Earnings for S&P 500 companies are projected to be flat or negative from the same quarter last year. Even with the slowest growth in 3 years, stocks have been ticking to new highs.

 

We Even Track… Full Moons?

For those observing Tuesday’s Buck Moon (full moon in July), it hasn’t been such a great sign for stocks. After all 5 full moons in July over the past 20 years, if the S&P was at or near a high, it fell over the next 1 or 2 months.  Actually, it is more about the date and time of year in earnings season than anything about the moon!

 

Complacency

This reliance on the Fed has led to a marked rise in “complacency” by investors in recent weeks despite a burgeoning list of issues.As shown in the chart below, the ratio of the “volatility index,” as compared to the S&P 500 index, is near its lowest level on record going back to 1995.

 

  

 

(Of course, exceedingly low levels of volatility relative to the S&P 500 have historically denoted periods of price corrections or worse.)

The following considerations fly in the face of the high level of complacency ruling the financial markets:

  • The global economy is slowing.
  • Growth in European economies is slowing dramatically, including Germany where 10-year bond yields dropped below zero for the first time since 2016.
  • China, representing 30% of global GDP growth, is weakening rapidly.
  • Domestic GDP is expected to rise by only 1.50% in the second quarter, which is a sharp reversal from last year.
  • The trade war with China, and to a lesser degree Europe, has not been resolved and could accelerate on a tweet.
  • Despite being 10 years into an expansion, markets at record highs, and unemployment near 50-year lows, the Fed is talking about cutting rates at the end of the month. What does the Fed know that we do not? 
  • The potential for a hard BREXIT is still prevalent.
  • Earnings expectations have fallen markedly along with actual earnings and revenues.

There is much more, but you get the idea.

 

Art Cashin

Moments after the S&P 500 crossed above 3,000 points, Art Cashin, managing director at UBS Financial Services, spoke to CNBC’s “Squawk on the Street” about his forecast for the US economy. Cashin said his hat, with “S&P 3000″ emblazoned on the front, was tongue-in-cheek, cautioning that investors should not get overly excited by the day’s milestone.

Cashin pointed to New York Fed’s recession indicator, which is based off of the spread between the 10-year and 3-month US Treasury yields.

“For the first time in a long, long time, [it] has popped above 30% likelihood of a recession in 2020,” Cashin said. “Whenever it gets up to 30%, it’s had a pretty good history of calling it.”

The New York Fed’s forecast shows is not far-fetched. Here is their latest data showing a roughly 33% probability of recession within 12 months. The longer the yield curve stays inverted and the more it inverts the more probable a recession is. We have now had an inverted yield curve for three+ months and, as I write, are still in that situation. The New York Fed’s model has never reached a probability of 100% prior to any recession. But, if memory serves, there has always been a recession anywhere from 9 to 18 months after the model reaches its current level. The timing isn’t precise, but it’s close enough for our discussion.

 

 

SPY closed at a 52-week high, but nobody seemed to care. Its range and volume were the lowest in months. We’ve never seen this outside of holiday-influenced sessions. All others were in November or December.

 

Stock vs Bonds

Here is another look at the way markets are being distorted due to the latest shift in monetary policy. Normally, bond yields will rise and fall in tandem with stock prices. That, however, has not happened this year.

 

 

Bond yields have dropped to multi-year lows, with the expectation of a slower economy, while stock prices keep jumping to all-time highs, indicating an expectation of a stronger economy. Who is right?

During the second quarter, the earnings per share (EPS) estimates for the S&P 500 dropped 2.6% while the index gained 3.8%.

 

 

The divide between earnings and price was likely due to investor euphoria about lower interest rates ahead. Investors will need to see earnings catch up with stock prices, or an already richly valued market will become even more so.

 

Worldwide Bond Market Bubble

Greek 10-year bond yields are now roughly the same as the 10-year Treasury. Are the risks the same? Absolutely not! The drive for yield worldwide has blinded investors to credit risks, and this is illustrative.

 

 

 

The FED – Observations from Four Economists at John Maulden’s Conference in May of This Year

Lacy Hunt, PhD– What’s going to happen?

