Tag: S&P 500

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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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“A hell of a mess in every direction” – Paul Volcker

The S&P 500 strengthened on Friday, closing at a new high of 3067. Volatility (21-day) crossed below 1%, signaling that risk is easing. Money Flow strengthened; a trough above zero suggests another advance. The medium-term target is 3250.

S&P 500

Dow Jones Industrial Average is weaker, with Money Flow having dipped below zero, but breakout above 27,400 would signal another advance. Target for the advance is 29,400.

DJ Industrial Average

“We’re in a hell of a mess in every direction,” is how Paul Volcker, the former Fed Chairman describes it.

Equities are making new highs, while the Fed cuts interest rates. Donald Trump is effectively dictating monetary policy. This could only end badly.

Unemployment and initial jobless claims are near record lows.

Unemployment and Jobless Claims

Inflationary pressures are moderate, with average wage rates growing between 3.0% and 3.5% (production and non-supervisory employees).

Average Wage Rates

GDP growth is slowing, however, and likely to fall further according to our advance indicator (estimated hours worked).

Real GDP and Estimated Hours Worked

Payroll growth is also slowing. While this has been explained as a result of record low unemployment (new employees may be hard to find) it is likely that rising uncertainty has played a big part.

Payroll Growth and Fed Funds Rate

The 3-month TMO of Non-Farm Payrolls kicked up to 0.58%, above the amber risk level of 0.5%.

Payroll Recession Warnings

With 73.5% of stocks having reported for Q3, the price-earnings ratio remains elevated. A reading above 20 warns that stocks are over-priced, especially because expected earnings growth is low.

P/E of Highest Earnings

If we project nominal GDP growth (including inflation) at 3.5% and buyback yields at 3.0% (Q2: 3.26%) that gives us anticipated growth of 6.5%. Add dividend yield of 2.0% (Q2: 1.96%) and we can expect stocks to yield a total return (dividends plus growth) of 8.5%.

Nominal GDP and Estimated Hours Worked * Average wage rate

But that assumes that current price-earnings multiples are maintained. Any downward revision, from earnings disappointments, would most likely result in a negative return.

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If you thought the sell-off was over

Flush with new money, the S&P 500 broke resistance at 3030 this week to set a new high. Declining Money Flow,  however, warns of selling pressure. Expect retracement to test the new support level at 3000. Breach would signal another test of support at the recent lows of 2830 to 2860.

S&P 500

Selling pressure on blue chips is a lot stronger, with Money Flow on Dow Jones Industrial Average dipping below zero. Reversal below 26800 would warn of a correction.

DJ Industrial Average

The investment outlook remains Risk-Off, with last week’s ETF investment flows heavily weighted towards bonds.

ETF Flows W/E 25 October 2019

Year-to-date flows reflect a similar picture, with fixed income inflows outweighing the much larger equity ETF market.

ETF Flows YTD 25 October 2019

Supply & Demand

We normally gauge whether stocks are under- or over-priced by comparing earnings to market capitalization, whether in the form of P/E or Robert Shiller’s inflation-adjusted CAPE. But the Fed has shown that stock prices are really a function of supply and demand.

Investment demand skyrocketed in the last decade, with QE driving down bond yields and forcing a large flow of investment funds into equities, searching for yield. The chart below shows estimated market value of publicly-held equity of U.S. domestic (financial and non-financial) corporations and the market value of closely-held equity.

Stock Market Capitalization

Supply of equities in the same period experienced limited growth because of three related factors. First, GDP growth slowed (partly because of QE). Corporate profit growth then slowed as a result. That left management little option. With limited investment opportunities, they returned capital to investors by way of stock buybacks. That restricted the supply of new equities for investment while demand was soaring.

The result was an inevitable surge in prices relative to earnings.

The chart below compares market cap (above) to corporate profits before tax. I have circled 1987 for comparison.

Market Cap/Corporate Profits Before Tax

We remain cautious. Stocks are highly-priced compared to earnings.

