500

Falling bond yields, however, warn of a flight to safety. 10-Year Treasury yields have fallen close to 120 basis points (bps) since late 2018, as investors shift from equities to bonds. Prices are being supported by stock buybacks rather than investor inflows.

10-year Treasury Yields

The Yield Differential between 10-year (purple) and 3-month (lime) Treasury yields is now negative, a reliable early warning of recession.

Yield Differential: 10-Year and 3-Month Treasuries

Corporate bond spreads, the difference between lowest investment grade (Baa) and Treasury yields, are rising. An indicator of credit risk, a spread above 2.5% (amber) is an early warning of trouble ahead, while 3.0% (red) signals that risk is elevated.

10-Year Baa minus Treasury Yield

Falling employment growth is another important warning. Annual employment growth below 1.0% (amber) would normally cause the Fed to cut interest rates. In the current scenario, that is almost certain.

Employment Growth & FFR

What is holding the Fed back is average hourly wages. Annual growth above 3.0% is indicative of a tight labor market and warns against cutting rates too hastily.

Average Hourly wage Rate

Stats for Q1 2019 warn that compensation is rising as a percentage of net value added, while profits are falling. As can be seen from the previous two recessions (gray bars), rising compensation (as % of NVA) normally leads to falling profits and a recession. Cutting interest rates would accelerate this.

Profits & Compensation % of Value Added

Annual GDP growth came in at 3.2% (after inflation) for the first quarter, but growth in hours worked is slowing. GDP growth is likely to follow.

Real GDP & Hours Worked

Personal consumption expenditure for Q1 was largely positive, with an uptick in services and non-durable goods. But consumption of durable goods fell sharply, warning that consumer confidence in the medium-to-long-term is declining.

Consumption

On the global stage, commodity prices are falling, indicating an anticipated drop in demand, especially from China.

DJ-UBS Commodity Index

Nymex crude is following, and expected to test support between $40 and $45 per barrel.

Crude Oil

Short-term prospects may appear reasonable, but the long-term outlook is decidedly negative.

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

~ Benjamin Graham