S&P 500 bubble risk

S&P 500 valuations are higher than the 1929 (Black Friday) Wall Street crash and the October 1987 (Black Monday) crash. The Dotcom bubble is the only time in the last 120 years that the ratio between Price and highest trailing earnings (PEmax) was higher.

S&P 500 PE of Highest Trailing Earnings (PEmax)

PEmax eliminates distortions in the price/earnings multiple caused by sharp falls in earnings during recessions. The current multiple of 26.93 compares the index at December 31, 2020 to highest trailing earnings of 139.47 (for the 12 months ended December 2019) rather than expected earnings of 95.22 for the 12 months ended December 2020. Highest trailing earnings in such a case are a far better reflection of future earnings potential than more recent results.

Payback model

Using our payback valuation model, we arrive at a fair value estimate of 2331 for the S&P 500 based on:

  • highest trailing earnings of 139.47;
  • a long-term growth rate of 5% (the highest nominal GDP growth achieved in recent years was 6.0% in Q2 2018); and
  • a payback period of 12 years — normally only used for stable companies with a strong defensive market position.

The LT growth rate required to match the current index value (3851) is 12.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was in double-digits.

Nominal GDP & Inflation (CPI)

Conclusion

Stock prices are in a bubble of epic proportions. Risk of a major collapse remains elevated.

S&P 500: Leaders no longer leading

Daily new cases of COVID-19 continue to spike upwards, warning of further shutdowns as medical facilities are overrun.

USA: Daily COVID-19 cases

Payrolls

The latest labor report disappointed, especially as the November survey came before the latest round of layoffs after states imposed tighter restrictions.

Payroll growth flattened, leaving total payroll down 5.99% compared to November last year.

Payrolls Annual Change

Hours worked are slightly more encouraging, down 4.68% on an annual basis, compared to -2.9% change in real GDP.

Real GDP & Hours Worked

Vaccines

Encouraging news on the vaccine front but “when you hear the cavalry is coming to your rescue, you don’t stop shooting. You redouble your efforts.” (Dr Anthony Fauci)

Now This News

Stocks

Progress in manufacturing vaccines that will soon be widely available has buoyed stocks despite the dismal economic outlook. The S&P 500 made new highs, assisted by hopes of further stimulus and ultra-low interest rates. The large megaphone pattern is a poor indicator of future direction but does flag unusual volatility.

S&P 500 SPDR (SPY)

Growth in the big five technology stocks has slowed in recent months, with only Alphabet (GOOGL) breaking above its September high. Too early to tell, but failure of market leaders to make new highs is typical of the late stages of a bull market.

AAPL, AMZN, GOOGL, MSFT, FB

Conclusion

Vaccines should succeed in flattening the third wave and suppressing future outbreaks but are unlikely to succeed in restoring the economy to normalcy.

Federal debt is at a record 123% of GDP and growing. Further stimulus is required to support the still-fragile recovery.

The Fed will continue to expand its balance sheet to support Treasury issuance.

Ultra-low interest rates are likely to stay for a number of years.

If massive federal debt, QE and ultra-low interest rates does not cause a spike in inflation, that will encourage authorities to push the envelope even further (we fear this would have disastrous consequences).

Unemployment is expected to remain high and GDP growth likely to remain low.

Zombie corporations and commercial real estate with unsustainable debt levels will continue to be a drag on economic growth.

Growth stocks are expected to remain overpriced relative to current and future earnings.

Bearish divergence warns of tech stock retracement

The US recorded more than 75,000 new COVID19 cases on July 16th. The CCP must be smiling behind their masks after successfully containing last month’s outbreak in Beijing.

COVID19 Daily New Cases

Source JHU CSSE

Technology stocks have screamed upwards despite the chaos, but bearish divergence on Twiggs Money Flow now warns of selling pressure. Expect retracement to test support at 2650 on the Dow Jones US Technology Index.

DJ US Technology Index

Dow Jones Banks Index is a more realistic representation of the broader US economy. The weak rally has fizzled out, with a Money Flow peak at zero now warning of strong selling pressure. Breach of short-term support at 320 would signal another test of primary support at 270/280.

DJ US Banks Index

Government support can only cushion the impact of a massive surge in unemployment for a limited time. Then we will witness the full extent of the damage.

Continued unemployment claims jumped to 17.355 million on July 4th, up by 840,000 from a week earlier. Judging by the rising virus count, further increases are likely.

Continuous Claims

But that is only the tip of the iceberg.

The latest Department of Labor update shows 32 million people claimed unemployment insurance benefits in all programs for the week ending June 27.

Department of Labor: PERSONS CLAIMING UI BENEFITS IN ALL PROGRAMS

…..21% of the 152.4 million non-farm workforce in February 2020.

Pandemic Unemployment Assistance (PUA) under the CARES Act, signed into law on March 27, 2020 provides benefits to those individuals “not eligible for regular unemployment compensation or extended benefits under state or Federal law or pandemic emergency unemployment compensation (PEUC), including those who have exhausted all rights to such benefits.”