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Don’t fight the Fed

The Fed is again expanding its balance sheet in response to the recent interest rate spike in repo markets. The effect is the same as QE: the Fed is creating new money (reserve balances) and pumping this into financial markets.

Fed Assets and Excess Reserves on Deposit

Why is this happening?

The US government is issuing record amounts of new Treasuries to cover Donald Trump’s record deficit.

Fed Assets and Excess Reserves on Deposit

According to Luke Gromen: “US govt is on pace to issue $11.3T in USTs on a gross basis in F19.”

Gregor Samsa at Macro-Monitor sums up the problem with the following diagram.

Macro Monitor - US Treasury Supply Demand Curves

If supply-demand curves do your head in, the above graph simply says that when you suppress interest rates, there will be a surplus of Treasuries. The yield is less attractive and demand from investors will fall.

Not only do we not have enough domestic buyers, foreign (Chinese?) purchases of US Treasuries are drying up. Primary dealers are required to take up the shortfall on any new issues. The recent price spike tells us they don’t want them.

10-Year Treasury Yields

So it’s all hands to the pump at the Fed. We are likely to see further balance sheet expansion in the months ahead, driving down Treasury yields and the Dollar.

And lifting equities.

The flush of new money is likely to suppress volatility.

S&P 500

And drive equities even further out along the risk curve. Breakout above 3025 would signal another advance.

S&P 500

We remain cautious. Stocks are highly-priced compared to earnings.

Corporate profits are falling in real terms.

Real Corporate Profits

And rising personal savings warn that consumption is likely to fall.

Personal Savings

It all depends on how much money the Fed will print.

Fed Assets and Broad Money

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S&P 500 bearish as Fed forced to expand

Juliet Declercq at JDI Research maintains that the normal business cycle has been replaced by a liquidity cycle, where market conditions are dictated by the ebb and flow of money from central banks. Risk will remain elevated for as long as natural price discovery is suppressed and risk-reward decisions are made in an artificial environment controlled by central bankers.

The Fed is again expanding its balance sheet (commonly known as QE) in response to the recent interest rate spike in repo markets.

Fed Assets and Excess Reserves on Deposit

Jeff Snider from Alhambra Partners maintains that the Dollar shortage has been signaled for some time. First by an inverted yield curve in Eurodollar futures, well ahead of in US Treasuries. Then in March 2019, the effective Fed Funds Rate (EFFR) stepped above the interest rate paid by the Fed on excess reserves (deposited by commercial banks at the Fed). According to Jeff, this showed that primary dealers were willing to pay a premium for liquidity. The likely explanation is that they anticipated a severe contraction in inter-bank markets, similar to 2008.

Effective Fed Funds Rate - Interest on Excess Reserves

When the spread spiked upwards in late September, the Fed finally woke up and started pumping money into the system, expanding their balance sheet by over $200 billion in the past few weeks.

Fed balance sheet expansion is normally welcomed by financial markets but broad money (MZM plus time deposits) is surging. Far from a reassuring sign, a similar surge occurred ahead of the last two recessions.

Broad Money

Bearish divergence between the S&P 500 and Trend Index on the daily chart warns of secondary selling pressure. An engulfing candle closed below 3000, strengthening the bear signal. Expect a test of secondary support at 2840.

S&P 500

Volatility (21-day) remains elevated. Volatility spikes at close to, or above, 2% normally accompany market down-turns signaled by arrows on the index chart. Note how rising troughs precede most down-turns and culminate in a trough above 1%. We are not there yet but Volatility above 1% is an amber-level warning.

S&P 500 Volatility

CEO Confidence is falling and normally precedes a fall in the S&P 500 index. What is more concerning is that confidence is at the same lows (right-hand scale) seen in 2001 and 2009.

CEO Confidence

Exercise caution. Probability of a down-turn is high and we maintain a reduced 34% exposure to international equities.

