Big Money Turns Bearish – A Safer Market Commentary

Small businesses here in the US are ready to grow and would be doing so if not for two factors they can’t control: labor shortages and trade policy uncertainty. So all the other good news doesn’t really matter unless those barriers fall. There is little reason to think they will.

Stock Market Valuation

Big Money Turns Bearish

The latest survey of big money managers by Barron’s delivered a bullish ratio that hit its lowest level in 20 years. It was far more pessimistic than its all-time low, recorded in 2002. So, how should we interpret this clue? Is it an early-warning sign?

Looking Ahead to Q4 Earnings

It looks like Q3 might be the third straight quarter of declining year-over-year earnings. According to FACTSET, that has not happened since the fourth quarter of 2015. And analysts are forecasting that earnings will repeat this decline in Q4.

Also, the deviation between corporate GAAP earnings and corporate profits is currently at record levels. It is also entirely unsustainable. Either corporate profits will catch up with earnings, or vice-versa. Historically, profits have never caught up with earnings, it is always the other way around. See next two charts:

The Fed

The Fed’s balance sheet normalization (quantitative tightening) lasted about 21 months. Some 40% of this reduction has been reversed in just over two months.

However, reserves have risen only modestly so far.  Not much “bang for the buck”.  See chart below.

Market Cycles

We move in cycles, and all cycles inevitably reach extremes. Then they correct, and opportunity arrives once again. What is the tipping point in any given cycle? No one knows for sure, but what is clear is that a lot of the buying that has driven prices higher is behind us.

Stock Buybacks Deceptively Produce Higher Earnings

Since the late 1990s, the total number of listed companies on the New York Stock Exchange, NASDAQ and Amex has dropped from approximately 8,900 to 4,828 as of November 8, 2019. This is due to M&A activity, fewer companies wishing to go public, and—you guessed it—a record level of corporate share buyback campaigns over the last 10 years. There are simply fewer tradable shares available for you and me to buy.

Market Capitalization of $1T for Two Stocks

Market capitalization is number of shares outstanding for a company times share price.  Apple sits comfortably atop the list with a $1 trillion market cap, followed by Amazon at $872 billion, Google-parent Alphabet at $844 billion, Microsoft at $816 billion.  Since we are a math-based firm consider this math:  For a $1T company to grow at 20% per year they would need to create a NEW company the size of Chevron, Coke, Wells Fargo or Merck every year!  Think about that for a moment.  Historically, it has never happened.  Once a company gets this big it is VERY difficult to continue to see share price appreciation that matches the past due to sheer size.  Anyone expecting to see future growth from Apple, Amazon, Microsoft or Google, like the growth in the past, is arguing against math.  FANG stocks have produced about half of the growth of the Nasdaq and about 30% of the S&P growth for the last 5 years.  What happens when you take that away from future growth?

The combined market cap of Apple and Microsoft is now roughly equal to the Russell 2,000 market cap.

Update on Negative Interest Rate Policy (NIRP)

Thanks to its widespread adoption by the central banks of Europe and Japan, roughly 25% of all outstanding government debt now trades with a negative yield.

This includes half of all European sovereign debt… 85% of Germany’s debt… and as of last week, all of Switzerland’s outstanding debt. That’s right, the entire Swiss government bond market – ranging from maturities of one month all the way out to 50 years – now trades with a negative yield.

Worse, we’re now seeing yields on some European high-yield corporate (or “junk”) bonds begin to dip into negative territory. This is complete and utter madness.

Negative interest rates, along with quantitative easing and other central bank stimulus programs, have helped drive up the prices of many financial assets in recent years.

The costs of these policies were beginning to do just that in Europe… Swiss bank UBS (UBS) said it would start charging a 0.75% fee on cash balances above $2 million this month.

Since then, two other major Swiss banks, Credit Suisse (CS) and PostFinance, have announced similar policies… Credit Suisse started charging business clients with balances above $2 million a 0.75% fee today, in fact.