  • Lacy thinks we are going back to zero bound (Fed Funds rate to zero percent). He expects velocity to fall, and he’s concerned we will be stuck in a quagmire with a zero percent Fed Funds rate for some time. The yield curve will be a lot flatter. His fund has greater than 20-year duration.
  • It will be ugly economically. He believes the 10-year is going to decline to 1%, and the 30-year is going to bottom at a yield of 2%.
  • We are not going to get growth. We are not yet at the end of the declining rate cycle; we have not yet seen the low in yields.

David Rosenberg – What’s going to happen?

  • Rosie argues that recession is coming, rates are heading lower, and we will move to even more unconventional Fed policy.
  • Rosie sees a future “debt jubilee” where debt gets monetized somehow. Then inflation.

William R White  – What’s going to happen?

Bill says the central bankers’ policies are fundamentally flawed, and their flawed theory has led to flawed policy, both before and after the last crisis. He believes their flawed policy is going to lead to the next crisis.

He said, “We’ve had non-inflationary boom and, in the next crisis, predicts we are going to have a “debt deflationary bust, but what that might morph into is high inflation or even hyperinflation.”

The Fed’s (and other central bankers’) capacity to respond is now significantly reduced.

  • Last time, interest rates were much higher. Now, the interest rates are pretty close to zero in most places and are actually negative in many others.
  • The size of the balance sheets are much larger. In the United States, the Fed’s balance sheet is 20% of GDP, in Europe, the ECB is 40% of GDP, and in Japan, the BOJ is 100% of GDP.
  • There may still be room, but it’s going to be much more limited room due to the degree to which sovereign debt ratios in the advanced countries have ballooned — incredible.
  • And this: The Fed’s “crisis resolution tools are inadequate.” The last time around, the central banks reacted in the right way. Now, “Dodd-Frank has got six separate provisions in it that will prevent the Fed from doing next time what they did the last time.”
  • When you get a crisis, there are three phases. There is crisis prevention, crisis management, and crisis resolution. Crisis resolution comes down to — we’ve got a big debt problem.
  • As you sort of think your way through (the outcome I see), first the deflation and then maybe the inflation, is to also put a lot more emphasis on the geopolitical stuff because increasingly, that’s where the action is going to be taking place.

Felix Zulauf – What’s going to happen?

“When I look at markets, I first start to create a long-term big picture. I look at structural trends in economics, in demographics, in politics, etc. etc. And then I try to analyze the business cycle and where we sit in the cycle.”

  • What is not well understood today is demographics. I do not know of any econometric model that factors demographics into the model. There should be. I don’t know why. They have their models, and they do not adapt.
  • Some numbers… When you look at the OECD-member countries plus China, Brazil, and Russia and you look at the age group of 0-64 year-olds, that age group was growing by 25 million every year from 1950s to early 1990s. Since then, that number has been declining. It was down to 14 million in 2008, the last time we had a crisis. Last year it was down to zero growth. This year will be the first year it is negative at -1.7 million and it goes down to -12 million (estimate) by the year 2030. And then it stays there until the early 2040s. So that’s the demographic picture.
  • Lacy Hunt gave a great lecture about productivity and he explained why productivity is going to remain depressed.
  • Economic growth (GDP) equals Productivity times Population Growth (demographics). When you take these two factors together, we will not see a lot of growth.
  • Our economic system is built on growth. We need growth for the system to survive. So, when the pie doesn’t grow much, all of a sudden you have to fight for market share, and that’s what comes up in trade.
  • First, one starts cheating with currency manipulation, then you set your products up in a way that benefits the local producer and then finally you have tariffs. That’s where we are today and this will get worse and worse over the next 10 years.
  • That’s why we have entered the period of rising conflicts in trade and in geopolitics. This is compounded where a dominating power is being challenged by a rising economic power who also has a strong military – that’s China and the U.S.
  • Over the last 500 years, we’ve had 16 such cases of which 12 ended in outright war, there were smaller wars (like Korea, Vietnam…) and one was a serious war (between Great Britain and the U.S.). So, we are moving into that sort of environment.
  • Then we come to the business cycle. Many people believe the problem in the economy is coming from the trade conflicts, but this is not true. I saw the slowdown coming in late 2017 and put out in my publication to my clients and expected slowdown into the second half of 2019. And we are pretty much on track.
  • The tariff and trade problems are just compounding the slowdown we are seeing.
  • The slowdown is a result of over-tightening in the U.S. and over-tightening in China (because they have to restructure some of the excesses in the financial sector – they realize they can’t go on like this or they will run into even more serious problems).
  • We have a classic slowdown in the world’s two major economies. And Europe heavily depends on China. Half of its growth over the last 10 years came from China directly and indirectly.
  • The slowdown should eventually impact markets.