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S&P 500 and Europe: New deal or a false dawn?

Donald Trump and is making noises about an interim trade deal with the CCP, while Boris Johnson appears to be making progress on a Brexit deal with Ireland premier Leo Varadkar.

Trump’s announcement is little more than a sham, intended to goose financial markets, with nothing yet committed to writing:

“Trump said the deal would take three to five weeks to write and could possibly be wrapped up and signed by the middle of November….”

…what could possibly go wrong?

The economy continues to tick along steadily, with unemployment and initial jobless claims near record lows.

Unemployment & Initial Jobless Claims

But high levels of uncertainty are likely to create a drag on consumer spending and stock earnings.

At the outset of Donal Trump’s presidency, value investor Seth Klarman, who runs the $30 billion Baupost Group hedge fund, predicted the impact that Trump would have on financial markets:

“The erratic tendencies and overconfidence in his own wisdom and judgment that Donald Trump has demonstrated to date are inconsistent with strong leadership and sound decision-making…..

The big picture for investors is this: Trump is high volatility, and investors generally abhor volatility and shun uncertainty…. Not only is Trump shockingly unpredictable, he’s apparently deliberately so; he says it’s part of his plan.”

In his letter, Mr Klarman warned: “If things go wrong, we could find ourselves at the beginning of a lengthy decline in dollar hegemony, a rapid rise in interest rates and inflation, and global angst.”

While not entirely prescient — we have low interest rates and low inflation — Klarman was right about the decline in dollar hegemony and the rise in global angst.

Markets are clearly in risk-off mode.

US Equity ETFs recorded a net outflow of $824m this week, compared to a net inflow of $2,104m into US Fixed Income. Year-to-date flows present a similar picture, with a 3.3% inflow into US Equity compared to 13.9% into US Fixed Income (Source: ETF.com).

ETF Flows YTD

Long tails on the S&P 500 candles indicate buying support. Expect another test of our long-term target at 3000. Volatility remains above 1%, however, indicating elevated risk. Breach of 2800 is unlikely at present but would offer a target of 2400.

S&P 500

According to Factset, the S&P 500 is likely to report a third quarter this year with a year-on-year decline in earnings.

S&P 500 Earnings

The Nasdaq 100 paints a similar picture, with another test of 8000 likely.

Nasdaq 100

It is becoming impossible to justify current heady earnings multiples when reported earnings are declining.

Europe

If Johnson’s “free trade zone” for Northern Ireland can break the Brexit impasse, then there may be room for optimism over the future UK – EU relationship.

Europe seems to be stirring. Trailing a distant third, to North America and Asia in terms of investment performance, there are some early encouraging signs. A higher trough indicates buying pressure and breakout above 400 on DJ Stoxx Euro 600 would signal a primary advance.

DJ Euro Stoxx 600

The Footsie shows similar early signs of a potential recovery. A higher trough on the trend Index indicates buying pressure. Breakout above 7600 would signal a primary advance.

FTSE 100

Let us hope that this is not a false dawn and the UK and EU are able to resolve their differences.

For the present, our outlook for the global economy remains bearish and equity exposure for International Growth is a low 34% of portfolio value.

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S&P 500 survives but risk is elevated

Our recession indicator, a 3-month TMO of seasonally adjusted non-farm payrolls, ticked up slightly to 0.52%. This reflects a slight improvement in monthly employment data but the indicator remains precariously close to the amber (high risk) warning level of 0.50%. The red warning level of 0.30% would signal extreme risk of recession.

Non-Farm Payrolls Recession Indicator

During the week we discussed the high cost of uncertainty and how this impacts on business investment and consumer spending. Slowing growth in hours worked suggests that real GDP growth is likely to slow towards an annual rate of 1.0%. This would obviously be a drag on stock earnings.

Real GDP and Hours Worked

The S&P 500 retreated from resistance at 3000 but a long tail on this week’s candle indicates buying support. Another test of 3000 is likely. Breach of 2800 is unlikely at present but would signal a reversal with a target of 2400.

