The policy interest rate in the US is higher than all other developed countries. There’s more to that fact than a shoulder shrug. A big gap in the policy rate between the US and most other developed countries have historically coincided with recessions and market downturns, as you can see in the chart below.
Kevin Muir, strategist at Toronto-based East West Investment Management, calls it the most important chart in the world.
What Are Corporate Insiders Doing With Their Stock?
Insiders have sold $19 billion in stock so far this year. If that pace continues, insider sales are on track to hit $26 billion for the full year. If we reach that figure, it would be a two-decade high.
Such heavy insider selling could reflect a dismal outlook for the market and the economy.
What About S&P 500 Earnings So Far This Quarter?
Of the 113 S&P 500 companies releasing Q3 guidance (as of September 27), 82 have been negative. That number is way above the five-year average of 72.
The Information Technology and Health Care sectors have led the way to higher numbers. The 29 Info Tech companies that have issued negative guidance are 45% higher than the five-year average. If that 29 number holds, it will be the highest number since 2006.
Quantifying Trade War Risk
US stocks have held up during the US-China trade war, in part because investors think the US economy is less export-dependent. Gavekal’s Tan Kai Xian says this belief may be mistaken as further escalation could sharply reduce US corporate profit margins. He shows the numbers in this short analysis.
Key Points
- US political trends point to a harder line on economic engagement with China, no matter who is in the White House after 2020.
- The likely outcome will be a substantial reversal of the 30-year globalization megatrend.
- Globalization was a main driver of the structural growth in US corporate profit margins since the early 2000s and in the structural increase in the share going to capital instead of labor.
- A return to pre-2000 labor cost share would reduce the US after-tax return on invested capital from its current 4.7% to 2.5%.
- In Wicksellian analysis, this brings the US much closer to the recession frontier.
Bottom Line: The part Gavekal doesn’t mention is that de-globalization is happening even without a trade war as technology brings production closer to consumers. The US-China dispute is accelerating pre-existent trends. That implies the profit compression is coming, too, regardless of trade policy. The real question is when.
Trade War Options: US vs China
Plan A – Assuming we are correct and Trump does ‘cave’ into China in mid-October to get a ‘small deal’ done, what does this mean for the market?
The most obvious impact, assuming all ‘tariffs’ are removed, would be a psychological ‘pop’ to the markets which, given that markets are already hovering near all-time highs, would suggest a rally into the end of the year.
Plan B – No trade deal, no new tariffs.
Unfortunately, that outcome does little for the market in the short-term as existing tariffs continue to weigh on corporate profitability, as well as consumption. Given that earnings are already on the decline, the benefits of tax cut legislation have been absorbed, and economic growth is weakening, there is little to boost asset prices higher.
Therefore, under this scenario, current tariffs will continue to weigh on corporate profitability, but “hopes” for future talks will likely continue to keep markets intact for a while longer. However, as we head into 2020, a potential retracement will likely occur as markets re-price for slower earnings and economic growth.
Plan C – No trade deal, plus new tariffs.
The second outcome is more problematic.
In this scenario, Trump allows emotion to get the better of him, and he blows up at the meeting. In a swift retaliation, he reinstates the “tariffs” on discretionary goods and increases tariffs across the board as a punitive measure. The Chinese, in an immediate retaliation, levy additional tariffs as well.
With both sides now fully entrenched in the trade war, the market will lose faith in the ability to get a “deal” done. The increased tariffs will immediately be factored into earnings forecast, and the market will begin to re-price for a more negative outcome.
US GDP Estimates
Economists are less optimistic of GDP numbers (especially with soft consumer spending figures). Morgan Stanley downgraded its Q3 forecast to 1.5% from 2%, while Oxford Economics is expecting 1.3%.
Below, Is The ISM Manufacturing Report That Takes The Market Last Tuesday
The September ISM manufacturing PMI report, which was below economists’ forecasts, shows US factory activity is rapidly shrinking (PMI below 50). We have talked about this for many weeks.
Manufacturing In Europe Has Slowed, Even With ECB (European Central Bank) Lowering Rates As Stimulus
Mexican Manufacturing Is In Trouble
Russia’s Factory Activity Is Shrinking At The Fastest Pace Since 2009
Soft/hard economic momentum gap has widened sharply, as surveys pick up more uncertainty. Soft data has led the markets. See the downward gap below.
What, Then, Is Holding The World Economies Together? Services, But Even Services Are Slowing.
The ISM Non-Manufacturing index surprised to the downside, suggesting that the latest slowdown is not limited to US factories.
Bruce Mehlman: Tech Policy’s Fall And Future
The technology sector is arguably as important to the US economy as oil is to some OPEC countries. It’s both a key export and the fuel that drives domestic consumption. Yet, their very success now has tech companies on the defense against their customers, workers, and particularly government policy. Washington expert Bruce Mehlman outlines the politics and players in this short piece.
Key Points
- The “techlash” is highly company-specific. Microsoft is not under the gun, for example, and the industry’s overall public image is net positive. Attacks have focused on social media and e-commerce segments.