And Switzerland, where the central bank has used negative interest rates since 2015, isn’t the only country where this is happening…

Denmark’s Jyske Bank, one of the country’s largest banks, will start charging a 0.60% fee in December for customers with at least $1.1 million deposited. It will be the third Danish bank to introduce negative interest rates. And Italian bank UniCredit said it will do something similar starting in 2020.

With NIRP in place, and with the European Central Bank continuing cuts into negative territory as recently as September, it’s been much harder for banks to make a profit on loans and mortgages…

And these banks are now passing on some of the costs to their wealthiest clients.

It just shows what we’ve long warned… and what’s obvious to folks who think it’s a good idea to balance their checkbooks… If you owe money, NIRP might sound fun in the short term, but this “perversion of capitalism” risks destroying the banking system.

In case you haven’t noticed, our negative-rate-loving overseas friends are having a change of heart. The Bank of Japan and European Central Bank are plainly looking for an exit from NIRP as their commercial banking sectors find it increasingly impossible to turn a profit.

Bond Market Bubble

More than once I have called bonds “the biggest bubble in history,” due primarily to the sheer size of the problem.

For a moment in August – the hottest month of the global bond bubble – there was $17 trillion worth of negative-yielding debt in the world, nearly all of it Japanese and European sovereign debt. As insane as it sounds, you could even find some negative-yielding European high-yield (or “junk”) debt.

It’s no surprise then that the bloom is coming off that rose at both ends of the credit spectrum.

Yesterday, a Barron’s article from Randall Forsyth announced, “The Bubble Is Deflating for 100-Year Bonds.” The article specifically mentioned Austria’s 100-year bonds. Economist Julian Brigden called the Austrian bonds the “poster child of the bond bubble.”

When the global bond bubble peaked in August, Austria’s 100-year bonds hit 210 euros – more than double face value. That price pushed the yield down to just 0.61%. The bonds had been issued in two tranches – one a couple years ago at a yield of 2.1%, and another last June at a yield of 1.17%.

I can’t imagine lending even an advanced Western economy so much as a penny for 100 years. What if Austria doesn’t exist 100 years from now?

The iShares 20+ Year Treasury Bond Fund (TLT) – an exchange-traded fund (“ETF”) that holds a basket of long-term U.S. Treasury bonds – has fallen 7% from its August peak… even as the Federal Reserve dropped interest rates twice in that stretch, by a total of 0.5%.

That $17 trillion of negative-yielding debt has fallen to a mere $12.5 trillion, according to data compiled by Bloomberg.

This is happening even though the European Central Bank (“ECB”) is buying back 20 billion euros worth of bonds each month.

Central bank intervention clearly has its limits… Every time I say that, somebody says no, the Fed is obviously able to keep rates low and stock prices high, as if it’s so obvious. Yes, obviously.

For now…

This morning, Bloomberg reported that Black Rock’s IHYG – the largest ETF that owns European junk bonds – has seen 1.1 billion euros in outflows over the past 14 weeks, with money leaving the ETF in 13 of those weeks. Even with the recent retreat, European junk-bond ETFs have seen 5.9 billion euros of new money year to date, more than any year since 2010.

Barron’s reported yesterday that November is gearing up to be the second month in a row to see a drop in the face value of US bonds in the widely followed ICE BofA/ML U.S. BBB Corporate Index.

BBB is the lowest investment-grade rating. As we’ve reported several times in the Digest over the past year, more BBB debt is outstanding today than any other rating level of investment-grade credit. That has concerned us for some time.

Debt

Treasury Secretary Powell warned that the federal budget is on “an unsustainable path,” and with the national debt now topping $23T, it could make it difficult for the economy to recover from future market downturns. According to the Treasury Department, the federal deficit reached $134B in October – the first month of fiscal 2020.

Comments from Ned Davis Research’s (NDR’s) Chief Global Macro Strategist Joe Kalish.

I really like the way he thinks. It’s balanced.