The S&P 500 is inching upwards, reflecting the tug-of-war between technology stocks and the broader market. We expect retracement of the Technology Index to cause another test of support at 3000 (on the S&P 500).

S&P 500

Nasdaq: Devil take the hindmost

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.

Nasdaq 100

Even retail sales (ex food) have recovered sharply, from -15.3% in April to -1.4% in May (annual % gain).

Retail Sales (ex Food)

Light vehicle sales are more sluggish but June sales of 13.05 million are still a sizable bounce.

Light Vehicle Sales

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.

COVID19 Daily Cases

Source JHU CSSE

Let’s look at where the money is coming from.

Federal Debt

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.

Crude oil: Opportunities and value traps

On the weekend we wrote that the bottom had fallen out of the oil market after Nymex crude broke support at $20 per barrel.

Now, the previously unimaginable has occurred, with Nymex Light Crude falling below zero for the first time in history, closing at -$13.10 per barrel with reports of intra-day lows at -$37.63.

WTI Crude

From The Age:

“Traders are still paying $US20.43 for a barrel of US oil to be delivered in June, which analysts consider to be closer to the “true” price of oil. Crude to be delivered next month, meanwhile, is running up against a stark problem: traders are running out of places to keep it, with storage tanks close to full amid a collapse in demand as factories, automobiles and airplanes sit idled around the world.

Tanks at a key energy hub in Oklahoma could hit their limits within three weeks, according to Chris Midgley, head of analytics at S&P Global Platts. Because of that, traders are willing to pay others to take that oil for delivery in May off their hands, so long as they also take the burden of figuring out where to keep it.”

Cushing Storage

Brent Crude is trading at $25.57 per barrel but a Trend Index peak deep below zero warns of similar strong selling pressure.

Brent Crude

Outlook

Crude oil production is still in a long-term up-trend. Low prices may present opportunities to buy cyclical stocks at historically low prices.

IEA Oil Production

The Oil & Gas sector has plunged as expected.

DJ US Oil & Gas

Oil infrastructure is also suffering from low activity levels.

DJ US Pipelines

Energy-consuming industries, however, may benefit from lower oil prices.

EIA: Industrial Sectors

Transport

Transport is the biggest consumer of crude oil products.

IEA Oil Sectors

If we break usage down by fuel types, the largest is diesel/gas, followed closely by motor gasoline, with jet kerosene significantly smaller.

Products from Crude

Airlines which have suffered from a massive drop in air travel.

DJ US Airlines

While delivery services (formerly air freight) are suffering from the collapse of global trade.

DJ US Delivery Services

So is marine transport.

DJ US Marine Transport
But trucking is holding up well.

DJ US Trucking

Construction Materials

Crude oil runs a distant second to coal as the chief energy source for cement production.

IEA Cement - Energy Usage

But the industry is a heavy transport user and should benefit from lower oil prices.

DJ US Construction Materials

Mining

Mining is also likely to benefit from lower extraction and transport costs.

DJ US Basic Materials

Forestry & Paper

Forestry is another heavy fuel user.

DJ US Forestry & Paper

Chemicals & Plastics

Basic chemicals (including fertilizers) are the largest industrial consumer of crude oil.

DJ US Chemicals

Specialty chemicals are also largely oil-based.

DJ US Specialty Chemicals

Aerospace & Automobiles

Aerospace, laid low by problems at Boeing (BA), has been floored by a massive downturn in the airline industry and will take a long time to recover.

DJ US Aerospace

Automobiles have so far stood up well because of stellar performance from the likes of Tesla (TSLA).

DJ US Automobiles

But the sting is in the tail. Light vehicle sales have plummeted.

Light Vehicle Sales

Low vehicle sales and less travel also means lower tire sales.

DJ US Tires

Oil Producers in Affected Regions

The IEA graph below shows producing regions that are uneconomic at varying prices/barrel (x-axis). If we take $25/barrel as the average over the next two years, North American producers would suffer the most, followed by Asia-Pacific and Latin America.

Uneconomic Crude Production by Country

Middle-Eastern producers enjoy the lowest extraction costs and are mostly still profitable at lower prices.

Avoiding Value Traps

Value opportunities abound in industries that are badly affected by the economic contraction and falling crude prices — as well as by those industries that stand to benefit from low oil prices. Some affected industries, however, are going to struggle to survive without state assistance.

The problem with value stocks is that, although they may seem cheap, prices can fall a lot further. That is why we use both technical and fundamental analysis to evaluate opportunities.

There are many stocks that are trading well below our assessment of fair value at present but we will not buy until the technical outlook turns bullish. It takes plenty of patience. But helps to avoid value traps.

The stock market remains an exceptionally efficient mechanism
for the transfer of wealth from the impatient to the patient.

~ Warren Buffett

Dow: Not so fast WSJ

We were surprised to receive this from The Wall Street Journal this morning:

Markets Alert

Dow Industrials Rally, Ending Bear Market

A new bull market has begun. The Dow Jones Industrial Average has rallied more than 20% since hitting a low three days ago, ending the shortest bear market ever.