- “Technology” has a muddled definition. We have to distinguish between companies that produce technology (Apple) and those that use technology in innovative ways (Uber and Netflix). The latter are often categorized in other sectors.
- Attacks on “big tech” are increasing on both left and right. This will likely intensify as the 2020 campaign season approaches.
- It isn’t just Washington. Other national governments are increasing scrutiny, as are state and local governments within the US.
- Antitrust, privacy, cybersecurity, and taxation are all distinct policy areas with varying degrees of vulnerability.
Bottom Line: Mehlman sees three broad trends developing:
- The US-China technology decoupling,
- pressure on companies to represent more stakeholders, and
- calls to address inequality and competition issues.
He believes major change is coming whether the companies like it or not. Companies that “disrupt” society are finding that society can push back.
Four Signs Of A Potential Turn In The Market
1. An Aging Bull – Our current bull market began on March 9, 2009. It turned ten years old this past March, which makes it the longest bull market on record. In fact, as of March, this bull was 78% longer than average bull market length of 54 months.
2. Elevated Valuations – In simplest terms, we believe the stock market is overvalued. Below is the respected “Buffett Valuation” (based on Warren Buffett’s fondness for this metric, calling it “probably the best single measure of where valuations stand at any given moment”). It compares the total value of the stock market to a country’s GDP. As of the time of this writing, the US Buffett valuation is about 1.3, meaning the stock market is about 30% larger than the entire US economy. Historically, markets start getting in trouble when this ratio passes 1.0. If you’re wondering, the ratio hit a top of around 1.1 before the 2008 crash.
For another example, here’s my favorite Shiller 10-year PE (CAPE) ratio.
Note, we’re at the highest valuation we’ve seen since the record-highs in the 2000 crash. For any Shiller-detractors, don’t miss the main point. Pick a basket of your own favorite valuation metrics, and, collectively, they’ll provide you the same “overvalued” takeaway. Some indicators are even at all-time highs. We could argue over how accurately any single, specific valuation metric approximates by how much, but that would be largely irrelevant. If you look at a basket of common valuation metrics – things like price-to-earnings, price-to-book, price-to-free-cash-flow, and so on – they’re all generally saying the same thing: the market is expensive.
Economist and asset manager John Hussman chimed in recently on Twitter, pointing out that the most overvalued 10% of stocks in 2000 lost 80% of their value in the bear market that bottomed in the fall of 2002. Hussman added ominously, “Currently, every remaining decile (1/10) of S&P 500 components trades at a richer [price-to-sales ratio] than in 2000.”
In other words, 90% of US equities are more expensive right now than they were at the peak of the dot-com bubble. By implication, the inevitable bear market will be a lot more painful than the 2000-2002 rout that took the benchmark S&P 500 Index down 49% and the Nasdaq Composite Index down 78%.
3. Sentiment – Then, there’s investor sentiment. When everyone is loving the stock market and convinced it’s going higher, it’s often an unwise time to expect new highs in the market. There are several different investor sentiment indicators suggesting investors are more bullish than ever, but I’ll just draw your attention to a recent Meb Faber Show podcast with Doug Ramsey from Leuthold. In the podcast, Doug told us this is the most optimistic sentiment he’s seen in the last eight years. Remember Warren Buffett’s adage: “Be fearful when others are greedy and greedy when others are fearful.”
4. Lack of Volatility – To illustrate our fourth, and final, red flag, let’s borrow a popular cliché from Hollywood: “It’s quiet. Almost too quiet.” To make sure we’re all on the same page, the most common measure of volatility is “the VIX.” VIX is the symbol for the Chicago Board Options Exchange Volatility Index. Without getting into too much detail, it’s a measure of expected stock market volatility over the short term (ensuing 30 days). The general line in the sand separating calm markets from fearful markets is a VIX reading of 20. At the end of January, the VIX dropped below 10 for the first time in a decade. On June 9, the VIX dropped to 9.37, which is the lowest reading in 23 years. Even the Fed is concerned. The Fed minutes from the January report to Congress read, “They also expressed concern that the low level of implied volatility in equity markets appeared inconsistent with the considerable uncertainty attending the outlook for such policy initiatives.”
Solutions
- Our clients have emergency cash built into their plan with FDIC insurance on those funds.
- Our clients have laddered, principal guaranteed accounts from which they distribute their income for the next 10 to 20 years. Market declines will not hurt principal.
- The Risk bucket did well in the last two bear markets of 2000 to 2002 and in 2008. We expect the diversification of Equity, Gold, Silver, Oil, and Treasury Bond strategies to help as well as two-sided strategies for each asset class.
Market Data
- Late cycle behavior – Investors have become concerned that we’re late in the business cycle and potential recession. News articles catering to the fears are abundant. Over the past year, sector and factor returns supposedly support this view.
- Confidence conflict – Over the past week, we learned that “dumb money” consumers are still supremely optimistic, while “smart money” insiders like CEOs and purchasing managers are the most depressed in a decade. That seems like an ominous spread.