S&P 500

21-Day Volatility remains high and the recent trough above 1.0% warns of elevated risk.

S&P 500 21-Day Volatility

The plunge on 10-Year Treasury Yields, testing support at 1.5%, also warns of a risk-off environment.

10-Year Treasury Yields

On the global stage, low manufacturing purchasing managers index (PMI)  warn that Europe is at risk of recession.  DJ Euro Stoxx 600 is retracing to test support at 360/366. Breach would signal a primary down-trend.

DJ Euro Stoxx 600

The Footsie is similarly testing support at 7000.

FTSE 100

Nymex Crude is heading for a test of support at $50/barrel. Trend Index peaks below zero warn of selling pressure. Breach of support would signal a primary down-trend — suggesting a contraction in global demand.

Nymex Light Crude

The outlook for the global economy is bearish and we have reduced our equity exposure for International Growth to 34% of portfolio value.

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The high cost of uncertainty

High levels of uncertainty in international trade, geopolitical outlook, and domestic politics in the USA are likely to have a domino effect on business and consumer confidence.

Business is likely to postpone or curtail new investment decisions. This is already evident in a down-turn in new capital formation, along with GDP growth, in the first half of the calendar year.

New Capital Formation

A similar picture is emerging in construction spending.

Construction/GDP

CEO confidence levels are way down.

CEO Confidence Levels

A slow-down in business investment in turn impacts on employment, causing a decline in payroll growth and average weekly hours worked.

Non-farm Payroll Growth and Weekly Hours Worked

Which in turn impacts on consumer sentiment as employees’ anticipation of future earnings declines.

Consumer Sentiment

The feedback loop will be completed if consumption falls. Retail sales dipped sharply in late 2018 but are keeping their head above water.

Retail Sales

And purchases of durables, like light motor vehicles, have leveled off but there is no significant decline so far.

Light Vehicle Sales (Units)

New housing starts and building permits even kicked up in August in response to lower interest rates.

Housing Starts

Consumers have, so far, continued spending but a down-turn in the stock market would weigh heavily on sentiment and consumption.

The S&P 500 broke its rising trendline, indicating a correction. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure and a test of support at 2800. Breach of support is by no means certain but would offer a target of 2400.

S&P 500

We have reduced our equity exposure for International Growth to 34% of portfolio value because of our bearish outlook for the global economy.

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Fedex breaks support

Bellwether transport stock Fedex (FDX) broke long-term support at 150, warning of a decline with a long-term target of 100. A down-trend on Fedex has bearish implications for the broader economy, signaling that activity is declining.

Fedex

We have been here before: November 2007 – Fedex Warns of Worse to Come.

A down-turn in durable goods orders (adjusted for inflation) reinforces our bearish outlook.

Durable Goods Orders

The S&P 500 is retreating from resistance at 3000. Expect a test of support at 2800. Breach remains unlikely but would signal a reversal with a target of 2400.

S&P 500

With year-on-year earnings growth projected at a low 2.1% for the third quarter, the forward price-earnings ratio remains high at 18.97 times forecast earnings. A rough rule-of-thumb:

  • below 15 is a buy signal; and
  • above 20 is a sell signal.

But when long-term growth prospects are low, then both levels should be adjusted downward.

S&P 500 Forward PE

On the global front, crude has recovered from the attack on Saudi Arabia. Follow-trough below $55/barrel would signal another test of long-term support at $50. Trend Index peaks below zero warn of selling pressure.

Nymex Light Crude

DJ-UBS Commodity Index likewise displays Trend Index peaks below zero. Expect another test of support at 76. Breach would signal a (primary) decline.

DJ-UBS Commodities Index

The outlook for commodities — and the global economy — remains bearish.

We have reduced our equity exposure for International Growth to 36% of portfolio value because of our bearish outlook on the global economy.

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