The problem with calls for “S&P 4000” is there is no technical or fundamental basis for the assumption.

From a fundamental perspective, if we assume current 2021 estimates are correct, the market will be trading at 26x forward reported earnings. However, given estimates are regularly 30% too high, forward reported earnings will be closer to $130/share leaving valuations at 30x.

Valuations may not seem to matter currently. However, if the economy continues to lag, and employment and wages weaken, they will. Corporate earnings and profits are going to become more critical. Already, the deviation between the market and corporate profits is at extremes. As with all extremes, an eventual reversion completes the cycle.

 

 

Furthermore, given the depth of the profits decline, it is improbable that earnings will remain at these levels and not worsen.

 

 

Importantly, while “valuations” may not seem to matter at the moment, they always, without exception, eventually do.

Technical Deviations

Secondly, the technical trends don’t support S&P 4000 either.

From the 2009 lows, the S&P has traded withing a fairly defined trend channel, as shown below. The upper bullish trend line, which coincides with the February 2020 market peak and the polynomial trend line, suggests 3750 as the next target.

 

 

As noted above, this would suggest a 12.2% advance from Friday’s close. While the 4000 number sounds excellent, it would violate trends that have existed for 11 years.

Furthermore, 3750, much less 4000, is going to stretch the deviation from the long-term bullish trendline (lower line) to more extreme levels. The last time the market reached this extreme was in February of this year. It is also notable that 3750 also intersects with the accelerated trendline from the 2016 lows.

 

 

With the market at all-time highs, there are numerous warning signs of excess built up, which could trigger a reversion.

  • Low participation
  • An extremely low put/call ratio (speculative excess)
  • Markets trading 2 and 3 standard deviations above their means
  • Large deviations from respective 200-dma’s
  • High levels of investor optimism
  • A historical deviation between value and growth
  • A high level of equity allocations
  • Technical extremes

Light at the End of the Tunnel

The problem for investors currently is there is precious little that hasn’t already been fully priced into the market.

  • A full economic recovery
  • A return to full unemployment
  • More stimulus
  • Low bond yields
  • No recession
  • A return to pre-pandemic earnings levels

 

Market Valuations and Future Returns

 

Warren Buffett’s favorite valuation indicator. It compares the total Stock Market Capitalization (the value of 3,800 stocks: their shares outstanding times current price) to Nominal GDP. The value of US common stocks vs. what the US produces.

It’s notable that the July month-end reading is higher than it was at the tech bubble peak in 2000, pre-Great Financial Crisis in 2008, and just prior to the 1929 stock market crash. Just focus in on the blue line. Not the “We’d be better off here” arrow. A price reversion back to or below the upsloping dotted black line is your returns will be good again target. There, 10% 10-year annualized returns are probable.

 

 

Valuations tell us a great deal about coming returns. Take a look at the 10-year real return forecasts:

 

 

The 10-year traditional 60/40 allocation outlook at -0.20% won’t cut it. Show these numbers to the local politician forecasting a 7% annualized pension plan return. Not going to hit the bogie.

Not sure how this will play out, but I’m pretty sure -0.20% will not pay the pension bills.

 

The Fed

 

Never has the Fed provided so much money. Note the spike in the money supply in the next two charts from Rosenberg Research:

 

 

 

US Economy

 

The list of companies filing for bankruptcy so far in 2020 includes 112-year old gas-engine maker Briggs & Stratton… acrobatic-show company Cirque du Soleil… gym operator 24 Hour Fitness… restaurant chain California Pizza Kitchen… vitamin and supplement retailer GNC (GNC)… Ascena Retail, owner of women’s apparel stores Ann Taylor, Loft, and Lane Bryant… and most recently, Lord & Taylor, the country’s oldest department store.

And unfortunately, this is just the beginning. Things will get much worse. We can see what’s coming by looking at the number of companies whose credit has been downgraded. Downgrades are an early warning sign… They always come before defaults.

So far this year, S&P has downgraded the credit of more than 1,970 companies, including 1,100 in the second quarter. That’s already more than any year on record. Take a look.

 

 

Watch the “Weakest links”.  These are companies with already poor credit ratings (“B-” or lower) that are on negative credit watches or with negative credit outlooks from S&P.

As you can see in the following chart, the number of weakest links globally is now at an all-time high of 611. It’s more than double the peak during the 2008-2009 financial crisis.

 

 

The default rate for the weakest-link companies is around eight times higher than the overall default rate.

In other words, we can expect the default rate among weakest links to soar soon… and the overall default rate to follow. When the default rate soars, investors panic.