Bottom line: Felix sees a summer market high to then be followed by a 20% correction starting by the third quarter of 2019 and going into early 2020. It’s possible we will be at 0% Fed Funds rate by early 2020. The central bankers will respond aggressively, the market will bottom (after the 20% decline), and then rally. He sees big swings both up and down in the market over the next 10 years with no net gain in price. We are moving from a “passive investors’” market to “a trader’s market.”

Brian’s summary comments: The other day, I read that 60% of assets under management are in index funds, 20% is in factor/quant strategies, and only the remaining 20% is actively managed. The next 10 years will be where our models should put a huge gap between our performance and the expected flat markets!

 

Has the Quantitative Easing Fed Strategy Worked Since 2009?

Key Points:

  • Pre-2009 research found output losses were deeper and more persistent when sparked by a banking crisis rather than normal recession.
  • In 2009, 91 countries accounting for two-thirds of global GDP suffered output declines, more than twice as many as the harsh 1982 recession.
  • Of the 24 countries that experienced banking crises, 85% still show negative deviation from their pre-crisis growth trends.
  • Sluggish investment in these countries contributed to a worldwide productivity slowdown over the last decade.
  • In the US, real per capita GDP grew at a 2.1% average rate from 1970-2007. It is now almost 13% below where that trend line would have it.
  • At the recent 2.6% growth rate, it would take the US economy until 2048 to get back to its previous growth trend.

Bottom Line: We can debate whether QE (Quantitative Easing), ZIRP (Fed low interest rate strategy), and other extraordinary policies were necessary or effective. Regardless, mounting evidence suggests they can’t restore the kind of growth that was normal pre-2009. That world is gone and not coming back. Yet, central banks and governments persist in thinking they can restore it. Their “help” may cause more harm than good.

 

Should the Fed Cut Rates?

Key Points:

  • Ohio State coach, Woody Hayes, used to say of the forward pass, “Three things can happen, and two of them are bad.”
  • Similarly, but even worse, the Federal Reserve has three choices: cut rates, hike them, or do nothing. All have potentially serious negative consequences.
  • Opting not to change rates would surprise markets and expose divisions within the FOMC and fuel more speculation about future meetings. Eisenbeis calls this “the Chinese water torture option.”
  • Yet, a rate cut (of any size) also creates problems. President Trump will say it confirms his assertions that the Fed’s previous choices were wrong. It will also add to perceptions the Fed caved to political pressure.
  • Pressure for further cuts will continue and likely intensify, reducing the Fed’s flexibility if the recession threat grows.
  • It is not clear that either trade war fallout or global slowdown justify the kind of “insurance cut” Jerome Powell has mentioned, yet he has left himself little choice but to implement at least one.

Bottom Line: Rate cuts now mean the Fed will have less room to cut if recession appears in 2020 or later. That may not matter because it’s not clear lower rates would soften a recession in any case. However, the last thing we need is for the Fed to be forced into negative rates because it has no other options. That may be where they’re headed, though.

The Fed is dead set on shielding the economy from further weakness with rate cuts.

“It’s better to take preventative measures than to wait for disaster to unfold.” John Williams, NY Fed

 

Market Data
  • Within days of the Nasdaq Composite closing at a new high, there were more stocks sliding to 52-week lows than rising to 52-week highs on that exchange.
  • A Hindenburg Omen triggered for both the NYSE and Nasdaq on Thursday. According to the Backtest Engine, there have been 200 days since 1962 that triggered an NYSE Omen and a month later the S&P 500 was higher only 29% of the time.
  • For the first time since October 2018, there are hints of trouble brewing beneath the market. While major indexes have been at or near all-time highs, under the surface there are more and more stocks losing momentum, and there has been a split with many securities at 52-week highs AND lows.