Category: GDP and Activity

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US Stocks: Bull or Bear?

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)

Treasury 10 Year-3 Month Yield Differential

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.

Retail excluding Auto

Auto sales are still flat but housing starts have also jumped.

Housing Starts & Permits

Economic Activity (Bearish)

When it comes to economic activity, Cass freight shipments are falling.

Cass Index

Rail freight indicators also point to declining activity levels.

Rail Freight

Employment (Neutral)

Leading employment indicators, such as temporary jobs and job openings, warn that labor market growth is slowing.

Temporary Jobs

Job Openings

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.

Payroll TMO

Valuations (Bearish)

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.

Market Cap/Corporate Profits after Tax

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.

Berkshire Hathaway Cash Holdings

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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.

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S&P 500: Stocks lift but jobs and profits a red flag

The S&P 500 has advanced steadily since breaking resistance at 3000.

S&P 500

Lifted by Fed liquidity injections in the repo market.

S&P 500 and Fed Assets

Optimism over improved global trade has spread, with the DJ Euro Stoxx 600 breaking resistance at 400.

DJ Euro Stoxx 600

South Korea’s KOSPI completed a double-bottom reversal to signal an up-trend.

KOSPI

And India’s Nifty Index broke resistance at 12,000.

Nifty

Commodity prices remain low but rising Trend Index troughs on the DJ-UBS Commodity Index suggest that a bottom is forming.

DJ-UBS Commodity Index

Crude spiked up with rising US-Iran tensions but is expected to re-test support at 50 as supply threats fade.

Nymex Light Crude

Fedex recovered above primary support at 150, but the outlook for economic activity remains bearish.

Fedex

Falling US wages growth warns of slowing job creation.

Average Hourly Wages

Declining employment growth highlights similar weakness.

Employment Growth

Initial jobless claims, while not alarming, are now starting to rise.

Initial Claims

Growth in weekly hours worked has slowed, with real GDP expected to follow.

Real GDP and Weekly Hours Worked

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

Corporate profits Before Tax/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.

Market Cap/Corporate Profits before Tax

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.

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Australia: Bearish apart from mining

Household disposable income lifted in response to the recent tax cuts but households remain risk-averse, with consumption still falling and extra income going straight to debt repayment — reflected by a jump in the Saving ratio below.
Australia Household Saving

Housing prices are recovering despite high levels of mortgage stress in the outer suburbs but building approvals for new housing continue to fall. Construction expenditure is likely to follow.

Australia Building Approvals

GDP growth is falling, while corporate profits (% of GDP) remain in the doldrums apart from the mining sector.

Australia Corporate Profits

Low household disposable income and corporate profit growth in turn lead to low business investment (% of GDP).

Australia Business Investment

Low investment leads to low job creation. Job vacancies and job ads both warn of declining employment growth.

Australia Job Ads

Cyclical employment growth is expected to slow in line with the fall in the Leading Indicator over the past year.

Australia Leading Employment Indicator

We maintain a bearish outlook for the Australian economy, though Mining continues to surprise to the upside.

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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.”

Fedex

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.

CNYUSD

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.

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S&P 500 recovers but employment gains sluggish

Short retracement on the S&P 500 that respected support at 3000 strengthens the bull signal. Further gains are expected in the short- to medium-term.

S&P 500

Corporate profits before tax continue to decline after adjusting for inflation, exposing the vulnerability of high earnings multiples.

S&P 500

Hours worked (non-farm payroll x average weekly hours) for November also point to low annual GDP growth of around 1.5% after inflation.

Real GDP and Hours Worked

Employment growth for the 12 months to November came in at a similar 1.48%.

Employment Growth & Fed Funds Rate

Not enough to justify a P/E multiple of 23.25.

Average hourly earnings growth is increasing, especially for production & non-supervisory employees (3.65% for 12 months to November), but in the present environment the Fed seems unconcerned about inflationary pressures.

Average Hourly Earnings

Patience

Patience is required. We have had a weak S&P 500 retracement confirm the breakout but there is minimal up-turn in November employment indicators to support the bull signal. Market risk is elevated and investors should exercise caution.

“The world has a way of undermining complex plans. This is particularly true in fast moving environments. A fast moving environment can evolve more quickly than a complex plan can be adapted to it….”
~ Carl Von Clausewitz, Vom Kriege (On War) (1780-1831)

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S&P 500: Betting on QE

The S&P 500 continued its cautious advance in a shortened week due to Thanksgiving. Expect retracement to test the new support level at 3000.