Add to this how banks are tightening credit, making it MORE difficult to get a loan.  In the latest Federal Reserve survey on the lending standards of large and small banks across the U.S., more than 70% of banks said they’re tightening credit. That’s the highest percentage since October 2008.

And tighter credit conditions often precede a soaring default rate. Take a look.

 

 

This is important…

Many companies that rely on banks to simply “roll over” their debt when it comes due will have nowhere to turn when banks are tightening. These borrowers depend on new loans to pay off their existing debt as it comes due. Without access to new credit, they’ll simply die.

A trend of tightening credit will hasten the wave of bankruptcies.

The U.S. high-yield default rate is about 5% today. That means only 5% of all corporate borrowers have defaulted over the past year. That’s only slightly higher than its long-term average of 3% to 4%.

But S&P is now forecasting that the high-yield default rate will rise to 12.5% by next March. That would be the highest default rate since the Great Depression in 1932.

S&P’s current “pessimistic” forecast projects the default rate to reach 15.5%, up from 13% just a few months ago. As you can see, the storms will likely get much worse.

 

COVID Damage to US Economy

 

I have argued that unless a solution is found by September, the probability that the recession could turn into a depression would mount. A recession is a normal part of the economy, a primarily financial event that imposes disciplines on an overheated economy. A depression, from a geopolitical standpoint, involves the physical destruction of the economy, something that lays waste to businesses, dislocates labor and vaporizes capital. A recession is the economy cycling. A depression is an economy breaking.

I chose September because two quarters of intense economic contraction is instructive. Economists’ definition of a recession is two successive quarters of negative growth (also known in English as decline). This is generally enough time to understand how resilient an economy is. Uncoincidentally, it is also the point at which economies begin to recover in normal cycles. Under normal circumstances, basic economic structures remain intact during recessions so financial stimulus measures can restart the system.

Just for the record, there have been five depressions in the history of the US: 1807–1814; 1837–1844; 1873–1879; 1893–1898; 1929–1941. I believe all of them were associated with banking crises and financial panics.

The first four “depressions” were indeed banking panics. But they were also associated with the agricultural cycle.

Farmers would borrow money in the spring and pay it back after the fall harvest. Money would move from money-center banks in the big cities, especially New York, to smaller banks out in the country. And then back.

Not long afterward, the US became less dominated by the agricultural cycle and more dominated by the manufacturing cycle.

Up until 2000, recessions were associated with the manufacturing cycle. But those became milder over time. That is because manufacturing had less of an impact on the economy.

Going into 2020, 85% of the US economy was in the service economy. The Great Recession was caused by financial excess, but we worked through it.

And then we get to the current crisis. And something happened that never happened before…

We literally shut down 30% to 40% of the service economy. Wiped it out. Restaurants, hotels, gyms, airlines, tourism, all manner of personal services. The list can go on forever.

Potentially 85% of independent food establishments, gone forever.

It’s not just restaurants…

Half of hotel rooms in the US are empty as of six days ago. They need at least 80% occupancy to break even. Some 70% of hotels in India are expected to close.

Hotels that depend on tourism? Toast. Airlines? The list goes on and on.

Here are some bullet points:

  • The service economy has imploded.
  • We have seen the largest central bank intervention, not just in the US but in many parts of the world, ever in history.
  • Federal Reserve policy and, to some extent, government policy has short-circuited both Schumpeter’s creative destruction cycle and moral hazard.
  • Global trade is beginning to implode.
  • On average, six companies with assets larger than $50 million have filed for bankruptcy every week since April.
  • The working class will be last to see the recovery.

Now for some good news…

  • Entrepreneurs will re-emerge, and new ones will seize this moment to shine.
  • We are in the midst of The Greatest Transformation in history.

In Summary, there are three economic takeaways:

  1. This is going to change the way we live. This crisis is simply the greatest demand destruction of our lifetimes. It will come back, but it is not going to come back to what it looked like in 2019. Our future economic buying decisions are going to be different.

Everything, I mean everything, is going to be repriced and thought through. You can’t take anything for granted. Inflation numbers and measures are going to be warped for at least a few years. We are using old tools to measure a new economy. We are going to have to develop new models to appropriately analyze the world we now live in. How do we value the price of a home or apartment? I don’t think it is unreasonable to expect 10% unemployment, or something close to it, in the middle of 2021. That is going to affect prices up and down the housing value chain.