Dow Jones Industrial Average

That is news to us. A 20% reversal is a quick rule of thumb used by brokers. It is not part of Dow Theory. To suggest that we are now in a bull market is ludicrous.

Dow Theory tracks secondary movements in the index which last from ten to sixty days (Nelson, 1903). Only if the secondary movement forms a higher trough followed by a higher peak does that signal reversal to an up-trend. And the same pattern has to occur on the Transport Average to confirm the change.

A three-day rally is a normal part of a bear market and, with volatility near record highs, it is likely that some rallies are going to reach 20 per cent.

Dow Jones Industrial Average

Bear markets are more volatile than bull markets. You can see this from the volatility spikes above in 1991, 2000-2003, 2008, and 2020. Stocks go up on the escalator and down in the elevator.

According to data from S&P Dow Jones Indices, most days with the biggest gains occur in a bear market. Eighteen of the top twenty biggest daily % gains on the Dow occurred in a bear market. Only two (marked in blue) were in a bull market.

Dow Jones Industrial Average

The largest gains in the 1930s bear market were as high as 15% in a single day!

Interesting that eighteen of the top twenty biggest daily % losses on the Dow also occurred in a bear market (red).

Dow Jones Industrial Average

That is because volatility is a lot higher in bear markets than in bull markets.

So expect big moves in both directions.

ASX catches a virus

It’s not a pretty sight. The ASX 200 fell close to 10% in a single week. The severity of the fall suggests that sellers are committed and buyers are scarce. Breach of support at 6400 is highly likely and would offer a target of 5400 (a 25% draw-down).

ASX 200

A V-shaped recovery is unlikely.

The ASX 300 Metals & Mining index broke primary support at 4100, completing a double-top reversal with a target of 3400.

ASX 300 Metals & Mining

The Aussie Dollar is also getting smashed, headed for a target of 64 cents after breaking support at 67.

AUDUSD

The ASX 300 Banks index is headed for a test of 7250/7300. Breach is likely and would offer a test of 6750.

ASX 300 Banks

Our conclusion hasn’t changed from last week:

Threats continue to outweigh opportunities in our view and we retain a bearish view on the global and domestic economies. Our focus remains on defensive and contra-cyclical (gold) stocks.

A worm in the Apple

Apple Inc (AAPL) enjoyed stellar growth over the past 12 months, jumping more than 50%.

Apple Inc (AAPL)

But is that due to solid operating performance or window-dressing, with almost $140 billion of stock buybacks in the last two years?

Apple Inc (AAPL)

Free cash flow — operating cash flow less stock compensation and investment in plant and equipment — has been falling since 2015.

Apple Inc (AAPL)

And the company has depleted its cash reserves over the last two years, to fund stock buybacks. The graph below depicts the change in Apple’s net cash position (cash plus marketable securities less debt).

Apple Inc (AAPL)

So why the management enthusiasm for stock buybacks?

Is the stock a good investment? No. Free cash flow per share has barely lifted since 2015 despite $237.5 billion used to repurchase 1144 million shares.

Apple Inc (AAPL)

Apple have returned surplus cash to stockholders in the most tax-efficient way possible, by buying back stock rather than paying dividends. The added bonus is the reduced share count which gooses up earnings per share growth and return on equity.

Apple Inc (AAPL)

Investors in turn get excited and run up earnings multiples. The current price/free cash flow ratio of 23.2 exceeds that of the heady growth days up to 2015.

Apple Inc (AAPL)

The stock keeps climbing, supported by buybacks and rosy EPS projections. The problem for Apple is when they run out of cash, or exceed reasonable debt levels, then the band will stop playing and those heady multiples are likely to come crashing down to earth.

It’s not only Apple that’s doing this. The entire S&P 500 is distributing more by way of buybacks and dividends than it makes in earnings, eating into reserves meant to fund new investment.

S&P 500 Buybacks & Dividends

The result is likely to be low growth and even more precarious earnings multiples.

The S&P 500 and Plan B

The S&P 500 penetrated its rising trendline, warning of a re-test of support at 3000. But selling pressure on the Trend Index appears to be secondary.

S&P 500

Transport bellwether Fedex retreated below long-term support at 150 on the monthly chart — on fears of a slow-down in international trade. Follow-through below 140 would strengthen the bear signal, offering a target of 100. The bear-trend warns that economic activity is contracting.

Fedex

Brent crude dropped below $60/barrel on fears of a global slow-down. Expect a test of primary support at 50.

Brent Crude

Dow Jones – UBS Commodity Index broke primary support at 76 on the monthly chart, also anticipating a global slow-down.

DJ-UBS Commodity Index

South Korea’s KOSPI Index is a good barometer for global trade. Expect a re-test of primary support at 250.

KOSPI

While Dr Copper, another useful barometer, warns that the patient (the global economy) is in need of medical assistance.

Copper (S1)

The Fed can keep pumping Dollars into financial markets but at some point, the patient is going to stop responding. In which case you had better have a Plan B.