Here are some general takeaways:

• Joe believes there’s no sign of U.S. recession ahead. Of his 10 favorite recession indicators, only one—CEO Confidence—is flashing a warning. According to Joe, we are not in a recession, but if there is a downward shock to the economy we are not in great shape to deal with it.
• He puts less weight on the inverted yield curve (which I disagree with) and believes the market is pricing in one more rate cut, with a 25% chance of recession in the next 12 months. If recession happens, rates go to zero.
• Inflation is ticking higher and has surprised to the upside, but it will take a prolonged period of higher inflation to move the Fed. (I agree.) Keep a close eye on this.
• He believes the Fed is on hold for six to 12 months. (I agree.)
• There is a good chance the long-term bond market rally (which began in the early 1980’s) has ended. He suggested, “Maybe we are done.” (I think we need to start thinking about that dynamic.)
• Expect low economic growth. Perhaps 1.9% GDP next year. (I agree.)
• Wages are pressuring corporate profit margins. This is a concern for earnings. (Agreed, especially given how far prices are above trend.)
• He suggested we pay close attention to investor sentiment, as it has done a good job at calling the swings in the market this year. (Investor sentiment is currently signaling “Extreme Optimism.” This suggests caution.)
• Growth in China is slowing and will remain slow. They had been the globe’s economic engine. This is not good news, particularly for many emerging market (EM) countries. EM does not do well when there is no global engine of growth. And if we (that aged population) don’t want to buy stuff, the EM won’t grow. Recall that much of what we buy is manufactured in EM countries. (I agree.)

Negative Interest Rates:  The New Norm?

• The world has gone mad when investors are willing to lend money knowing they will get back less than they give.
• This is because central banks are pushing more money on investors than the investors can spend wisely.
• As a result, financial asset prices have soared and expected returns plummeted while economic growth and inflation remain sluggish.
• Speculative companies can sell stock without having a viable path to profitability because cash-flush investors are desperate for places to invest.
• At the same time, huge and growing government deficits seem likely to drive interest rates higher, devastating highly-leveraged borrowers.
• Pension and healthcare liabilities are coming due when assets to pay them do not exist. This will produce either benefit cuts, tax increases or money printing.
• Money printing is the easiest path because it is the most hidden way to create a wealth transfer. The risk is it will threaten the viability of major world currencies.

Good News for the Markets

• A ratio of cyclical to defensive stocks has broken out to a 5-year high for the first time in months.
• Equity flows show investors betting on a rebound in global growth.

Bad New for the Markets

• The October Cass Freight index fell 5.9% year over year which is the 11th straight month of y/o/y declines. Cass Freight repeated what they’ve said for the past 5 months that “the shipments index has gone from ‘warning of a potential slowdown’ to ‘signaling an economic contraction.’” Moreover, “Several key modes, and key segments of modes, are suffering material increases in the rates of decline, signaling the contraction is getting worse.” To continue, “The weakness in spot market pricing for many transportation services, especially trucking, along with recent airfreight and railroad volume trends, heightens our concerns about the economy.”
• We are concerned about the increasingly severe declines in international airfreight volumes (especially in Asia) and the ongoing swoon in railroad volumes, especially in auto and building materials.
• We see the weakness in spot market pricing for transportation services, especially in trucking, as consistent with and a confirmation of the negative trend in the Cass Shipments Index.
• As volumes of chemical shipments have lost momentum, our concerns of the global slowdown spreading to the US increase…The trade war looks as if it has reached a ‘point of no return’ from an economic perspective, as the rates of decline are accelerating. Again, the underline is theirs (Cass Freight report).

Energy

Oil demand growth is expected to slow sharply over the next decade.

US crude oil production hit another record high.

Market Data

• Since early October, holders of the S&P 500 have not had to suffer back-to-back losses. It’s been 25 sessions since the S&P faced losses on consecutive days, its longest streak since 2012.
• For the first time in several months, two technical warning signs triggered on the Nasdaq exchange on Wednesday. Then they triggered again on Thursday.
• Breadth lagging. The S&P 500 has risen over the past 7 days, but 6 of them saw more declining than advancing issues on the NYSE. That last happened in 1999.
• Over the past week, there have been an increasing number of signs of a “split” market, with a large number of winning and losing stocks. That has caused the HiLo Logic Index to spike for the NYSE and, especially, the Nasdaq.