How do you value retail and office space? If your tenants are gone, do you pay the mortgage? Hotels will come back, eventually, but who is going to own them? The old private-equity owners or the new ones? At what price? We already knew we had too many retail stores. What is the correct number in the future? How will malls and commercial space be repurposed?

Hundreds, if not thousands of planes are sitting on the tarmac. Who is going to own them?

  1. Inequality is not going to get better.It’s a battle between the Fed’s $750 billion SPV to buy corporate IG (Investment Grade) and HY (High Yield) bonds and those who don’t have access to this free money. And funds are buying what the Fed is buying. Thus, the oversubscription of new offerings. ETFs must put the money to work. It’s insane but that is what is happening. Also, companies who can access debt and those who can’t. Unprecedented government stimulus has allowed more companies to borrow at lower rates than ever before. Yet amid the credit boom, smaller firms that power America’s economic engine are often being shut out. PPP money has run out, stores are boarded up, and survival capital for many small businesses is hard to find.

It’s about to get real.

On the winning side are tech firms and online retailers who have issued debt at low rates, loading up on capital. Losers are the brick-and-mortar retailers and mom & pop shops. They are collapsing. Banks are tightening lending standards. They also raised interest rates, raised collateral requirements, and are charging higher fees. Nearly a third of the companies in the Russell 2000 Index are financially insolvent. They’ve been living off debt. When access to capital dries up, doors shut. Many businesses will never come back.

  1. We have two major cycles coming into play at the same time in this decade. Two separate cycles in American history, an 80-year cycle and a 50-year cycle. Both are disruptive. For the first time, they coincide in the latter part of this decade.

The 2020s will bring dramatic upheaval and reshaping of government, foreign policy, economics, and culture.

I am a believer in the entrepreneurial free market society, and I believe that is what will ultimately bring us into that period that George Friedman calls “The Calm” after the upheaval of the ’20s.

 

What US-China Decoupling Means for the Dollar

 

China, the world’s largest commodity importer, pays for the goods in US dollars and is one of the biggest anomalies in global markets. This is unlikely to continue. Dollar bulls may not like the consequences.

Key Points:

  • China began paying for commodity imports in USD only because its post-2000 economy grew faster than a parallel financial system could be built.
  • Now being “anti-China” is possibly the only bipartisan issue in an increasingly polarized Washington DC.
  • Yet markets presently believe China will keep itself reliant on USD indefinitely, even as geopolitical winds blow the other way.
  • More likely, China will shift its trades to settle in either renminbi or gold.
  • The most likely scenarios are bullish for gold and renminbi bonds, and bearish for the dollar.

Bottom Line: The US dollar faces a significant downward adjustment if China manages this transition. Central banks will hold fewer dollars because they will no longer need them to settle Chinese import transactions. The question is no longer “if” but “when.”

 

Market Data

 

  • How low will the S&P 500 dividend yield go?

 

 

  • Overall speculative activity is now the highest since the spring of 2000.
  • The S&P 500’s total return index, which includes dividends, has hit a new all-time high. The equal-weight version of the index, which puts all of the stocks on equal footing, is still more than 7% below its own high. This has only happened on four other days in 30 years, in late 1999 and early 2000.
  • The S&P 500 ETF, SPY, has stretched more than 11.5% above its Volume-Weighted Average Price (VWAP) over the past 250 sessions. This is a large deviation from its trend, one of the few times in 25 years it has rebounded from far below average to far above it.
  • Global stock market capitalization is higher than global GDP for one of the few times ever. Even just the valuation of U.S. stocks is nearing half of global output, a level seen only twice before in the past 60 years.
  • A handful of times over the past month or so, we’ve noted weak breadth readings despite big gains in some of the indexes. So far, it has not mattered one whit. It happened again on Wednesday, with the Nasdaq Composite gaining more than 2% yet its Up Volume Ratio was only 53%. That is the lowest in history, dating to 1984, on a day the Composite gained more than 2%. There have been 6 other days when the Up Volume Ratio was below 60% on a day with this large of a gain in the Composite, and they were not auspicious: 1999-04-05, 2000-03-21, 2000-03-31, 2000-04-17, 2000-05-24, and 2000-08-03.
  • The average holding period for stocks has declined sharply over the past few decades.

 

 

  • This has been the 2nd-best start to August in 30 years, only exceeded by the year 2000. The S&P 500 has rallied 7 out of the first 10 days, gaining more than 2% in the process. After the other “best starts to August” the S&P showed a negative return either 2 or 3 months later after 8 of the 9 signals.

 

 

 

All content is the opinion of Brian J. Decker