S&P 500

I believe that the latest surge has little do with an improved earnings outlook and is simply a straight bet that Fed balance sheet expansion (QE) will goose stock prices in the short- to medium-term. The chart below highlights the timing of the increase in Fed assets and its effect on the S&P 500 index.

S&P 500 and Fed Total Assets

There is plenty of research on the web pointing to a strong correlation between QE and equity prices. Here are two of the better ones:

Economic Activity

If we look at fundamentals, many of them are headed in the opposite direction.

Bellwether transport stock Fedex (FDX) is testing primary support at 150. Breach would warn of a slow-down in economic activity.

Fedex

Monthly container traffic at the Port of Los Angeles shows a marked year-on-year fall in imports and, to a lesser extent, exports.

Port of Los Angeles: Container Imports & Exports

Rather than boosting local manufacturers, industrial production is falling.

Industrial Production

Production of durable consumer goods is falling even faster, though the October figure may be distorted by the GM strike.

Industrial Production: Durable Consumer Goods

What is clear is that slowing growth in the global economy is unlikely to reverse any time soon.

Market Cap v. Corporate Profits

Yet market capitalization for non-financial stocks is at a precarious 24.7 times profits before tax, second only to the Dotcom bubble. The surge since 2010 coincides with Fed injection of a net $2.0 trillion into financial markets ($4.5T – $2.5T in excess reserves).

Nonfinancial corporations: Market Capitalisation/Profits before tax

The problem, as the Fed unwind showed, is that once central banks embark on this path, it is difficult for them to stop. The Bank of Japan started in the late 1980s — and is still at it.

Bank of Japan: Total Assets

Margin Debt

This chart from Advisor Perspectives compares the S&P 500 to margin debt. The decline since late 2018 appears ominous but November margin debt levels may reflect an up-turn. We will have to keep a weather eye on this.

FINRA Margin Debt & S&P 500 Index

Patience

Patience is required. First, wait for S&P 500 retracement to confirm the breakout. Second, look for an up-turn in November economic indicators, especially employment, to support the bull signal. Failure of economic indicators to confirm the breakout will flag that market risk is elevated and investors should exercise caution.

“If the mind is to emerge unscathed from this relentless struggle with the unforeseen, two qualities are indispensable: first, an intellect that, even in the darkest hour, retains some glimmerings of the inner light which leads to truth; and second, the courage to follow this faint light wherever it may lead.”
~ Carl Von Clausewitz, Vom Kriege (On War) (1780-1831)

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S&P 500: A cautious advance

A monthly chart shows the S&P 500 cautiously advancing after breaking resistance at 3000. Short candle bodies reflect hesitancy but Trend Index troughs above zero remain bullish.

S&P 500

ETF flows reveal risk-averse investors, with outflows from US Equities in the last week and a relatively much larger outflow from Leveraged ETFs. Inflows are mainly into Fixed Income and Inverse.

ETF Flows

Year-to-date flows tell a similar story, with outflows from Equities and into Fixed Income. So where is the money flow into equities coming from?

Twitter: Buybacks

Meanwhile, the Fed has eased up on their balance sheet expansion now that the PBOC is back in the market. But broad money (MZM plus time deposits) continues to spike upwards, warning that the Fed is trying to head off a potential liquidity squeeze. They are not always successful. A similar spike occurred before the last two recessions.

Fed Assets and Broad Money Growth

The personal savings rate is climbing. Far from a positive sign, this warns that personal consumption, the largest contributor to GDP, is likely to fall.

Saving Rate

This is a dangerous market and we urge investors to be cautious.

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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.

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Business confidence sags

Australian business confidence is sagging, according to the latest Roy Morgan poll, signaling the end of the post-election bounce*.

Roy Morgan Poll results October 2019

Source: Roy Morgan Business Single Source, Dec 2010-Oct 2019. Average monthly sample over the last 12 months=912.

  • A decreasing number of businesses (40.7%, down 5.8ppts) expect the Australian economy to have ‘good times’ economically over the next year while 52.4% (up 4.2ppts) expect ‘bad times’;
  • In addition, just 44.1% (down 7ppts) of businesses expect ‘good times’ for the Australian economy over the next five years and 45.9% (up 2.9ppts) now expect ‘bad times’.

RBA interest rate cuts don’t seem to be working.

A similar picture is emerging in the US, where CEO confidence is near recession levels.

CEO Confidence Levels

CEO confidence affects hiring and investment decisions and is an important leading indicator for GDP and earnings growth.

*Hat tip to Macrobusiness.

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